A red rag to the Revenue

A high-income fund investing in Latin America is testing the rules on PEPs. Steve Lodge reports

A firm specialising in emerging markets investment claims to have discovered a loophole in the PEP regulations that could provide investors with the highest-income PEP yet.

But the claim risks falling foul of the Inland Revenue, which is already concerned about the high-income PEPs being put together for investors.

Baring Asset Management claims its new Sovereign Debt Trust - which invests in the bonds of such countries as Mexico, Peru and Argentina, and offers an income of 11.5 per cent - fully qualifies for a PEP, allowing for tax-free income.

You cannot normally put a full pounds 6,000 PEP allowance into high-yielding emerging market bond funds. Barings is the first to challenge this view. Barings claims its new fund does qualify because it is incorporated elsewhere in the EU, in Ireland. It says the PEP regulations do not exclude emerging market bond funds that are Irish companies, although they would if the same fund was set up in the UK.

But David Thomas of stock brokers Greig Middleton & Co, which is the chief promoter of the new fund, said: "Whether the PEP office [the Inland Revenue] is going to throw a tantrum remains to be seen."

The worry for potential PEP investors should be that the Revenue might rule the fund outside the PEP universe. Investors who buy the fund hoping to take its income tax-free would end up with a less tax-efficient investment and might incur costs removing it from their PEPs.

The Revenue declined to comment specifically on the new fund, but it has recently expressed concern about the launch of PEPs which are against the spirit of what was originally intended by the Government. Last Budget, Kenneth Clarke widened the choice of investments for PEPs from shares to bonds. The idea was to help smaller and medium-sized UK companies raise finance. Emerging market bonds could hardly be further from this.

Previously the Revenue's main worries have been that the PEP widening should not solely provide a cheap source of finance for bigger companies - particularly not for financial companies - and that investors should take risks to benefit from the PEP tax breaks. Bond PEPs already launched by Legal & General and Johnson Fry, offering a fixed 7 per cent tax- free a year for five years, with your money back at the end, have been seen as pushing at the spirit of the regulations, as have suggestions for other guaranteed products. Some years ago the Scottish investment firm Abtrust claimed it could offer a PEP wholly invested in gilts by using a fund set up in Luxembourg. But it withdrew the product. The Revenue declined to say whether this was any sort of precedent.

Solicitors for the new Baring fund said there were other reasons for setting up in Ireland than exploiting the PEP loophole. A similar fund set up in the UK, such as an investment trust, would in tax terms be a relatively inefficient way of investing in bonds even if the fund fully qualified for PEPs, they said. But the solicitors foresee other funds taking advantage of the loophole.

The fund is the first to be launched by Barings since its parent bank crashed earlier this year after lack of control of investment activities in Singapore. ING, a Dutch bank, now owns Baring, having rescued it.

Barings says that as well as providing a high-income, emerging market bonds are less risky than emerging market shares, which is what most small savers in funds investing in Asia and other emerging markets are exposed to. Despite recovery since the Mexican crash last year, Barings believes emerging market bonds are still cheap.

At least half of the fund will be in Brady bonds, which is restructured debt, mostly of Latin American countries. These bonds came out of plans initiated by the then US Treasury Secretary, Nicholas Brady, for a number of less-developed countries, aimed at returning them to the economic straight and narrow after debt defaults in the 1980s.

Barings is not offering a PEP for the new fund, which means any investors will have to buy a PEP elsewhere and transfer the new fund's shares into it.