Budget Brief: ACT back under the microscope: Enhanced scrip dividend could be in danger, say Terence Wilkinson and Heather Connon

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The Independent Online
EVERY year, UK companies lend pounds 300m to pounds 500m to the Inland Revenue in the form of advance corporation tax, a sum that they may never see again.

Grim as public finances are, they would look a lot worse were it not for an estimated pounds 3bn to pounds 5bn of unrelieved ACT. In effect, this is a free and indefinite loan to the state that has accumulated over the years and is increasing by about 10 per cent a year.

Unrelieved or surplus ACT scarcely attracts the public notoriety reserved for VAT on pensioners' heating bills. But it is big money and a matter that greatly exercises the minds of finance directors.

Earlier this year, City brains came to the rescue of companies saddled with this tax burden. An ingenious wheeze, called enhanced scrip dividends, appeared to be the answer to a finance director's dreams.

But the wheeze has proved controversial among a number of large investing institutions and, after costing the Inland Revenue about pounds 400m in lost tax (according to calculations at the stockbrokers Kleinwort Benson), it could well come under fire in Kenneth Clarke's Budget at the end of this month.

ACT is a prepayment of a company's mainstream corporation tax bill. It is levied when dividends are paid. Shareholders receive a tax credit for the amount to show that tax has been paid out of the company's earnings.

If the investors are standard-rate taxpayers, they are not liable for any more tax. Non-taxpayers - pension funds, for example - can claim repayment of the credit, while higher- rate payers will have to settle up with the Inland Revenue.

The pleasing symmetry of the ACT system breaks down when the amount of ACT paid on dividends to shareholders exceeds a company's mainstream UK tax liabilities. Businesses in this position find they are paying over large sums to the Revenue that accumulate as prepayments until UK profits grow large enough to absorb them.

In his March Budget, Norman Lamont, the then Chancellor, showed he had recognised at least part of the surplus ACT problem. Next year's Finance Act will introduce an optional foreign income dividend scheme allowing ACT to be repaid out of profits originating overseas.

But also in his last Budget, Mr Lamont took pounds 500m from the tax- privileged pensions industry by reducing the tax credit attached to dividends from 25 to 20 per cent - an amount non-taxpayers such as pension funds can reclaim from the Revenue.

If Mr Clarke eliminates the credit, the Institute of Fiscal Studies estimates that he could boost the public purse to the tune of pounds 3bn. The National Association of Pension Funds is predicting dire consequences for schemes if the temptation proves too great for the Chancellor, since the income of funds and the value of their assets would be lowered as a result.

The fate of enhanced scrip dividends is another matter. They were dreamt up by Barclays de Zoete Wedd, the merchant bank, which saw them as an elegant way of persuading investors to help companies alleviate the problem of unrelieved ACT, at no cost to themselves.

BZW built on the virtues of ordinary scrip dividends, which do not carry any ACT because they are paid in shares rather than cash. So the greater the number of shareholders who opt for them, the lower the tax bill of companies that do not make enough UK profits to offset the ACT bill.

But just as companies do not have to pay ACT on scrip dividends, so tax-exempt investors such as pension funds - which account for a significant proportion of the stock market - cannot reclaim a tax credit on them. That made them unattractive to most investors and their take-up was generally low.

BZW's scheme aimed to twist shareholders' arms by offering them 50 per cent more than the cash payment, providing they took the dividend in shares. There would still be no tax credit but the increase in the dividend level meant shareholders should be no worse off. And to ensure that investors could still have the cash if they wanted it, BZW offered a special dealing facility under which they would sell the shares in the market on the investors' behalf.

When the scheme was first unveiled, by the tobacco and financial services group BAT, it looked almost too good to be true. Its tax rate last year was 41.5 per cent as BAT suffered from the fact that it makes much of its profit overseas. But the ACT on its dividends had to be offset against tax on its UK profits. By offering an enhanced scrip dividend it saved pounds 97m of ACT, and provided it could earn at least a 9.3 per cent return on the money saved, its earnings would be unaffected. The scheme also saved BAT up to pounds 330m in cash.

BZW said at the time that only a 'large handful' of FT-SE 100 companies would satisfy the two criteria for a successful enhanced scrip: unrelieved ACT and the ability to generate a sufficient return on the money saved to avoid earnings dilution. Investors would have added a third: that the company could afford to pay a fully covered cash dividend and was not just using the enhanced scrip to keep funds within the business or avoid a dividend cut. Otherwise, the scheme would be nothing other than a mini-rights issue.

That became clearer as others rolled out their scrips. Companies such as Redland, Ladbroke and Lucas had to work hard to justify maintaining their dividends and were also heavily borrowed. So they were likely to have been attracted to the scheme as much by the cash saving as the tax benefits. While all have overseas interests, their ACT problems were also due to the recession and, unlike those of BAT, could be expected to fall away as recovery advanced. Meanwhile, all these companies would have their work cut out demonstrating that they could make a good enough return to prevent dilution.

Investors were also aware that while there may be a tax-saving this year, enhanced scrips were merely compounding the problem for future years. The extra shares in issue - up to 4 per cent in the case of BAT, rather more for other companies - would mean a higher dividend bill, and thus more ACT, in future.

And they are becoming increasingly reluctant to support them. One investor told North-West Water it would only support the scheme for one dividend payment; repeats would not be welcome. While the company could justify the scheme on the grounds that it would invest the money in its unregulated businesses overseas, where returns were acceptable, other water companies more dependent on their core UK businesses would be rejected.

Even if the Chancellor decides to leave the enhanced scrip scheme alone, institutions may eventually ensure it dies quietly. Already, at least two companies have been told that an enhanced scrip would not be supported. And opposition is, if anything, growing.

A graphic example of the problems it can cause came from Automated Securities Holdings. Just three days after the reference price for its enhanced scrip was set at 136p, it issued a profits warning and its shares plunged to 102p. BZW resigned after it refused to cancel the scheme, but the experience will have made shareholders wary.

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