Budget's bite on business: Reform of advance corporation tax could drive up pension costs and dividend expectations, writes Richard Thomson

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The Independent Online
WHEN Norman Lamont sat down after his Budget speech on Tuesday, he had at least managed not to panic the financial markets. He had attempted a balancing act - addressing the Government's debt without choking recovery - and the stock market seemed willing to give it a chance. The FT-SE 100 index fell only 50 points or so last week.

On the face of it, the Chancellor has offered little that is positive to corporate Britain or to the stock market.

For a start, there was no interest rate cut, which many companies had been expecting.

But the biggest blow was his reform of Advance Corporation Tax. In theory, this will benefit corporate Britain by cutting the tax which it pays to the Inland Revenue on dividends. But there is a snag. The Chancellor also cut, from 25 per cent to 20 over the next two years, the tax rebate which big, tax-exempt institutional share investors (mainly company pension funds) are now able to claim on ACT. By 1995-6, the reforms will bring an extra pounds 900m into the Exchequer from companies and investors.

These tax-exempt funds account for more than 45 per cent of the stock market, and the reduction in their tax credits, taken on its own, could mean a drop in their investment yield of about 6 per cent (see panel).

To compensate for the loss of yield, share prices on the FT-SE 100 would have to fall by about 200 points. If they do not drop by that much, the institutional investors will have a strong incentive to switch out of equities and into the higher-yielding property market, foreign stock markets and especially the gilts market - which would please the money-hungry Treasury.

Because company pension schemes will be affected by the ACT change, companies may find they have to contribute more to maintain the value of benefits. The funds' income will be reduced, and since they are valued by calculating their future income stream, the values will fall immediately - by up to a third or a half in many cases, according to Nigel Hugh-Smith, investment strategist for Hoare Govett.

Since some large corporate funds have been depleted in recent years by contribution holidays - more than half the members of the National Association of Pension Funds had reduced or stopped payments last year - the extra cost could be high. Contribution holidays will have to end sooner than most companies had anticipated.

This is not the only way in which the Chancellor's ACT reduction will raise costs for a corporate sector already hard pressed by recession. Institutions are already indicating that they will want to be compensated for the fall in their investment yield by higher dividends. They argue that many companies will get an immediate cash-flow advantage from the lower ACT payments and should pass this along to shareholders immediately.

This could well swing investors' interest away from high to lower-yielding stocks on the grounds that the latter have more scope to raise their dividends. According to Sushil Wadhwani, equity strategist for Goldman Sachs, top of the list will be low-yielding stocks in sectors such as stores, food retailing, health and household products, electronics and business services. High-yielding sectors like construction, motors and conglomerates will suffer.

At this stage, few City folk are willing to stick their neck out and predict how specific companies will be affected. According to James Capel, those that can afford to raise their dividends without trouble include companies as diverse as BTR, Grand Metropolitan, Cadbury Schweppes, Unilever, Glaxo, SmithKline Beecham, Wellcome, Granada, Pearson, GUS, Kingfisher, Marks & Spencer, WH Smith, British Airways, National Power, Abbey National, Lloyds Bank and water groups.

Companies with limited scope to raise dividends, however, will find themselves at a sudden disadvantage in the stock market. James Capel includes in this list Redland, Rolls- Royce, British Steel, United Biscuits, Forte, Carlton, Reuters, Hanson, Tomkins, Lonrho, P&O, BP, Shell, Barclays and National Westminster.

Some of these companies, such as Hanson, may even have a double disadvantage because they have built up an ACT surplus (see panel). This may be offset against corporation tax earned in Britain in future years, but by then the tax rate - and hence what they can reclaim - will have fallen from 25 per cent to 22.5 or 20 per cent. This, too, will count against share prices.

Another group of companies - those which have substantial overseas earnings - will gain from the new ACT proposals on reclaiming dividends on foreign profits (see panel).

Building materials companies such as Redland, Pilkington, Blue Circle and Marley should benefit. So, too, might engineering and metals companies such as Johnson Matthey, FKI, APV and Babcock.

The Budget also contained a googly of a different nature for oil exploration companies. The Chancellor abolished the Petroleum Revenue Tax on new fields, and will allow companies to set exploration costs against tax on old fields for only two more years. Without relief, say the companies, the cost of exploration could quadruple. Inevitably, this sector of the stock market is now looking vulnerable.

But despite the lack of an interest rate cut, the ACT changes and the rise in company pension costs, the stock market remained reasonably resilient. This was partly because this was a Budget for accountants. It will take weeks or even months for companies, investors and stockbrokers to work out the implications. Shares may drift lower as the effect of the Chancellor's measures sink in.

But Mr Lamont is fortunate that the stock market is in an optimistic mood. Mr Hugh-Smith, for example, has only downgraded his forecast for the FT- SE 100 index at the half year from 3,150 to 3,000, and for the year end from 3,200 to 3,150 since the Budget. Share prices are supported by relatively high yields, and the market is, rightly or wrongly, betting that an economic recovery is under way.

If that sentiment changes, however, things could turn ugly. There would be little to prevent a sharp downturn in share prices and the Chancellor's Budget would not look like such a clever balancing act after all.

(Photograph omitted)