Funds worried about further cuts in advance corporation tax relief

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WHILE the pension funds scrutinise the Goode Report, they are also looking forward with growing apprehension to November's Budget, writes Richard Thomson.

They fear the Chancellor may spring at least one nasty surprise - a renewal of the attack begun in the last Budget on the tax which pension funds can reclaim on dividend payments.

Companies pay dividends to their investors net of advance corporation tax, but pension funds are allowed to reclaim the tax under a special tax- credit system. In the last Budget, Norman Lamont cut the ACT rate from 25 to 22.5 per cent, but he also cut the tax credit rate by even more - to 20 per cent over two years.

In the first year, this has saved the Treasury pounds 1bn. 'This would indicate another pounds 2.5- pounds 3bn per year of funds available if the whole credit were to be scrapped,' said Robert Buckland, at NatWest Securities. 'A tempting sum to a cash-strapped Chancellor.'

The Chancellor is all the more likely to go for a reduction in the ACT tax credit, because there was so little complaint from the pensions industry after the reduction earlier this year. 'It is a soft target,' commented one analyst.

But the effects could be enormous. The tax credit, which currently totals around pounds 3bn a year, is an important component of pension funds' overall income. Since pension funds own about 50 per cent of the stock market, their reaction to a reduction in the tax credit would have a big effect on share prices.

If the credit were completely abolished, the stock market would have to fall by 10 per cent for pension funds to maintain the same yield as they currently get from their UK equity investments, according to calculations by Mr Buckland. Share prices could be pushed into a sharp fall, if the funds turned more towards gilt- edged investments where the tax treatment is more attractive. 'It could set the stock market back by a year,' said Mr Buckley.

The loss of the tax credit, and an accompanying fall in share prices would hit the value of company pension funds hard. British Telecom has already felt obliged to pump an extra pounds 800m into its pension fund - partly to make up for the reduced tax credit after the last Budget.

Many more companies are almost certain to have to follow suit, particularly those that have allowed the value of their pension funds to decline by taking pension holidays over the last few years. A massive drain of company cash resources would result.

Despite these dangers, however, the pensions industry remains relaxed. Steven Dorrell, the Financial Secretary, told Parliament in June: 'The Government's basic view is that the rate of ACT and the tax credit should be the same.' In other words, any reduction in one would trigger a reduction in the other, producing a neutral result for companies and pension funds.

'We're aware of the threat and we are concerned, but we believe Dorrell's assurances,' said a spokesman for the National Association of Pension Funds.

----------------------------------------------------------------- HOW CREDIT REDUCTIONS COULD AFFECT EQUITIES ----------------------------------------------------------------- Credit FT-SE Fall %Fall 20p 3050 0 0.0 15p 2962 88 2.9 10p 2879 171 5.6 5p 2809 241 7.9 0p 2745 305 10.0 ----------------------------------------------------------------- Source: NatWest Securities -----------------------------------------------------------------