PEPS: The Final Countdown: In the world of tax, all is not as it seems

Despite what's said to the contrary, non-taxpayers are set to be affected by new measures. By John Andrew
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The Independent Online
FROM APRIL, a little-publicised aspect of last year's Budget will begin to impact on everyone who enjoys income from UK shares, equity-based unit trust and investment trusts.

Non-taxpayers will see their income decline by 20 per cent, while investors who have sheltered their equities in PEPs will experience an income decline of 11.11 per cent. Lower, basic and higher rate taxpayers will not be affected. The income from shares, equity unit and investment trusts held in ISAs will also suffer, despite the fact that these are being widely marketed as tax-free. The majority of the marketing literature neatly glosses over the effect of the changes.

There are some clues. The brochures refer to ISAs being free of income and capital gains tax (CGT) in the hands of the investor. Reference is also sometimes made to dividends from shares being paid with a 10 per cent tax credit. The impact of these words is not explained.

The subtleties are triggered by the abolition on 6 April of advanced corporation tax (ACT). The relationship between the tax companies pay and personal income tax may seem obscure. However, it will have significant and far-reaching implications for hundreds of thousands of people.

Currently, companies pay 20 per cent ACT on "qualifying distributions" - which include dividends. This is deducted from the gross dividend before payment. However, the payment is made with a 20 per cent tax credit. Non-taxpayers may reclaim this, while lower and basic rate taxpayers have no further liability to income tax. PEP managers may also claim the credit on behalf of their investors.

From 6 April, companies will not have to pay ACT, but 20 per cent will be deducted from dividends. The dividends will be paid with a 10 per cent tax credit as an interim measure. However, non-taxpayers will not be able to reclaim the credit, while PEP and ISA managers will be able to do so until 5 April 2004.

The effect of this change can be seen in the table. As from 6 April, investors sheltering shares, investment and equity unit trusts in PEPs and ISAs will be no better off than non, lower and basic rate taxpayers.

The taxation changes will not impact upon the income paid on corporate bonds and gifts held by non-taxpayers. Taxpayers who have corporate bond PEPs, or corporate bonds in an ISA, will also not be affected. These are funds where at least 60 per cent is invested in gifts, bonds and cash.

It is only people who enjoy an equity income from investments held directly or in a PEP or ISA will feel the chilling blow. Is it still worthwhile sheltering equities in a PEP or ISA? As a rough rule of thumb, for the five years from 6 April, lower and basic rate taxpayers will only save pounds 24 a year assuming they have pounds 6,000 in a PEP or ISA. Charges of 0.4 per cent a year or more will wipe this out. Higher rate taxpayers will only be at an advantage if the charges are less than around 1 per cent a year.

However, the fact that any growth is free of CGT in a PEP or ISA will still make both vehicles attractive to investors with larger portfolios. But do not be fooled by claims of PEPs and ISAs being entirely tax free.