The dividend tax credit "grosses up" these dividends by 25 per cent, or an effective rate of 20 per cent. Most PEP managers claim the dividend tax credit on behalf of PEP holders.
The credit is paid to your PEP manager in cash. If you have a plan set up for growth, it will automatically be reinvested to buy extra fund units. If your plan is set to pay income, it can be added to distributions.
From 6 April 1999, this credit will be reduced to 10 per cent of the dividend, or an effective rate of 8.89 per cent of dividends paid. Even this reduced rate of dividend tax credit is due to be phased out on 6 April 2004. These changes will apply both to PEPs and ISAs.
What does this mean in terms of any reduction in income you will receive from PEPs or ISAs? At present for every pounds 100 of dividend income you receive from a PEP, the same holding out with a PEP will pay pounds 80 net to a basic rate income tax payer. Tax year end "top slicing" reduces this to a net payout of just pounds 60 for high rate tax payers.
After next April, the amount you receive from a PEP or ISA will be reduced to pounds 88.90. The dividend payable to basic and high rate tax payers on un- pepped dividends will remain the same - income tax deducted from dividends is being reduced to compensate for the loss of the tax credit.
The impact of this change will be largest on "high income equity" funds - some of the most popular and best performing of those available in the PEP format. Typically these invest into shares which have low "price to earnings" ratios: in less technical jargon they pay high dividends against the price per share.
"This change will reduce the yield on equity income funds," argues Chris Brealey, tax adviser to the Association of Unit Trusts and Investment Funds, "but its biggest effect will be in slowing growth on funds where income is re-invested."
Assume you have invested pounds 5,000 into a PEP fund which yields 7 per cent each year over five years. The underlying value of the shares does not increase, but you reinvest the income for compound growth.
If dividend tax credits remained unchanged, your investment would be worth pounds 6,554 after five years. Assume the new lower rate of tax credit and growth is reduced to pounds 6,729 per rent compound, giving a final value of pounds 6,381. Without any tax credit - the situation from 6 April 2004 - growth is cut to 5.76 per cent and your final return will be just pounds 6,221.
Investments like corporate bonds which are deemed to pay "interest" have 20 per cent basic rate income tax deducted at source, but if held in a PEP/ISA, this can be reclaimed.
"A lot of people think this means the 20 per cent tax credit on interest payments will be worth more than the 8.98 per cent tax credit on dividends," warns Mr Brealey, "but a little care is needed. A dividend of 8 per cent is increased to 8.89 per cent, while interest of 8 per cent, first loses then reclaims 1.6 per cent - ending up still being worth 8 per cent."
The moral of the story is that if offered the same rate of dividend or interest, a PEP or ISA holder will do better choosing the dividend at least until 2004. Meanwhile, the change is expected to shift the focus of fund managers trying to maximise returns for investors.
"This change will remove the incentive to look for high income from share funds, unless you really need it," thinks Daniel Godfrey, director general of the Association of Investment Trust Companies, "and fund managers will find other ways of offering investors `income', say, by cashing in tax free capital gains."