Explaining investment funds

13 May 2017

At this time of year many investors will be thinking about reviewing their portfolios, but how many will make the link between tax and performance? When investing in collective investments or funds, the tax you pay can vary substantially depending on the choices you make. We can’t tell you which funds to pick to make your fortune, but we can answer some common questions about how they work.

What is a fund?

In investment-speak, ‘fund’ is a catchall term for an investment that bundles together a number of different assets. Funds can take many different forms: for example, trackers try to match the composition of a particular financial index such as the FTSE; and managed funds hold investments chosen by the fund manager, often with a particular geographic and/or sector focus (eg US biotech shares). Funds can also give access to types of investment in a convenient way – investing in a gold fund may be easier than buying a gold bar.

How are funds taxed?

The UK taxes funds in two different ways, depending on whether the fund is reporting or non-reporting.

Reporting funds have to register with HMRC, and declare details of the income they receive each year. This income is taxed on the owner of the fund in the year it arises, even if it is not paid out. When the fund is sold, any profit is subject to capital gains tax (CGT).

All other funds are non-reporting funds. These funds are not required to declare income details, and owners are only taxed on the income they actually receive. However, when the fund is sold, the whole profit made is taxed as income – and if the fund is sold at a loss, no tax relief is available.

What sort of fund should I choose?

It depends. As with any investment, you should focus primarily on investment matters, not tax. However, there are some general tax points that are worth bearing in mind.

Match your fund type to your investment strategy. If you invest in a fund that you expect to generate capital growth but no income, a non-reporting fund is likely to be a bad idea, because the profit you make will be taxed at income tax rates on disposal, rather than much lower CGT rates. On the other hand, a fund focusing on income, where the income is re-invested each year, may be an ideal candidate for a non-reporting fund, as the income will grow tax-free until the units are finally sold.

Traditionally, UK resident non domiciled individuals (non-doms) favoured non-reporting funds because investment growth rolls up without tax, and if the owner is taxed on the remittance basis when the fund is sold, tax is only payable when the proceeds are brought to the UK. Following the changes expected to apply from April 2017 , long term UK resident non-doms may want to reconsider this approach, as it is expected they will no longer be able to defer tax in this way.

Just as choosing the right investment can affect how quickly your portfolio grows, so choosing the right type of fund can have a significant impact on your net of tax investment returns. Tax should never drive investment decisions, but being tax aware can help you to get the most out of your funds.

For more information please get in touch with Andrew Robins, or your usual RSM contact.