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1

Tax issues affecting investment decisions

Taxation of investment return is one of the major factors considered by investors in selecting investments. Each investor, individual or institution, will attempt to maximise after-tax returns (subject of course to risk constraints) and will therefore attempt to find tax-efficient investments.

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Factors that need to be considered are:

  the total rate of tax on an investment 

  how the tax is split between different components of the investment return – in practice, this usually means between income and capital gains 

  the timing of tax payments 

  whether the tax is deducted at source or has to be paid subsequently 

  the extent to which tax deducted at source can be reclaimed by the investor 

  to what extent losses or gains can be aggregated between different investments or over different time periods for tax purposes. 
In other words we need to know the effective rate of tax once we have allowed for the time at which tax becomes payable and the extent to which tax paid on an asset can be offset against other tax liabilities.

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All else being equal, the aim of the investor is to

maximise the net rate of return obtained from their investment after allowing for any tax due. The impact of taxation upon the return obtained is greater the higher the amount of tax paid and the earlier the actual payment of tax falls due. Investors therefore prefer to pay as little tax as possible, as late as possible, so as to reduce the present value of tax payments and so they will often seek ways to minimise their tax liability and/or to defer it.
The impact of the above factors will in practice depend upon a number of things.

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These factors will be affected by:

These factors will be affected by:
  the overall tax system, eg tax rates and exemptions 

  particular rules for individual types of asset 

  the investor’s own status (individual or particular type of institution) 

  the investor’s financial position 

  the tax-efficiency of the vehicle used to hold the assets.

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“The investor’s own financial position” may

affect both the tax rates and the basis for taxation. Many tax systems are progressive, ie marginal tax rates increase as the investor’s income increases. Conversely, a regressive tax system is one in which marginal tax rates decline with income.

Where an investment vehicle (eg a collective investment vehicle) is used to hold an asset the investor may need to consider both the tax paid by the investment vehicle on the underlying assets and also any further tax due on the investor’s ownership of the units in the investment vehicle. 
The possible permutations of the above factors can make tax planning extremely complicated. Even the tax authorities find it hard to predict accurately the effects of changes to the rules because the market may adapt to new regulations in unpredicted ways. 




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Example
One example of how investment markets react to the tax environment in which they operate is provided by the existence of

split-capital collective investment vehicles. These are investment funds that offer investors a choice of two types of share capital – one providing an entitlement to the income earned by the fund and one providing an entitlement to the capital gains.

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All else being equal, investors wish to

avoid paying tax, as it ultimately reduces the amount of money they have available in their hand to meet investment objectives. Consequently, investors who are taxed more heavily on income than on capital gains will tend to prefer investments that provide most of the investment return via capital gain as opposed to income (and vice versa). Thus, the share capital that provides an entitlement to income will tend to appeal to investors facing low or zero tax rates on income – though there are also likely to be other factors affecting the investment choice. Conversely, the share capital that provides an entitlement to capital gains will tend to appeal more to investors who are taxed less heavily on capital gains (or have less need for income).

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Taxes on income and capital gains:
Rates and allowances

Many tax systems distinguish between income and the increase in value of a capital asset. It is possible for the rates of tax to be different for income and capital gains and each may be subject to a separate annual tax-free allowance. Furthermore, investment income may be subject to a different rate of tax than “earned” income, ie wages and salaries earned by working.
For example, in the UK the annual capital gains tax allowance is about 50% higher than the annual income tax allowance applicable to the total of earned income and investment income.

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Taxes on capital gains

In some tax systems, tax on capital gains is only charged on the increase in the real value of an asset, that is, after allowing for the effects of inflation. This is usually achieved in practice by increasing or indexing the purchase price originally paid in line with a price index, tax then being payable only on any excess of the sale price over the indexed purchase price. However, the computations involved with this can quickly become complicated.
Capital gains tax is usually payable on disposal of an asset, in contrast to income tax, which is usually payable very soon after the income is received.
This can lead to investors attempting to defer tax liabilities by avoiding the crystallisation of a capital gain. Derivatives can be used to reduce exposure to an asset rather than selling the asset itself.

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By using derivatives the investor’s effective exposure to the underlying assets can b

changed in almost exactly the same way as if the underlying assets themselves were changed. However, because the underlying asset is not actually sold, past capital gains are not crystallised and a tax liability is avoided (or at least deferred until the asset is ultimately sold). Instead tax is paid only on any capital gains during the lifetime of the derivative trade.

11

The existence of an annual tax-free allowance can also lead to

investors selling and repurchasing assets to crystallise a gain in order to take advantage of their annual allowance.
This process is sometimes known as “bed and breakfasting”. If the gain from selling and repurchasing is less than the annual exemption then no tax liability will be incurred. If subsequent capital gains are taxed on the basis of the repurchase price, rather than the original purchase price, the eventual tax liability will be reduced. Any tax saving should be compared against the extra transaction costs involved. Also, tax authorities may insist on a minimum period between selling and repurchasing for the crystallisation of the gain to be effective. In this case the investor will be taking a risk that the asset increases in price between the time of sale and the time of repurchase.

12

A further variation on the treatment of capital gains is to

make the rate of tax depend upon the length of time for which the asset has been held. If tax rates decrease over time, long-term investment might be encouraged. If rates increase over time, more frequent turnover of portfolios might be encouraged.

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The different ways in which income and capital gains are taxed can

distort the market, even within a particular asset class. For example, if income is taxed but capital gains are not, taxable investors will prefer assets which produce a lower level of income over high income investments. Tax-exempt investors, who are indifferent between income and capital gains, will then find high coupon bonds more attractive because taxpayers have bid up the price of low coupons. This is just one example of the effect of tax on investment markets.

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The actual price of an asset at any time will reflect the impact of

taxation on the net return that it provides to the marginal investor, who is just willing to pay that price in order to purchase it. The impact of taxation upon the return to the investor is therefore one of several reasons why the actual value that an investor places upon a particular asset may differ from the market value and, consequently, why assets may be valued using bases other than market value.

15

The distinction between income and capital gains can

cause problems because it can be difficult to classify investment return as income or capital gain for some instruments. An example of this occurs when bonds are stripped to provide a series of instruments, each providing a single payment.


Stripping a bond means that each coupon payment and the redemption proceeds can be traded independently. Each individual coupon payment is then an investment that provides a certain single payment at a known point in time. Consequently, there is little distinction between the stripped coupon payable at time t and a zero-coupon bond providing a return of capital at time t.

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An alternative to taxing income and capital gains separately is to

tax the total return on an investment. This avoids some of the problems of separate taxation but, unless tax is only due when an asset is sold, valuations will be needed in order to calculate the total return. The problem then arises as to who performs the valuations, when and on what basis.

Also, investors can face the problem of having a tax bill but no income with which to pay it. Thus, taxation of total return is only likely to be feasible for marketable assets, which could then be sold to pay the tax liability.

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Other forms of taxation that may be incurred by the investor include:

  a tax on the purchase of assets, this is known as stamp duty in many countries. For example, in the UK, it is paid on the purchase of shares and property. In some countries, the rate of stamp duty on property can be of the order of several percent. 

  withholding taxes payable on investments held overseas, which will generally be at different rates to those applying to domestic investments. The overseas investment income of domestic residents (private or corporate) is typically subject to tax both in the country of origin and in the investor’s own country. However, the existence of double taxation agreements between countries means that tax paid in overseas countries can be often be offset against domestic tax. Normally, however, gross investors, who are not subject to tax on domestic returns, are unable to reclaim taxes on investments paid overseas.

18

In a particular market there are two investors. Investor A is subject to tax at 50% on income and 20% on capital gains. Investor B is subject to tax at 40% on income and 30% on capital gains.
There are also two types of investment available, each offering a similar total pre-tax return and similar features, except that:
  Investment X provides a low level of income 

  Investment Y provides a high level of income. 
Assuming that Investors A and B have similar levels of wealth and that the quantity of Investment X available is similar to the quantity of Investment Y, which type of investment is Investor B likely to choose?

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Corporate taxation

2.1  Dividend policy
 Taxation of debt and equity
2.3 Corporation tax systems

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Dividend policy

Company profits can be distributed to shareholders or retained within the company. The way in which retained profits and distributions are taxed will influence investors’ preferences for dividends or the increase in share values which should follow from retained profits or the company buying back its own shares. 
In other words, different tax rates on retained profits and distributed profits may influence the level of equity dividends paid by companies. As before, investors will tend to prefer whichever minimises their liability to tax. 
For example, a system which makes dividends attractive from a tax point of view to a significant number of investors can lead to pressure on companies to pay a high rate of dividends. 
Governments may attempt to make the system as neutral as possible or may take a view on the desirability or otherwise of dividends and manipulate the system accordingly.

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Taxation of debt and equity

The tax treatment of interest payable on corporate loans will also affect the relative attractiveness of debt and equity finance and hence companies’ choices as regards capital structure. 
In many countries, interest on corporate loans is payable out of pre-tax profits, whereas equity dividends are paid out of post-tax profits. This difference in tax treatment may induce a preference for debt finance over equity finance where the company would otherwise be neutral between the two alternatives. 


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Corporation tax systems

Corporation tax systems vary from country to country. So it can be important for the investor to be familiar with the tax system of a particular country before choosing to invest in companies that operate in that country.
There are three main systems.

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Classical

In the classical system of corporation tax, company profits are taxed twice: once in the hands of the company and once in the hands of the investor. In other words, the company pays tax on its profits, dividends are then paid out of post-tax profits and the investor is taxed on those dividends
The investor may be subject to income tax on distributions and capital gains tax arising from increases in the share price.

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Split-rate

The split-rate system is similar to the classical system but different rates are levied on distributed profits and retained profits.
This system is often used when income and capital gains are taxed at different rates. Thus, a higher level of income tax than capital gains tax would be coupled with a higher tax rate on retained profits than on distributed profits.

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Imputation

In the imputation system the company has to deduct some of the tax payable by investors on distributions and pay it directly to the government. This amount can then be set off against the total corporation tax bill of the company.
The tax deducted by the company is “imputed” to the shareholder who may be able to reclaim it if they are not liable to tax. If the rate at which they are liable to tax is greater than the rate imputed they may have to pay some more tax on their dividend.

The exact details of the system can become quite complicated. For example, some classes of tax-exempt investor may be able to reclaim the imputed tax while others may not.

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Why might a government operate a split-rate system of corporate taxation?

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Example

An imputation system of the above form operated in the UK until the late 1990s. It involved a system of tax credits, which worked broadly in the following way.
If a company paid a (net of tax) dividend of £80 out of post-tax profits, this was deemed to be equivalent to a gross (ie pre-tax) dividend of £100. The shareholder then received a dividend cheque for £80 from the company plus a tax credit of £20 (ie 80/0.8 – 80). The company that paid the dividend would then pay corporation tax to the government equal to the amount of the tax credit. At the end of the tax year, the company then calculated its corporation tax liability based upon its gross profits for the year, which liability it was then able to reduce by the amount of tax it had already paid.

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Depending upon their own tax position, the recipients of the dividend would:

  then reclaim the tax credit – if they were gross investors, exempt from tax. So they ended up with £100. 

  be liable for no further tax in respect of that dividend – if basic-rate taxpayers, so they ended up with £80. 

  be liable for additional tax in respect of that dividend (at a rate equal to the difference between their own marginal rates of tax on income and the 20% rate at which corporation tax was deemed to have been deducted) – if higher-rate taxpayers. So with a higher tax rate of 40%, higher-rate taxpayers ultimately ended up with £60.