The collapse of dividends across multiple sectors has seen the UK’s love affair with income investing finally hit a rough patch. Payouts in the UK could fall by nearly half this year, according to Link Asset Services, with some estimates suggesting dividends may take several years to claw their way back to pre-coronavirus levels.
This new normal has triggered a fundamental rethink of some holdings once regarded as portfolio stalwarts, from banking shares stuck in a dividend moratorium to equity income funds left with fewer sources of yield. And it could prompt a new approach to investing.
If investing for income appears to be under threat, an alternative approach is to instead build a diversified portfolio that targets total returns, taking capital gains when required. Total return investing allows greater scope for true diversification by lessening a portfolio’s reliance on companies and markets with higher yields. On top of this, generating income by selling assets rather than taking dividends has proved to be significantly more tax-efficient: the capital gains tax (CGT) allowance is much higher than the dividend allowance, and breaching the former can sometimes incur lower rates of tax.
However, the Treasury could soon throw a spanner in the works for budding total return investors. Chancellor Rishi Sunak’s recent request that the Office of Tax Simplification review CGT with an eye on “how gains are taxed compared to other types of income” has the potential to turn total return investing into a more costly affair.
Dividends versus capital gains: the tax equation
While investors are protected from paying taxes on both capital gains and dividends within individual savings accounts (Isas) and pensions, a stark difference becomes apparent outside of these tax-efficient wrappers. Every individual has a capital gains allowance of £12,300 a year, an amount that dwarfs the £2,000 tax-free allowance on dividends.
On top of this, the taxes incurred by wealthier individuals taking dividends can appear much more punitive than those currently applied to capital gains. Basic-rate taxpayers will pay 7.5 per cent tax on any dividends above their annual allowance, but higher-rate taxpayers pay a heftier 32.5 per cent, with additional-rate taxpayers paying 38.1 per cent.
Basic-rate taxpayers pay CGT of 10 per cent on any investment gains above the allowance, with a rate of just 20 per cent applying to higher- and additional-rate taxpayers. Investors can also reduce their CGT liability by offsetting capital losses against gains.
The format of any tax changes would have a bearing on who exactly is affected. Lowering the CGT allowance would mean that more people are captured by a tax, which only tends to hit those with significant means. Michael Martin, private client manager at 7IM, notes that making an investment gain of more than £12,300 in a year beyond anything held in tax wrappers would require a very large portfolio, a bout of stellar returns, or a mix of the two.
Raising CGT rates, or doing so alongside a reduction in the allowance, might have more serious implications for those considering a move away from income investing. It would, at least, take away one additional benefit of the total return approach.
Separately, there remains a chance that the so-called CGT uplift on death comes under scrutiny. Currently, if an individual dies and they hold taxable assets that have appreciated in value, the measure of capital gains is effectively set back to zero when these are transferred to someone else.
More than tax
Those wary of a sudden tax raid might try to get ahead of any changes by either taking capital gains now or, if possible, making greater use of tax-efficient investments. But any CGT reform could also come with a silver lining.
The chancellor’s request for a review stressed a focus on simplification. And assessing your capital gains is currently far from straightforward.
“If you make regular investments into the same shares and you’re looking at disposing of them, you need to work out the average cost [and price gain],” says Gordon Andrews, trusts and technical solutions manager at Quilter. The complexity only grows if dividends, which would fall under the remit of income tax, have been reinvested. Any reform could strip away some of the complications that might currently deter some from a total return focus.