A distribution fund is defined as holding more than 60% of its assets in interest- bearing assets such as corporate bonds, government bonds and cash on deposit. This type of fund is deemed to distribute ‘interest’ to its investors. In order to declare interest distribution the market value of the fund’s interest bearing asset must be 60% of the market value of the total assets at al times during the distribution period. The distribution period is the period during which the Unit Trust received income from investments and determines the amount available for distribution. Distribution periods vary between each fund. Distribution funds are obliged to withhold 20% of interest payments for income tax purposes. ISA and PEP managers are able to reclaim the 20% on behalf of their investors. They therefore receive 100% of the ‘interest’ distribution. If the distribution is not made from an ISA or PEP it may still be possible for the investor to reclaim the 20% depending on the tax paying status of the investor. Income from a distribution fund is taxed under Schedule D Case III.

Any find that does not qualify as a distribution fund is equity find i.e. less than 60% of it’s assets are interest-bearing assets and it is deemed to distribute ‘dividends’. These are paid with a 10% tax credit therefore, for example, a dividend payment of £50 would be paid as £45. An ISA or PEP fund manager can currently reclaim this tax credit. The 10% tax credit is a notional amount and does not represent withheld tax. Dividend payments are made after corporation tax has been deducted and are also taxed in the hands of the investor. The purpose of the 10% tax credit was to provide some relief from this double taxation. Dividends are assessed under schedule F.

From 6 April 2004 it will not be possible for ISA’s or PEP’s to reclaim the 10% tax credit in respect of dividend payments. In this way equity funds have become slightly less attractive to some ISA investors. For example, whereas an investor would receive £111 from a £100 dividend after claiming the 10% tax credit previously, after 6th April 2004 they will receive £100, although this is the gross amount they would receive and does not take into account their personal tax status. It must still be considered worthwhile investing into an ISA because any gains within an ISA are free of capital gains tax. The withdrawal of the tax credit will not change the actual income tax inside or outside an ISA but it may affect fund returns because of the fund manager’s inability to reclaim the tax credit on their dividends.

For someone who is a basic rate taxpayer there is no difference between holding an equity fund inside or outside an ISA (although, of course. Qualifying ISA investments are exempt from CGT). In contrast, a client (who is a basic rate tax payer) investing in a distribution fund will be taxed at 20%.

With effect from April 21004 it is only higher-rate taxpayers who will gain any income tax advantage from an equity ISA.

It should always be remembers that investment decisions should not be made on the basis of taxation alone. A tax efficiency vehicle may enhance an investor’s return but should also be suitable in respect of the client’s objectives and expectations. You should also bear in mind asset allocation and investment strategy.