Could you please explain how tax affects an investor’s choice of investment?
There are many factors for an individual to take into account when assessing the acceptability of an investment. There are even more factors to be considered when it is a question of adding to a portfolio of investments. The nature and incidence of taxation is just one of those factors. In this article all that can be demonstrated is how the incidence of tax might affect an investor’s choice of investments, but only limited ground rules can be laid down because of the inter-relationship of tax with other variables.
The essential point can be made by examining two very different government stocks currently available through the stock market — Treasury 3% 1990 and Exchequer 12 1/2% 1990.
As a reminder, but especially for any new student readers, these stock certificates can be purchased by individuals, investment companies, unit trusts or pension funds, ie by anyone and in almost any amounts. For simplicity, analysis of stocks and the market price of such stocks is usually based on a stock certificate bearing a “face” value of £100. Stocks selling for £100 or simply 100 are selling at par, if for less they are selling below par. On occasions a stock may be quoted as selling for 25 above par, ie for £125, or at 25 below par, ie for £75. The reference to 3% and 12 1/2% is a reference to the coupon or nominal yield that the government will pay per £100 certificate, ie a dividend of £3 and £12.50 respectively. Dividends are, in most cases, paid twice a year and the specific dividend payment date can be ascertained in each case and may be relevant to the investment decision. Shortly before the dividend due date the stock will be quoted at a price “ex-dividend,” this is because for logistical reasons the dividends are paid to registered holders up to a given date and transfers of stock after that date will not receive that dividend. For clarity, price at other times may be quoted as “cum dividend”. If paid twice yearly then a dividend of £1.50 and £6.25 respectively will be paid. The amounts and the precise payment dates for dividends are essential for precise assessment of the real return from a given stock.
Apart from a few historic exceptions such as Consols and War Loan most stocks listed on the exchange are dated stocks. In this case they are both dated 1990. This means that each certificate will be redeemed (repaid) at the same time as the final dividend payment is due in the year 1990. Here again in the market the precise date of redemptions is necessary for the proper assessment of redemption yields and/or the market price.
In March this year these stocks could be purchased for £91.50 and £106 (give or take a few pence). The Treasury Stock were selling below par and the Exchequer stocks above par.
Given the purchase price it is possible to calculate two yields, the income-only yield and the redemption yield. The income-only yield is the relationship between the dividend and the price; the redemption yield takes into account the redemption at par due in 1990. Given all the data, a series of calculations can be made to help an investor make an investment decision. However, to simplify the illustration it has been assumed that the dividends are due annually in arrears and redemption is due in exactly three years’ time. So the figures obtained are not current and are not accurate in terms of today’s market for these stocks. The calculations are shown gross and net of tax at 40%.
In both cases the taxpayer with a 40% tax rate achieves a net of tax income yield which is 40% less than the gross yield, but the position in respect of the gross and net redemption yields is very different. In the case of the low coupon stock very little of the investment benefit is in income, most is in the receipt of the redemption value in three years’ time. The effect is that the net redemption yield is over 75% of the gross redemption yield. In the case of the high 12 1/2% coupon stock most of the return is in the income; indeed the market has pushed the price above par and as a result the net redemption yield is only about 49% of the gross redemption yield. Gains on stock held to redemption are free of capital gains tax.
The redemption yields for each are comparable in net terms but not in gross terms. So the investor must have regard to the effect of tax on the total net returns and must take account of both income and capital gains tax and capital growth.
The current level of interest rates has had an interesting effect on stock prices. In The Independent’s listing of some 85 stocks, only 24 were selling below par. Treasury 15 1/2% 1998 were selling in January at £136 and in the last 12 months have touched £145. The conundrum that student valuers find difficult to resolve is why anyone would pay £145 for a stock certificate which is to be redeemed in 1998 for £100. How in this sense does the investor achieve both a return on capital and a return of capital?
The explanation lies in a proper understanding of yields. This particular stock is paying £15.50 a year in dividends at a time when base rate is 9% and other rates are competitively in line with 9%. It is then inevitable that competition for such high-yielding stock will push the price up above par value to the point where the return is in line with the market.
Our illustration of the 12 1/2% Treasury 1990 at £106 illustrates that the redemption yield of 10.08% is the investment’s internal rate of return which is one of the investment measures considered by investors and means that a non-taxpayer will achieve a 10.08% return on the price of £106 and a return of the capital over the three years thus:
This interpretation of the meaning of yield or rate of return is essential to the continuing debate of dual rate and leaseholds.
The importance of tax treatment to the property investor has been significantly amended by the 1988 Budget.
Example. An investor has been offered the freehold in two identical adjoining shops. Shop A is let at its full rental value of £20,000 full repairing and insuring with regular rent reviews. Shop B is let at a peppercorn rent for the next five years on full repairing and insuring terms. The investor is liable to tax on income at 40%. Shops of this quality normally sell on an all-risks capitalisation basis of 5%.
To buy Shop A the investor must pay £400,000 in the market to achieve a net tax returnof 3.0%
Ignoring changes in value and assuming each is held for five years, then the purchase of Shop A provides the investor with an internal rate of return net of tax of 3%. Shop B, if purchased for £313,410, apparently provides the investor with a net-of-tax return of 5% because no income is received, so no income has to be declared for tax purposes. All the return is in capital, namely, the resale in five years at £400,000 (£20,000 x YP perp at 5%) minus the purchase price of £313,410 which is a gain of £86,590.
But because capital gains are now to be taxed at the taxpayer’s income tax rate of 25% or 40%, or a mixture of the two, reversionary property investments are no longer so attractive to the higher rate taxpayer as they were when CGT was at 30% and income tax at up to 60%.
So, yes, it is important to appreciate fully the impact of all taxes on investments if clear guidance is to be offered to personal investors.