They’re tax efficient – but should you invest in trusts?

Looking to invest tax efficiently? In recent years, some Irish investors have turned to UK-based investment trusts, which have been around for some 150 years, as a way of doing this.

Stymied by Irish rules, such as deemed disposal and complexities over which tax might apply to which investment product, investors are looking to these products as a way of achieving similar goals to an exchange-traded fund (ETF) or life-wrapped fund – without the tax complications.

While changes look to be on the way to the tax treatment of investments in Ireland, following an extensive recent consultation, and a commitment by Minister for Finance Michael McGrath to implement some revisions, this is unlikely to happen for some time.

In the meantime, if you are looking for a diversified investment that is liable to capital gains tax (CGT) at 33 per cent, rather than an exit tax at 41 per cent, what do you need to know?

What is an investment trust?

Like an investment fund, a trust is a pooled investment, which means they offer investors a wide range of opportunities. More like an ETF, however, it is quoted on a stock exchange, so it looks like a fund but trades like a company.

“They’re a different beast to what people would be used to here in terms of insurance investment funds,” says Paddy Delaney, a director at Informed Decisions financial planning.“Make sure you know what you’re getting into is the key thing, don’t be led by the tax piece.”

First of all, investment trusts are closed-ended funds, as they issue a fixed number of shares when they launch. It also means that they can borrow to pursue opportunities. This can result in better returns but also potentially greater losses, depending on how investment strategies work out.

Investment trusts have historically appealed to investors seeking income as like other public companies they will often pay out dividends. They don’t have to, however, and they can also keep up to 15 per cent of their income in reserve each year. This can then be used to pay out dividends when times are tough, such as during the Covid-19 pandemic, which keeps income payouts consistent.

What about reinvesting this income? It is possible to reinvest dividend income in the trust, but this doesn’t happen automatically; instead, you’ll need to find someone selling their shares at a price you’re happy to pay.

Risks and returns

As with other investments, the returns can be substantial. The top-performing trusts are spread across different sectors, including tech and European smaller companies, but what they do have in common is that they are all actively managed.

Take a look at the table of the top 10 performing investment trusts over the past 25 years. If you had put £20,000 (about €30,000 at the time) into Scottish Oriental’s Asia Pacific smaller companies fund back in 1999, you’d be sitting on a staggering £826,324 (€979,400) today.

Currently however, investment trusts are deemed to be a “sector under siege”, as the Financial Times described it back in November.

The issue facing such investments, it said, is that given sharp interest rate rises in recent years – up to 5.25 per cent in the UK – investors can earn about 5 per cent on their cash in a risk-free deposit. So why take on risk for a similar return?

This led to a sell-off of investment trusts, and the average discount – or the gap between the share prices of trusts and the net value of their assets – widened substantially. Back at the start of 2022, for example, the discount was around 2.2 per cent – but had risen to 17 per cent by the end of October, according to the Association of Investment Companies (AIC), the trust lobby group. It has since fallen back to 11 per cent.

Some claim that such a discount means it is the time to buy, and is a sign of sharp growth to come. Recent research from the AIC found that when the average discount is more than 10 per cent, it “may lead to significantly better returns over the subsequent five years”. It noted that since 2008, when the average discount exceeded this level, the average investment trust generated a return of almost 90 per cent over the following five years.

Or such a level of discount could be seen as a warning that the market is concerned about the future viability of the trust – it’s up to the investor to decide.

As Steven Barrett, managing director of Bluewater Financial, says: “There’s no guarantee that they’re going to come back to par or higher.”

Tax treatment

The reason we are writing about investment trusts is not really because of their investment characteristics – it’s for tax reasons.

This is what has largely attracted Irish investors.

“I never underestimate people’s desire to pay as little tax as possible,” says Barrett of people’s interest in products such as trusts, adding that when it comes to investment trusts, “it’s very much the tax tail that wags the dog”.

Unlike investment funds, trusts are typically not liable to deemed disposal, which, Barrett says, investors “hate with a passion”. This means that you won’t have to settle any tax owed every eight years, which saves you the hassle of doing so. It also allows your investment to grow for a longer period free of tax.

Instead, you will pay income tax, USC and PRSI on any income or dividend derived from a trust, and CGT on any profits, at a rate of 33 per cent. As with other assets liable to CGT, you will benefit from its three main advantages:

1) you will pay tax at 33 per cent rather than the exit tax rate of 41 per cent;

2) you’ll get a €1,270 (€2,540 combined) annual tax-free allowance; and

3) you should be able to offset a loss in an investment trust against tax on a future gain.

This is undeniably more attractive than exit tax.

As Delaney notes: “In an ideal world we’d be all investing under CGT.”

But how attractive is it? As Delaney says, under the current regime, to access CGT you typically need to sacrifice something. “And quite often that is diversification, regulation and fair fees,” he says.

Indeed, while investment trusts are far more diversified than buying an individual share, which is also liable to CGT, they tend to be more concentrated than funds.

Temple Bar plc, for example, has only about 30 holdings, which means that particular companies can have a sizeable share. Shell accounts for 7 per cent of the portfolio, and BP 6.7 per cent.

“In certain situations, when there is a lack of diversification if things go wrong you could potentially be exposed,” says Delaney.

Barrett agrees that this lack of diversification makes a trust a riskier proposition than a fund tracking the S&P and its 500 companies.

“They’re a lot riskier, they’re actively managed, and a lot more concentrated,” he says. “For me, as an adviser I do look at the trade-offs for clients, and certainly, taking more investment risk to pay lower tax isn’t something that sits well with me.”

And, while you might get a passive fund with an annual charge of about 0.1 per cent, you can pay fees of about 0.35 per cent to 2 per cent for an investment trust, says Delaney.

“Fees can become a significant negative,” he says.

Given that you will typically buy shares in an investment trust through a broker, you will also have to pay dealing fees to invest.

Consider a €100,000 investment delivering a return of 6 per cent each year. Based on the straight tax rates, paying CGT rather than exit tax would net you €2,709 more after five years.

But this extra could be wiped out if you have paid more in fees on the trust over the life of the investment.

Ultimately, perhaps, if you are thinking about trusts then the investment should stand up on its own. “If you take the tax piece out of it – would it be something that would be in huge demand?” Delaney asks.