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Collectives and equalisation

This article looks at how equalisation operates and why it is important when calculating Capital Gains Tax (CGT) for collectives.

At its most basic, equalisation is a process used by fund managers to accommodate investors who buy collectives part way through an income distribution period. However, it is important to remember that equalisation payments also interact with CGT calculations.

Background

When a fund manager declares an income distribution, every eligible investor in the fund receives the same payment, expressed as pence per unit. This is regardless of whether they have held units in that fund for the entire distribution period. If they have only owned units for part of the distribution period, the investor will not be entitled to the entire distribution.

Equalisation is paid as part of the first distribution received after units are purchased. It is a mechanism that means investors only receive income they have actually ‘earned’ since investing in the fund. The balance of the payment is equalisation and is treated as a partial return of the capital invested. As such, it is not treated as taxable income; however as it is capital it will reduce the amount invested for CGT purposes.

Accumulation (ACC) units

ACC unit funds still declare ‘notional’ distributions for income tax purposes, even though there is no actual payment of income to investors. The income tax treatment of ACC funds is therefore exactly the same as Income (INC) funds, which means the first notional distribution received after investing will also contain an equalisation element.

Any increase in the price of ACC units will, in part, be due to the reinvestment of income arising from the fund’s underlying assets. As outlined above, this notional income is taxable in the same way as income that is paid out from INC funds. However, there could be a double tax liability as the growth in the fund value arising from reinvested income is also potentially subject to CGT.

To avoid this, any increase in the value of an investment that is also liable to income tax will be disregarded for the purposes of calculating CGT. This means that the net notional distribution will be deducted from the sale proceeds when calculating any gain. The equalisation component of the notional payment is disregarded as it is a return of capital.

This is reflected in the reports generated by Old Mutual Wealth’s capital gains tool by showing an ‘equalisation retention in’ payment as an expense and an identical ‘equalisation retention out’ payment as a cost.

One amount will therefore cancel the other, so that the equalisation element of the notional distribution is not added to the cost base when calculating subsequent gains. The tax credit attached to a notional distribution is also disregarded as it is not in itself liable to income tax.

Income (INC) units

As noted above, the first distribution received after investing will contain an equalisation element and should be disregarded for CGT calculation purposes as it is a return of capital. This applies to income that is paid out to the investor, as well as income that is reinvested in the fund.

This is reflected in the reports generated by Old Mutual Wealth’s capital gains tool by showing a ‘purchase – income distribution’ payment as an expense and a smaller ‘equalisation’ amount as a cost. If income distributions from INC funds are reinvested, the additional units purchased will form part of a Section 104 holding and will increase the base cost when calculating subsequent gains. This process carried out by the tool has the effect of reducing the amount added to the s.104 holding.

Example calculations

The basis on which equalisation payments are incorporated into CGT calculations will be different, depending on whether the investor holds ACC units or they hold INC units and reinvest the distributions. However, the net result of the calculations will be the same, assuming the same growth and income. This is demonstrated in the following example:

Number of ACC units 100
Acquisition cost per unit 100p
Growth (10%) 10%
Net income per unit (INCLUDES 2p equalisation) 4p
Number of units 100
Unit price after 1 year 114p
Value of units £114
Acquisition cost ((£100 original inv + 
£4 net notional distribution) - £2 equalisation)
£102
Gain = £114 - £102 £12
 
Number of INC units 100
Acquisition cost per unit 100p
Growth (10%) 10%
Unit price after 1 year 110p
Net income per unit (INCLUDES 2p equalisation) 4p
Units purchased @ 110p with 400p income 3.63
New unit holding (s.104 holding) 103.63
Value of s.104 holding £114
Acquisition cost ((£100 original inv + £4 reinvested) - £2 equalisation) / 103.63) 98.43p
Gain = (110p - 98.43p) x 103.63 £12

Summary

Old Mutual Wealth’s capital gains reporting tool will automatically take equalisation into account when calculating gains or losses. But, given that equalisation payments will be highlighted in clients’ capital gains reports, it is clearly useful to understand the key considerations and assumptions that underpin these figures.

Whilst Old Mutual Wealth has endeavoured to ensure the capital gains reporting tool provides accurate data, we cannot guarantee that the calculations are correct. Consequently, they should be regarded as indicative only. Whilst we believe these reports will be of assistance, we cannot accept any liability for errors or omissions in the computations. Accordingly, we recommend that you should consult your accountant or tax adviser.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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