Taxable portfolio management for UK personal investors

 

I assume that the personal investor is a UK-resident higher rate tax-payer and can hold shares (or exceptionally, bonds) in five main ways:

(1) in a tax-advantaged Investment Savings Account (ISA) (and possibly in a substantial fund accumulated under the 1987-1999 predecessor of ISAs, ie PEPs)

(2) in a tax-advantaged Self-invested Personal Pension (SIPP)

(3) in a UK-resident company which the investor controls

(4) in direct personal holdings

(5) for short-term holdings, in spread bets.

 

(There are other ways, eg in contracts for difference, in unit trusts, in life insurance bonds, etc, but these are of lesser interest to me.)

 

This note is concerned with questions like: which type of investments should be held in which vehicles?  In which vehicles should turnover be concentrated?  How should the differing tax positions of the various vehicles influence portfolio management?

 

 

·         Objective: maximise post-tax returns.  

Conjectures (25/6/04):

-        this probably implies paying quite a lot of attention to tax (common mantra of “don’t let tax affect decisions” clearly wrong)

-        And also probably implies paying relatively little tax

-        But not necessarily low turnover (eg manufactured dividend losses in a company are OK).

Reasons:

-         Intuition: tax-avoidance stratagems generate relatively certain alpha; “high turnover to maximize pre-tax returns” risks large gains followed by large losses, and hence very high tax payments.

-         Intuition: a portfolio reallocation which generates tax implies a certain tax cost to capture uncertain alpha from the trade

-         DeMiguel (2005) also says this

 

·         Get all you can into PEPs / ISAs/ SIPPS.

 

·         Use loss harvesting, especially in early years of portfolios. 

 

·         PEPs/ISAs/SIPPS should have your “best ideas.”  Reasons –

-         Conjecture(25/6/04): the tax saving from “best ideas in PEP” dominates saving from optionality of CGT outside PEP (Porterba (2000) confirms this for 1962-98 data in US)

-         Assets in these vehicles worth substantially more than same £ outside (if tax drag is 3%pa, then say 8/5 effect in a perpetuity)

-         But also important to maintain the value of the tax shelter.

 

·         Concentrate turnover in PEPs/ISAs/pensions

-        but some turnover required in self to utilise CGT exemption and practise ‘loss harvesting’

-        and turnover for manufacturing “dividend losses” in a company is OK.

 

·         Where possible, for short-term trades, use spread bets

-         Preferred to cfd’s provided (loosely) Σ bookies’ extra spreads < 0.4x Σ pure share price gains

-         Particularly good for shorts – you typically receive benefit of LIBOR+1% tax-free.

 

·         In theory, portfolio changes are ‘opportunity cost’ comparisons including tax effects

-        But very difficult in practice, because some of the tax effects are in the future (ie “if you don’t realize the gain now, you will have to do so at some unknown later time”)

-        (If the anticipated holding period were long enough, it would always be right to switch to the higher return asset - differences in rate of return have exponential effect, but the tax has only a multiplicative effect(Andrew Weiss).

-        Hence heuristics as below.

 

·         Heuristic for portfolio management of direct holdings of shares:

-        (In view of extreme difficulty of post-tax portfolio decisions, I think the following is sensible)

-        Focus mainly on AIM shares; try to hold  for 1 or 2 years; after that, regard 20 or 10% tax as fairly inconsequential

-        Note that the 1-year threshold is the large (20%) marginal fall in tax; the two-year one (10%) is much less important.

-        Try to avoid adding to an AIM holding >3 months (say) after first purchase – the addition “chokes off” taper relief on earlier purchase

-         Comment (from US papers) “most of the damage is done at very low turnover” is not valid in UK – it’s holding for the first one or two years that is critical.

 

·         Where should I allocate new purchases?  See table for preference rankings:

 

	Expected holding period
Listing of stock	Short (eg <1yr)	Long (eg >1yr)
AIM (trading)	SIPP, self, company	SIPP=self, company
Fully listed	PEP, SIPP, company, self	Company, PEP, SIPP, self

 

 

·         In your company, actually indifferent between AIM shares and fully-listed

 

-        But because AIM better for self, fully-listed will tend to end up in PEP, then SIPP, then company

-        AIM shares in company is actually “no worse off” than non-AIM in company, provided you don’t end up with “AIM in company, non-AIM outside” which could have been swapped.

-        “avoid choking off taper relief” or “avoid high dividend taxed at 25% in self” may also sometimes be reasons for allocating AIM shares to company.

 

·         Can sell and buy back within 30 days without long-term CGT implications

-         The sale is matched against the later buy

-         Hence there is an argument for sell immediately on profit warnings, then decide what to do over the next 30 days.

-        So if the falls in the 30 days (as anticipated), you get a small gain; if they price actually rises in to 30 days (ie it goes wrong), you generate a loss.

-         a repurchase within 30 days but in April avoids immediate long-term CGT (the March sale is matched against the April buy, with the origin of the stock remaining undisturbed).

 

·         Where sold at PROFIT in {6 March to 5 April} –

-         Can defer most of the CGT one year by repurchasing and then reselling, within 30d but after 5 April.  (The March 2006 sale is matched against the April 2006 buy, for 2005/06 CGT; then, the next year, the April 2006 sale is matched against the origin of the stock eg Feb 1995 buy, for 2006/07 CGT.)

 

·         Where sold at LOSS in {6 March to 5 April} –

-         Can defer the loss by same means, if need to avoid “waste” of the annual exemption.

 

·         Taper relief

Holding period	Type of asset
(complete years)	Non-business	Business
1	40%	20%
2	40%	10%
3	38%	…
4	36%	…
…..	…	…
10	24%	…

 

 

 

You have to set current-year losses against gains before taper, or annual exemption.  This can result in ‘waste’ of both taper and exemption.  The position re annual exemption is better for losses b/f – you can use the annual exemption and c/f the b/f losses. [Tolleys Taper, p142]

 

Choose to set the losses against the gains with no taper [Tolleys Taper p144].  For this, note that where an asset has separate periods as business and non-business asset, this gives rise to TWO gains, with different tapers [Tolleys CGT 61.12].

Dispersed basis costs for different shares is more valuable than same basis cost for all

-         Can run gains while taking losses

-         Loosely, "portfolio of options > option on portfolio."

-         See Dammon et al (2002).

References

 

Dammon, R.M., Spatt, C.S. & Zhang, H.Z. (2002) ‘Diversification and capital gains taxes with multiple risky assets.’ Carnegie Mellon University Working Paper, Pittsburgh, PA.

 

DeMiguel, V. & Uppal, R. (2005) ‘Portfolio investment with the exact tax basis via nonlinear programming.’  Management Science, 51, 2, 277-290.

 

Poterba, J.M., Shoven, J.B. & Sialm, C. (2000) ‘Asset location for retirement savers.’ NBER Working Papers,  7991.

 

Tolleys Taper Relief 2000/01.  Tolley Publishing, Croydon, UK.