Discretionary Management and CGT
22 March 2016
One of the reasons for selecting a discretionary managed, segregated portfolio over a portfolio in a collective structure, such as ETF or OEIC, could be the treatment of tax. Specifically, the management of Capital Gains Tax. This, of course, very much depends on the clients circumstances, so there can be arguments for and against CGT management as a driver for DFM selection.
The annual exemption allowance is currently £11,100 and losses can be offset against this as well. Gains over this amount are charged at either 20% or 10% (from 6th April 2016), depending on your income tax band. Financial Advisers will be well aware of these figures and should be factoring them in to their financial planning strategy.
However, there is a danger that the extended period of relatively low returns could lull many into a false sense of security. We have all heard the argument that so few people actually pay any CGT that it is not really an issue.
While this argument is a strong one currently, I can recall periods in my own working life, and I am not exactly ancient, where portfolio values have doubled in value over a single year and if you are lucky enough to have invested in some securities or funds at exactly the right time, gains can far exceed even this. The point is, CGT is something that you need to keep an eye on. No-one knows for certain when game-changing events will make markets take off again.
Discretionary portfolios are segregated, in other words they are portfolios of individual holdings. If a sale is made, the profit or loss made immediately contributes to that tax year’s allowance. If the allowance is exceeded, capital gains tax needs to be paid.
A similar portfolio that is unitised (held within a collective structure such as OEIC, ETF or Investment Trust for example) is viewed as a single investment. This means that transactions can take place within that structure without being subject to CGT. CGT is only liable when units in the collective are sold. In effect this is rolling up gains (or losses) over a period of time.
So, these different structures mean different approaches to CGT and advisers need to determine which is most suitable for the client. Given the uncertainty of future markets, there is no right answer here, but advisers will need to exercise their professional judgement on what the most likely outcomes will be.
As far as discretionary solutions are concerned, there is a further consideration. Managed Portfolio Service portfolios are run to the mandate set by the discretionary managers, without reference to an individual client’s tax requirements. Sales of individual securities within these portfolios may give rise to CGT liabilities.
Crystalizing investment profits in holdings is not an unusual strategy. More often than not, especially in these markets, the CGT allowance is not likely to be breached, but advisers do have to keep an eye on the effects of transactions. With online adviser access to portfolio valuations and transaction histories, technology has made adviser oversight a lot easier.
For clients with considerable wealth or with a more complex tax position, the bespoke end of the market is likely to be more appropriate. Discretionary managers will construct portfolios with individual client requirements and issues as the driver. This would include CGT management, perhaps the drip feed of assets in to ISA’s on a yearly basis and managing legacy holdings in to portfolios over time to avoid CGT.
The bespoke discretionary manager would, often in discussion with the adviser, be able to factor in the client’s current position for example Capital Gains being realised outside of the discretionary solution. Again, advisors need to be aware of all of a client’s positions and agree, up-front with both client and discretionary manager the approach to take when CGT issues become a possibility.
One final point on CGT. Historically, advisers running a portfolio of funds for clients would have opportunities to crystalize gains and losses at various points in time by selling one fund and buying another in their normal management of the portfolio. With the advent of multi-asset and multi-manager funds, portfolios are likely to be less diverse, perhaps in some cases only a single fund.
If this single fund is meeting the client needs there would be no reason to change it, so potential capital gains roll up could be considerable over time. Again, advisers need to exercise their professional judgement on whether the occasional change of fund, or funds, is justifiable purely for tax reasons.
I have always said that I would love to be paying Capital Gains Tax, as it is usually a sign that investments are going well. Perhaps a bit of a flippant comment as some careful management should mean that CGT should rarely be an issue for anyone except the very wealthy.