New investment fund rules a fundamental change

Very little has been said but one of the most fundamental changes in the way investment funds are taxed kicks in at the start of next year. Despite the looming deadline, many of the State's largest life companies have yet to make clear their position on the new system, which was announced as part of the last Budget.

The term many existing and potential investors will hear about in coming months is "gross roll up". What it means, in effect, is that the money invested "rolls up" every year without being taxed - in much the same way that pension funds operate currently. Income tax will be charged only when the investor draws down on the fund. At that stage, the tax charge will be the basic rate of the day - 22 per cent at present - plus 3 per cent.

At the moment, the financial institutions pay tax on the fund at the basic rate each year. The new regime means that your investment accumulates tax-free until it matures and should, in effect, mean that it performs better from the investor's point of view. This should be true even with the three percentage point charge over the basic rate of tax that the Revenue Commissioners have imposed with a view to recouping some of the money they will lose on an annual basis.

The reason for the change is to bring the tax treatment of Irish investment funds into line with those of our European partners. At present, Ireland and Britain are out of step with the rest of the EU, although the IFSC already uses gross roll-up in selling such products overseas. It was this discrepancy between the IFSC and the domestic market that forced a change. Britain will continue to use the old set-up.

So what does the consumer need to do? Well, from January 1st, 2001, nothing, because all policies sold will conform to the new standard and will be subject to the new tax treatment. However, holders of existing policies - and especially those looking to take out policies between now and the new year - need to check with their life assurer if and how such policies will be transferred to the new regime.

In particular, they need to check:

the cost of transition to the new regime;

the mechanics of transferring to the new regime;

the charge structure under the new regime.

Ark Life, the assurance arm of AIB Group, has led the way in setting the policy for its customers. It has said it will not levy any applicable exit charge from the current fund or entry charge for the new fund to customers upon transfer. It has also reached agreement with the Revenue Commissioners to allow the automatic transfer of existing customers with policies taken out in recent years to the new type of policies.

Most importantly, Ark Life has given a commitment not to increase charges under the new structure. This is important because the industry claims it will have to raise charges under the new system. It claims costs to fund providers will rise because they will not be able to offset expenses against the annual tax bill on the fund in the same way they could in the past. These expenses include policy costs such as marketing, commissions, etc.

In the past, if a given fund made income of, say, £1,000 but had charges of £500, the financial institutions levied tax on the full £1,000, even though they only had to pay the Revenue the tax of the net income - income after charges, in this case £500. The balance went towards defraying costs and helped keep charges down. Under the new system, the tax will only be levied on the net profit - £500 in this case - leaving the institution short.

However, charges in Ireland are certainly not cheap by international standards. This has led Ark Life - since followed by Hibernian (including Norwich Union) and Irish Life - to commit itself to maintaining charges at their current level. It argues that, as with other financial products such as mortgages, institutions are having to accept lower margins than in the past and hope to offset them by selling more units and becoming more efficient and cost-effective.

One incentive to do so is that among other changes to the assurance market in the new year will be the arrival of competition from foreign firms, introducing the same sort of pressures Bank of Scotland has managed to bring to the mortgage market.

Others have yet to decide and some seem set to increase charges on customers. Existing and intending investors should check with their assurer to confirm what will happen come January 1st. The difference is substantial. One example indicates that, under the current system, a £100,000 investment bond growing at a rate of 10 per cent per annum with charges of 5 per cent upon entry and 0.75 per cent per annum would be valued at £376,319 after 20 years.

If institutions increase charges to 6.25 per cent upon entry and 1.25 per cent annually - the level it is estimated would be required to maintain existing levels of profitability - the same fund would be worth £392,814. While the figure shows the value of roll-up over annual tax deduction to the policyholder, more than offsetting the increased charges, it takes more than 10 years for the return to better the current system. Unfortunately, most investors tend to cash their policies in before 10 years.

If charges were not raised under the new system, the return after 20 years on the fund would be £437,334, a considerable improvement for the investor.

Another benefit of the new policies will be that there will be no tax deducted in the case of death or disability. This will mean, at the current tax rate, an improved return of 25 per cent on policies.

One industry source said: "Customers are not being told about the imminent changes, even as high-profile marketing campaigns are pressing them to invest their money in policies now which will be inferior come January. The problem is that money is rolling into the industry right now and there is no pressure to do the right thing by customers, because doing the right thing will mean taking a 25 per cent hit on profits."

Another assurer said: "It is worrying that so many assurance companies have still to announce how they are going to address the change come January."