End of a perk for pension funds

The mechanics of the share buybacks and special dividends that the Chancellor attacked yesterday are complex but the heart of the Government's problem lies in the cost of the preferential tax treatment enjoyed by institutional shareholders, which now own about 80 per cent of all UK equities.

When any shareholder receives a dividend, tax has already been paid on it by the company at the lower, 20 per cent, rate. If the shareholder is a taxpayer, he or she uses the tax credit to meet any tax liability and if the individual pays tax at the basic rate the credit settles the tax liability. If the individual is a higher rate, 40 per cent, taxpayer, he or she has to stump up extra tax.

However, certain shareholders, mainly pension funds, are exempt from tax and can claim the tax credit back from the Government. The benefit has been eroded slightly thanks to a reduction in the credit from 25 per cent to 20 per cent but it still represents a huge perk for pension funds and a big loss of revenue for the Government.

Up until yesterday share buy-backs and special dividends were treated for tax purposes as if they were ordinary dividend distributions. Tax on those one-off payments was paid directly by the company to the Inland Revenue in the form of advance corporation tax, which in most cases was then offset against mainstream corporation tax. Tax-exempt shareholders such as pension funds and charities reclaimed their credits from the Revenue.

In a share buyback, therefore, a pension fund received not just the market value of its shares, but a 20 per cent tax credit on top. Since the cost of this, in most cases, was offset against mainstream corporation tax the Inland Revenue lost out accordingly. The tax credit was paid for out of money that would otherwise go to the Treasury.

The changes proposed yesterday will mean that all share repurchases and some more complex special dividends will now no longer qualify for tax relief. The Revenue estimates it will save up to pounds 400m a year.

The measures do not necessarily mean the end of repurchases or special payouts because they are still attractive ways for companies to reduce their capital bases and the cost of that capital. The pension funds have been warned, however: their preferential tax treatment is no sacred cow.