• Stuart Fowler

The Budget: dwarfed by events

It did not even need the failure of Bear Stearns to happen before the UK 2008 Budget for the latter to be seen as a largely irrelevant sideshow. A Chancellor reeling off statistics about exceptionally long periods of growth cuts no ice once everyone knows growth only lasted longer because debt-fuelled liquidity was allowed to expand unchecked. With debt now causing acute solvency fears, total system liquidity is immaterial as it only goes to the people who least need it. In this climate, the economic assumptions on which the Government’s policy planning rest are academic: their actions will respond to but will not shape events.

As for the tax changes in the Budget, these were unusually pre-announced. Interest was of the more arcane kind, such as poring through the 270 pages of HMRC Notes for implementation details where consultation and lobbying had been going on right up to the last minute. In this post, we comment on some Budget detail relevant to private investors.

We start by updating our own view of the economic risks that will shape investment returns over the next few years. Financial orthodoxy is back on top. The message is clear: if you have not realistically stress tested your financial plans, your portfolios and your relationships with financial firms, you should get a move on.

Economic assumptions The Treasury has consistently erred on the side of higher mean growth forecasts than private sector economists. It has mostly been right, hence the Government’s self-congratulatory tone, although it has not flowed through to the tax take, hence its failure to hit its borrowing targets. Blaming ‘turbulence in the global financial markets’ (it used to be’ the gnomes of Zurich’), it has barely lowered its growth assumptions so is again above most private forecasts. Its mean assumption for 2008 is growth of 2% (2.25%) and 2009 is cut to 2.5% (2.75%) with no change to estimates for 2010 (2.75%).

We should expect the Government to avoid self-fulfilling prophecies of doom but it requires heroic optimism to assume a short-lived blip before the economy returns to a growth rate in line with its sustainable rate.

This is all academic. If the Treasury is wrong it is because, on a relatively benign view, real final sales in the US and other countries are hard hit by a continuing erosion of property prices and their feedback effects on consumer confidence. This has been a consistent theme of this blog and one of the few projections we make with confidence is that real house prices in both the US and the UK have a long way to fall.

Even this benign version has little case history to draw on as the US has not experienced strongly rising and then falling house prices in the post-war period. We can only guess at the confidence impact. But with savings so low it is sensible to assume that even the more conservatively financed households will want to improve their balance sheets. The feedback effects are from consumer spending to employment and from job losses to debt defaults and back to consumer spending.

From credit crisis to solvency crisis Why this cycle might rate as relatively benign is that the alternative is a much more rapid reduction of activity as a direct consequence of the banking system’s reluctance to lend. In this scenario, banks themselves are the object of low confidence and so struggle to gain access to funds (either permanent capital or liquid capital), need to shrink their balance sheet and want to hold more of it in liquid form. In fact, the monetary authorities incentivise this behaviour in the short term when they drive down short-term interest rates (as they are doing now) because banks’ profits (and hence capital) are predictably increased when they hold longer-dated bonds at higher yields than their borrowing costs, instead of making risky loans, and at the same time regulatory capital requirements fall. It is very difficult for central banks to ease banking system liquidity without perverse effects on loan volumes.

Bear Stearns collapsed because it was a victim of self-fulfilling scare stories in the market, possibly abetted by short selling. These stories spread quickly to other institutions including Lehman Brothers and UBS, which is not even an American bank. Note that none of these is a pure commercial bank. The risk preferences that are changing rapidly include where it is safe to deposit businesses’ working capital and institutional investment liquidity. Historically, these deposits would rarely have been placed with stockbrokers and market makers rather than big commercial banks. It was the commercial banks’ role to finance the working capital of the firms running all the plumbing of the capital markets. Supposedly, the crisis has been driven by banks refusing to lend to other banks but that has to feed off fear that the vulnerable ‘new banks’ are made vulnerable by their reliance on non-bank deposits. In other words, this is a reflection of changes in the competitive landscape amongst types of financial firm, as they crossed traditional boundaries on both sides of their balance sheet.

In this second version of the malign scenario, the second-order effects are essentially the same but much more rapid. More intense pressure to liquidate assets that are somebody else’s collateral for debt lead to fresh falls in asset prices. The process arguably becomes more predictable because of ‘fair value accounting’: writing assets up or down based on valuation benchmarks in financial markets, including derivatives markets.

The Japan parallel It is the feedback effects in either version of the scenario, drawing out the process, that explain why there has been so much commentary lately on the lessons of Japan’s ‘lost decade’. The term really applies to the period from 1990, when the equity bubble burst, and with it the property bubble, to about 2003, when Japan finally joined in a global recovery in equity prices, GDP began a sustained recovery and property started to move up. In that earlier period, there was no single year in which the value of land and buildings fell by more than a few percentage points. It is often suggested that the recession lasted so long because the authorities failed to force banks to recognise more of their losses. But even if they were then ‘marking to market’ it might actually have made little difference to the rate of write downs.

I will address the lessons of Japan in a separate post because they really are important. The significance for all markets is that it is one of only a handful of instances in the last 120 years of major stock price falls not being followed for many years by ‘reversion to the mean’, on which confidence in equity investing depends. Such a market path (which does not have much to do with volatility, incidentally) represents the bottom end of a range of probabilistic paths for real equity returns in our own long-term asset model. For investors drawing down from their total returns (whether income or capital), or who need to meet near-term liabilities, the combination of a fall and ‘long bottom’ is the worst-case scenario. For young accumulators, it is ironically a good scenario in terms of wealth outcomes – as long as their own incomes allow them to keep accumulating financial assets. Every contribution they make has higher expected real returns attached to them than if markets were normally valued.

The lesson for Japan, learned from the study of mean reversion in real equity returns from all other markets, is also important. For investors focused on real wealth outcomes, Japan is the best bet amongst major equity markets.

Implications of the CGT changes The pre-budget report had announced the removal of indexation and taper relief and the removal of the distinction between business assets and non-business assets.

Our initial briefing highlighted the fact that only old holdings with most of their nominal gains arising before indexation was replaced by taper relief in 1998 will have effective CGT rates below the new rate of 18%. Even then the difference may only be between 18% and about 14-16%. The effective rate will fall for non-business assets acquired since 1998. A more subtle effect is that the changes also reduce the amount of gross assets released from the CGT trap because all of the un-indexed tapered gain will be used to absorb the annual small gains allowance. For investors gradually selling as much as they can each year without triggering a liability, the change will mean they can expect to be doing this for several extra years.

The benefit of the indexation uplift to book costs need not necessarily be given up, however, as transfers to spouses before 6th April appear to crystalise and retain the uplifted book cost. A web search of ‘interspousal transfers to retain indexation’ will lead you to HMRC chapter and verse and also to observations of tax experts, usually suitably hedged. There may be little risk or other consequences, unless the change of beneficial owner conflicts with existing estate planning, in which case discussion with an accountant should deal with this too.

Insurance company bonds The Treasury paid no attention to the lobbying by life companies to spare them the consequences of a cut in the CGT rate on sales of investment bonds. One of the first lessons I learned as a financial analyst was never to mix insurance and investment. It was mainly tax features that gave insurance companies and advisers a good sales pitch for bonds but with high charges it was always doubtful whether the net benefits for investors were real. The charges were also skewed to paying IFAs fat commissions to recommend bonds so the risk of bad value (or outright misselling) was always greater. We rarely see a justification for investment bonds. Few fee-charging advisers will mourn their passing, if that is what results, any more than they did the demise of with-profits.

Entrepreneurs There were no more concessions on CGT on business assets beyond January’s announcement of a lifetime allowance for entrepreneurs of £1m of gain taxable at 10%. The logic may be to treat the sale of a business as if it was equivalent to a pension fund but the rules are quite flexible and the limit could theoretically be used on the first sale at age 30 rather than the last at age 60.

In keeping with the Government’s policy of incentivising risk-taking where the ‘funding gap’ for British capital formation is supposedly most apparent, the investment in Enterprise Investment Schemes (early-stage venture capital) goes up from £400,000 to £500,000. With the CGT rate at 18% and income tax benefit limited to the standard rate, there is now little difference in the value of each of the two elements of the tax incentive. Film finance, the last vestige of sideways loss relief, has lost its incentives, however.

VCTs have not been touched but they are unlikely to gather much in the way of new assets as long as disappointing achieved returns lead to heavy selling of existing trusts after the initial three-year period for tax benefits to be retained. Sharing risk with the Treasury has not been a ‘free lunch’ as returns have mostly been lower than the overall risk warranted. Plenty of headaches here for advisers who heavily promoted VCTs in the past, which does not include us (although we get to pick up the pieces on business we take over).

Private equity general partners, as serial entrepreneurs, did not get any of the concessions they lobbied for on the scrapping of business asset rules. In most countries their share of the payouts from partnership asset sales would be treated as income derived from employment, rather than gain, so they complain rather less in private than they do in public.

Non-doms get some concessions Resident but non-UK domiciled individuals had got most of the concessions they could reasonably expect from the consultation phase, including the ‘clarifications’ in the HMRC letter we carried in an earlier item. The important differences are both emotive and economic.

Offshore trusts are excluded except where distributions are made to the UK or where UK-based assets are converted into money and consumed here, in which case taxation will not be retrospective because assets can be ‘written up’ for this purpose to the value at 5th April. These changes have a material effect on some families but they also remove the fear of having details of their foreign affairs made available to HMRC, and therefore (in today’s collaborative world) other tax authorities. Children under 18 have also been excluded from the £30,000 charge. The regime as a whole will not apply to non-doms with foreign income below £2,000 (raised from £1,000).

The £30,000 levy has not been officially confirmed as a tax credit against US taxes but HMRC Notes included a legal opinion to the effect that, as now defined as a specific tax charge, it should be. This was material to the perception of the proposed tax treatment although it will not necessarily be material in practice.

The main impact for most non-doms arises from the closing of loopholes in the existing remittances legislation. In terms of the reaction of the affected parties (in which I include all UK-resident and domiciled tax payers), it is a pity the loopholes were not dealt with at an earlier and separate stage from the £30,000 option to cap additional liabilities. The two reach different people (as the loopholes affect non-doms’ remittances regardless of how long they have lived here) and confuse two rather different issues:

  • fairness and efficiency in applying the existing regime and

  • a more far-reaching reform of the approach to an existing tax, involving the extension of the worldwide tax regime to people who have made the UK their home

Viewed separately, the reform for long-stay residents has the merit of fairness whilst offering a significant concession that the resulting additional liability can be capped. When explained in these terms, I find people’s attitude changes significantly.

Combining the two sets of tax change may have made the Government’s communication task more difficult but it made this an uphill task anyway, by appearing to respond to a Conservative conference proposal instead of a reasoned policy the outgoing Chancellor had championed in at least six previous budget speeches. The real trigger was Blair standing down not Osborne standing up.

For non-doms themselves, the changes do not remove the need for new legal and/or accountancy fees. The specific impacts on most wealthy cross-border families are realistically beyond the scope of their wealth managers in the UK.

Foreign dividend tax credit When dividends from UK resident companies are charged to tax, shareholders are entitled to a non-payable tax credit of one ninth of the distribution (usually expressed as 10% of the gross). HMRC Notes say ‘Finance Bill 2008 will extend the non-payable tax credit of one ninth of the distribution to UK resident individuals and UK and other EEA nationals in receipt of dividends from non-UK resident companies, if they own less than a 10 per cent shareholding in the distributing non-UK resident company’; and the ‘tax credit will not be available if the source country does not levy a tax on corporate profits similar to corporation tax’.

As far as we can tell, this could apply also to some offshore OEICS in which case net income will be higher than from the same investments held through a UK collective – a curious anomaly. Worked examples indicate net income will be increased by 25% for both lower and higher-rate tax payers. This will obviously be most valuable where the vehicle is held for income, such as offshore bond funds or offshore money market funds.

Commuting trivial pensions Hitherto, only total pension funds below a threshold could be taken as a lump sum, on the basis of ‘triviality’. Now it will be possible to have large total pension funds and a few very small ones and still commute a total of £2,000 of the latter. It is a small but welcome measure.

Taxation of offshore funds Following consultation, the Government is going ahead with plans to replace the Distributor Status rules which determine whether gains from offshore funds are taxed in the hands of the investor as income or capital gains. The broad proposal was to allow a fund to fall into the CGT regime provided it was able to ‘report’ income to investors who will then be subject to tax on the reported income.

Draft regulations will be published just after the Finance Bill. HMRC Notes suggest ‘the conditions for obtaining the new qualifying fund status will be less onerous, and the test required for this will only be applied at the outset (instead of, as now, annually). It is also envisaged that minor failures to keep to the conditions will not result, as they do at present, in the fund being removed retrospectively from the more favourable regime.’

This is very encouraging but the challenge for offshore funds will be if they in turn invest in other funds and have to rely on them to provide the income information required.

The housing market It is obvious from our writing on the housing market that we are not eager to see more people over-reaching themselves because of the UK’s obsession with wealth creation from home ownership. The Treasury has three contributions to make in this Budget:

  • Key workers will now be able to take out shared-equity mortgages if they can afford just 50% (instead of 75%) of the cost and they will not pay stamp duty till they own 80%

  • The Housing Corporation will be able to build an extra 70,000 new homes over the next three years from additional public sector sites

  • It has published a paper demonstrating the value of long-term, fixed-rate mortgages relative to floating-rate mortgages or rolling over short-term fixes

The Government will be seeking views, drawing on international experience, on ‘the right framework’ to ‘help more people get on and stay on the housing ladder’. Perhaps amongst these views it will hear some that we would actually be better off encouraging young people to build up financial assets instead. If it looks abroad, it will also find that part of the solution to a healthy balance of supply and demand is property laws that are not so biased to tenants and leaseholders. And if it consults widely enough, someone may point out that, at anything other than high discount rates, the cost of a freehold property includes two elements of value: a roof over your head for the rest of your life and a bequest to your heirs at the end of it, only one of which most households will value. Deluded like the public it serves, the Government can learn a lot but not by asking only the questions that presume the answers it wants



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