Tax allowance in unit pricing: contracting fund

[Lindsay Smitherman]

I also have one more question on chapter 8, I couldnt understand very well, when the fund is contracting and company has unrealised gains, in what situation discounting of taxation is required and in what situation discounting wont be required? the paragraph written on core read(in unbold font) is not very clearly setting out the difference between the situations

To recap, the deferred tax adjustment for an unrealised gain on equities and property held in a BLAGAB fund is determined as:
indexed unrealised gain x tax rate t x discount factor v^n.

n represents the time period between the unit pricing date (ie now) and when the underlying assets are expected to be sold. This recognises the fact that the tax is not payable until the gains are actually realised.

For an expanding fund where there is no direct need to realise assets for liquidity purposes (since cash coming in exceeds cash going out), n needs to be estimated by considering things like how active the trading strategy is for that fund.

However, when the fund starts to contract the company needs to reconsider the value of n because it is now going to be forced to start selling its equities and property in order to obtain the cash required to pay the outflows.

So, the company might just decide to set n=0 to make things easier. In which case, there would be no discounting.

Or, it might not actually have to change the n that it was using when it was expanding because n might already be assuming that some assets would be sold in the very short term. For example, the company might have had quite an active trading strategy, so n could have been quite small already (even zero) for some of its assets. [The difference when the fund is contracting is that the cash obtained from the sale would be used to pay for outflows of claims, rather than being used to buy new attractive assets when the fund is expanding.]

Alternatively, the company might just reduce n to somewhere between 0 and what it was when the fund was expanding.

This is what that paragraph is trying to get across. Hope that makes it clearer?

 

[gruhaa]

To recap, the deferred tax adjustment for an unrealised gain on equities and property held in a BLAGAB fund is determined as:
indexed unrealised gain x tax rate t x discount factor v^n.

n represents the time period between the unit pricing date (ie now) and when the underlying assets are expected to be sold. This recognises the fact that the tax is not payable until the gains are actually realised.

For an expanding fund where there is no direct need to realise assets for liquidity purposes (since cash coming in exceeds cash going out), n needs to be estimated by considering things like how active the trading strategy is for that fund.

However, when the fund starts to contract the company needs to reconsider the value of n because it is now going to be forced to start selling its equities and property in order to obtain the cash required to pay the outflows.

So, the company might just decide to set n=0 to make things easier. In which case, there would be no discounting.

Or, it might not actually have to change the n that it was using when it was expanding because n might already be assuming that some assets would be sold in the very short term. For example, the company might have had quite an active trading strategy, so n could have been quite small already (even zero) for some of its assets. [The difference when the fund is contracting is that the cash obtained from the sale would be used to pay for outflows of claims, rather than being used to buy new attractive assets when the fund is expanding.]

Alternatively, the company might just reduce n to somewhere between 0 and what it was when the fund was expanding.

This is what that paragraph is trying to get across. Hope that makes it clearer?

yes, it cleared it very well. So even in expanding fund, n is tend to be smaller than the firm whose turnover of assets is low. my understanding with 'turnover of asset is low' is that company is not engaged in active selling and purchase of the assets.
And thus, the allowance of the tax on unrealised gain, in expanding fund, is higher than that under where the turnover of asset is low due to low discouting of the former . I suppose this is what is being said in the first paragraph of the page containing 'Allowance of unrealised gain in bid basis' in chapter 8.

 

[Lindsay Smitherman]

Yes - you are absolutely right. Sounds like you have understood this well.

 

[Mbotha]

Hi Lindsay

Why is it that gains (capital movements) in gilts, bonds and derivatives aren’t treated in the same way as realized gains on equities and property?

 

[Lindsay Smitherman]

Hi
I am not sure what you mean by them not being treated in the same way. In both cases, they are included in "I" for tax purposes, if within the BLAGAB fund.

If you are asking why HMRC chooses to tax equity/property gains only when they are realised but gains on gilts etc as they arise, then this is for historic reasons that would not be examinable for SA2. (The justification includes a desire not to draw a distinction between income and capital gains on fixed interest bonds, which makes sense given that we tend to consider bond returns in terms of gross redemption yield, which is a combination of both income and capital gains/losses, whereas equity and property returns are thought of more in terms of separate income stream (dividends, rent) and price growth).

If you are asking why the Core Reading talks about making adjustments to unit prices in relation to gains on equities and property etc, when it doesn't for gilts, then it is due to capital gains on the latter being taxed when they arise (unrealised or realised) but for the former only when they are realised (ie when the asset is sold). For the former (ie equities and property), just taking tax out of the fund when it is paid would therefore not be fair to unitholders, and the company has to make assumptions about how long it will be until the asset is sold and the tax is actually payable.

For gilts, etc, the tax adjustment for unit pricing in BLAGAB funds is much more straightforward - the tax will be payable at the end of each tax year and so in the interim period companies will tend just to make a tax adjustment to the accrued income/gains on a daily basis without any discount.

 

[Mbotha]

Thanks so much, Lindsay. Sorry about the lack of clarity in my question but your answer has helped a lot!!

 

[Lindsay Smitherman]

Glad it helped. It can indeed be tricky to express questions fully and without any possible ambiguities, as we all know from experience!