It’s not really possible (and it doesn’t make a lot of sense) to talk about the taxation of the earnings (income/gains) of those who invest in managed funds without also considering the taxation of the earnings of the fund itself. Obviously you want to avoid double taxation of the same earnings (once when they accrue to the fund and a second time when the investor receives them from the fund, or on realising their investment in the fund). But you also want to avoid funds being used to shelter income and gains from any tax at all for an indefinite, and possibly unlimited, period.
There’s a good deal of talk on AAM about the tax-favoured investment mechanisms available in the UK, Sweden, etc. But they operate by way of exception, and to make sense of them you have to look at them in the context of the tax regime that they are an exception
to.
A fairly common high-level policy position adopted in many countries is:
- We should be tax-neutral as between direct investment in equities, bonds, etc, and investment in funds that, in turn, invest in equities, bonds, etc — taxpayers shouldn’t be penalised for preferring direct over indirect investments or vice versa.
- Investment income and gains should be taxed as they accrue
- By way of exception to this, we’ll permit mechanisms by which investors can receive income and gains tax-free, or they can defer taxation on their income and gains. But these will have limits - usually monetary amounts that you can put into them, or that you can hold in them at any time.
You then adopt a taxation regime which requires managed funds to distribute their earnings (income and gains) in full every year. Investors are then taxed on these each year, except to the extent to which they can avail of a tax-favoured arrangement to avoid or defer tax.
A variant on this is a taxation regime requiring managed funds to
declare their income and gains each year. Investors are then taxed on these, whether or not they receive them. It’s up to the investor whether or not he wants to meet this tax liability by selling some units in the fund, or from other sources — the revenue authorities don’t care.
Either way, income and gains are taxed in the year that they accrue to the fund, but they are taxed in the hands of investors. Thus, when the investor redeems their investment, there’s no further tax to pay — the income and gains have already been fully taxed. (But if the investment has been sheltered in one of the tax-favoured mechanisms just mentioned, there may be tax to pay — it depends on whether the tax-favoured mechanism is designed to give a full tax exemption, or just a tax deferral.)
But then you have to consider the issue of offshore investments. The Revenue can’t tell a fund in, say, Luxembourg that it must distribute income or gains, or that it must declare its income and gains so that Irish investors in the fund can be assessed to tax. So a lot of countries have two parallel regimes:
- One regime for investments in funds established and taxed within the country (or in overseas funds which voluntarily participate in the system)
- A second regime for investments in overseas funds
The problem with this is that it’s messy. Plus, the second regime tends to be burdensome on taxpayers — they have to proactively get information about income and gains from the fund manager and then declare it to the revenue. So that operates as a disincentive to invest in foreign funds.
That’s a problem for the EU, which wants to facilitate cross-border investment funds. And it doesn’t take a genius to work out that the way to do this is to develop an EU-wide reporting regime in which all funds must either distribute their earnings, or declare their earnings to investors, so that each country can then tax those earnings (or not) in accordance with its national requirements. Each country can then decide for itself what tax exemptions or tax deferrals it wishes to allow via ISA-type accounts, or whatever.
The current tax regime in Ireland is generous to funds — they’re not taxed at all on either income or gains. Because it’s so generous, without
something like deemed disposal, investors in managed funds could defer taxation on income and gains indefinitely — hugely valuable to the investors, and a serious distortion of the investment market. (And a massive favouring of investment earnings over earnings from work, which would be politically sensitive.) Hence, deemed disposal.
If there is a move towards either distribution or reporting of income and gains by the funds, then a move away from deemed disposal becomes a lot easier, since you can tax investors on actual, known income and gains each year, rather than intermittently through a highly artificial deemed disposal. (It will mean a tax bill to investors, rather than the tax being deducted and remitted by the fund managers, though.)
In that context, an ISA-type arrangement looks attractive. You can set limits at a level that means that modest investors won’t have any tax compliance obligations — all their investments can be held in an ISA — and that means the availability of ISAs won’t mean money being diverted from retirement savings (which for public policy reasons the government doesn’t want). Only relatively large investors will have reporting obligations and tax liabilities, which means that we don’t have a big wodge of burdensome tax compliance encompassing a lot of taxpayers to collect relatively trivial amounts.
