For over the past 12 months, the investment trust sector has broadened its horizons and now encompasses a much wider range of closed-end investment companies.

The essential characteristics of these investment vehicles is that they are closed-ended, which means they have a fixed share capital in issue, and they are listed, usually on the London Stock Exchange, which means that their shares
are easily available to investors. But while all investment trusts are also investment companies, not all investment companies qualify as investment trusts.

What is an investment trust?

Strictly speaking a closed-end investment company will:

• Be a publicly quoted company whose shares are listed on a recognised stock exchange
• Have an investment portfolio run by a full-time professional fund manager
• Have an independent board to look after shareholders’ interests
• Have the ability to borrow
(or gear up) to enhance investment performance
• Have shares that trade freely and will therefore, at any given time, stand at a discount (or premium) to the underlying net asset value of their portfolios.

That is a standard summary of the attractions of an investment trust, but none of those elements are peculiar to investment trusts per se – they apply equally to all listed closed-end investment companies, at least those in which private investors are likely to be interested. What sets the group of investment companies known as investment trusts apart is that they qualify to be recognised as such under “Section 842”.

This refers to the fact that an approved investment trust company is one ‘which satisfies the requirements of Section 842 of the Income and Corporation Taxes Act 1988, as amended by Section 117 Finance Act 1988, section 55 Finance Act 1990 and Schedule 30 paragraph 2 Finance Act 1996. Trusts that meet these criteria are exempt from having to pay tax on the capital gains they realise from sales of the investments within their own portfolios.’

So now you know. Clearly the reason why investment companies have traditionally sought recognition under Section 842 is the internal exemption from tax on any gains they make within their investment portfolios. The rationale for this is quite simple – since investors in the investment trust (i.e. the shareholders) will be taxed on any gains they make from their investment trust shares, then levying tax on gains within the fund would tax them twice, which is deemed to be unfair, even by the Treasury (a similar exemption exists for open-ended investment funds, such as unit trusts and OEICs).

Put simply, an investment trust is a company in its own right that is run by an independent board of directors and invests, primarily, in the shares of other companies.

As such, it has a finite number of shares in issue so that when an individual invests, they are actually buying a share of the company itself. Unlike an OEIC or unit trust, an investment trust can borrow money (i.e. gear up) in order to make further investments. The board of directors has a responsibility to shareholders for the efficient running of the company and is also responsible for setting the investment policy and for appointing fund managers.

Alternative approaches

However, these attractions are not sufficient to make all investment company boards want to be investment trusts. There are some examples of “non-842 companies” turning themselves into investment trusts in recent years, Caledonia Investments being the most notable, to take advantage of these internal tax advantages. Caledonia is instructive because its move to investment trust status had a significant impact on its market profile, the demand for its shares and the way it approached its business.

Before it became an investment trust, Caledonia was effectively a private holding company which wasn’t particularly tax efficient and which provided relatively little information to shareholders – for example, issuing semi-annual NAV figures that were not totally comparable at market prices. Now, as a properly listed investment trust, its daily NAV figures are there for all to see.

But there are also examples of trusts moving in the opposite direction, a recent example being Henderson Far East Income. The reason for this is that the Section 842 rules can be quite restrictive. Henderson Far East Income moved to an offshore domicile in order to free itself from the restrictions imposed on what it could and couldn’t pay out as income (see box, right) and since one of the stipulations for investment trust status is that a company has to be resident in the UK, then it no longer qualifies as an investment trust.

Another reason why increasing numbers of investment companies are falling outside the narrow definition of ‘investment trust’ is down to the investment strategies they pursue. For example, Section 842 also doesn’t allow for investment trusts that are predominantly invested in fixed-income securities or direct property holdings. The simple reason why so many of the recently launched property investment companies or more innovative income-generating funds are domiciled in Guernsey or Jersey is that, given that they can’t qualify for investment trust status if they are domiciled onshore, it is more advantageous from a tax point of view to base themselves offshore.

Embracing change

Given the fact that a growing majority of new closed-end fund launches over recent years have been of these offshore-domiciled non-investment trust companies, it was not surprising when the trade body that represents investment trusts, the Association of Investment Trust Companies (AITC), became the Association of Investment Companies (AIC), last October, in order to represent the full range of closed-end investment funds.

This has already given a boost to the association’s membership, with around 80 companies singing up. Significantly the vast majority of these have been venture capital trusts (VCTs), another specialist group of funds that had previously been outside the investment trust remit.

This reflects the changing nature of the closed-end investment fund sector. The simple fact of the matter is that a decade ago, say, the vast majority of closed-end investment funds listed on the UK stock market were traditional, equity-based investment trusts, although even then some offshore funds, usually concentrating on individual emerging markets, were beginning to appear. Today there is a significant, and growing, body of closed-end investment companies that are not investment trusts, and have no intention of becoming investment trusts, for the reasons outlined above.

Expanding horizons

In particular, there has been a dramatic surge in the listings of AIM-traded closed-end funds over the past couple of years. Many of these funds are invested in highly specialist areas and, it has to be admitted, largely institutional vehicles. The same is true of the growing number of structured products that are increasingly being seen as a more modern alternative to the zero-dividend preference shares issued by split capital investment trusts.

So the message is that the closed fund sector continues to expand and develop and the creation of the AIC recognises this fluidity. The one thing you can be sure of is that the AIC’s membership will grow increasingly diverse in the years ahead as the investment company sector continues to develop.

Further information:

Section 842 explained
Approved investment trusts qualify as such under Section 842 of the Income and Corporation Tax Act 1988.

This key piece of tax legislation relates to conditions that a company must meet to obtain approval as an investment trust company and thus be exempt from capital gains tax (CGT) on dealings within the assets of the trust. Individual shareholders are potentially liable to CGT on any profits made on the sale of shares, but may, of course, make use of their annual CGT exemption (which for 2005/06 is £8,500).

These conditions are:

• The company is not a close company
• The company is resident in the UK
• The company’s income consists wholly or mainly of eligible investment income
• No holding in a company represents more than 15 per cent by value of the investing company’s investments
• The company’s ordinary share capital is listed on the London Stock Exchange
• The distribution, as dividend, of surpluses arising from the realisation of investments is prohibited by the company’s Memorandum or Articles of Association
• The company does not retain more than 15 per cent of its eligible income.