LONDON - Loss of tax credits for dividends paid to U.K. pension funds could knock up to 10% off U.K. equity prices and would force many U.K. companies to make cash injections into their pension funds.
The Financial Times-Stock Exchange 100 index last week fell 189.2 points, or 4%, from its record close on June 13 following rumors of abolishment of tax relief for U.K. tax-exempt investors that added to fears of rising interest rate and declines in international equity markets.
Some observers predicted the market could fall further, although it is unknown what action Chancellor of the Exchequer Gordon Brown actually will take in his July 2 budget.
In the past, Mr. Brown has said he wants to promote more corporate reinvestment and has been critical of high U.K. corporate dividend pay-outs. What's more, he needs to raise revenue to finance the newly elected Labor Party's ambitious programs.
Potential fallout from abolition of the tax credit - which experts speculated could occur in two stages - is generating widespread concern. Under the United Kingdom's advanced corporation tax, British companies pay tax on dividends paid to shareholders, but tax-exempt investors can reclaim part of that tax with a 20% tax credit.
Among the major ramifications of elimination of the ACT credit:
Loss of the tax credit could spell a 20% loss in dividend income for U.K. tax-exempt institutions. If the change is extended to foreign investors, U.S. pension funds and individual investors could lose 5% of income, making U.K. equities less attractive.
The value of British pension funds would drop because U.K. equity valuations are based on discounted income streams. A new study of 225 U.K. companies by Dresdner Kleinwort Benson, London, said the average funding rate would fall to 101% from 113% if tax relief were abolished.
Lower funding levels would force many companies to boost their plans to meet new minimum funding requirements. Imperial Chemical Industries would be worst hit, required to make a cash injection of 1.36 billion pounds ($2.23 billion), or 22.9% of its market capitalization, to restore its pension fund to 100% funding, the Dresdner study said. "It's all speculation on their part," said Vincent Leheny, head of investor relations at ICI.
Actuaries might move toward a market-based methodology from the current approach, which smooths out market volatility. Current proposed international accounting standards also are pushing actuarial methodology in this direction.
Market observers said elimination of tax relief could cause the U.K. market to decline by up to 10% in the short term. However, anticipated reduction of the tax benefit already has been partly discounted by the market, and some question just how much further it would fall.
Kevin Gardiner, a U.K. economist with Morgan Stanley, London, said he thought the potential effect on the market would be a 5% decline.
The head of research with a large London-based money manager predicted if the entire 20% tax credit were abolished, the market would fall 7% or 8%. "But it will probably be phased in over quite a long period, given the potential impact on solvency levels of pension funds," he said.
Despite the recent fall, most British fund managers believe the abolition of tax credits on dividend payments would have a minimal long-term effect on the U.K. equity market.
John Cozens, a director with Prudential Portfolio Managers Ltd., London, one of the U.K.'s largest fund managers, said much of the potential impact had already been factored into the market. "Assuming it happens in the budget and the market adjusts, that would be it," he said.
Moreover, he dismisses any talk of seismic changes in U.K. pension funds' asset allocations as overblown. "Over the last three or four years there appears to be a shift out of U.K. equities anyway," he said. He explained that's partly because of the Pension Act's funding rules and the increasing maturity of many pension funds.
"That's a trend that will continue, but what they're going to do to ACT wouldn't change it," Mr. Cozens added.
John Ainsworth, head of equities at Hill Samuel Asset Management Ltd., London, said most observers believe any change would affect only pension funds. He said recent market declines are an overreaction, and abolition of the tax credits should have a limited effect on the market.
"But no one can work out the impact. You can't quantify what the change will be," he conceded.
Impact on U.K. funds
Observers warn elimination of the tax credit would have a substantial effect on British pension funds.
Peter Ludvik, head of asset allocation and a partner with Watson Wyatt Worldwide, Reigate, said loss of the credit would have a far greater impact on actuarial calculations than on total returns. Repeal of the credit could result in a roughly 75 basis-point reduction in return assumptions for equities, if growth assumptions remain unchanged, he said.
"For the typical pension fund, we're talking up to a 10% increase in pension fund cost," Mr. Ludvik said.
That also would result in a 10% to 15% drop in solvency levels, he said.
In effect, U.K. funds would receive "a double whammy," he said, with asset values declining and liabilities rising because of reduced discount factors.
Other observers noted the effect on contributions will depend greatly on how the proposal is drawn up, and whether an overall review of ACT is involved. That could, for example, involve a reduction corporate taxation levels.
"We just don't know at this stage whether (Gordon Brown) will just do it or he will announce a complete review," said Graham Allen, chairman of the National Association of Pension Funds' investment committee and managing director of ICI Investment Management Ltd., London.
If the chancellor opts for complete repeal of the tax credit however, one consequence would be an increased attractiveness of going to a market-value based approach of valuing assets, said Andrew Dyson, head of U.K. pensions for William M. Mercer Ltd., London.
U.S. investor implications
Several international accounting firms note that changes in the ACT tax credit also could affect U.S. and other international investors.
For example, a U.S. portfolio investor who received a dividend of 80 would now receive an ACT-related tax refund of 20, less withholding tax of 15, entitling the investor to a refund of 5.
However, if the dividend rose to 90 and the tax credit were reduced to 10, then when withholding tax is subtracted, the investor would be left with a net repayment of zero.
This in turn could upset various international tax agreements between the United Kingdom and the United States, Canada and several European countries.
"Clearly it will have a major impact and will upset major inbound investors, particularly from the U.S.," predicted David Morgan, a senior tax manager at Coopers & Lybrand in London. Indeed, the U.K. government might even have to renegotiate its treaties with some of these countries.
However, other accountants were less pessimistic about the impact on overseas investors. "You won't have a queue of Americans about to leave the country, but it's one of the things you toss into the pot, alongside wages, golf courses and so on, when considering where to invest," said John Whiting, tax partner, Price Waterhouse, London.
"I suspect it wouldn't make a great deal of difference," said Terry Browne, an international tax partner with Deloitte & Touche in St. Albans, England.