Dodge the tax man with some zeros

Tax-efficient investing is more important than ever after Chancellor Alistair Darling's last Budget hiked the top rate of income tax on those earning over £150,000 to 50%. That makes capital gains look far more attractive, as they are only taxed at 18%. But how do you invest for capital gain rather than income? One way is through zero dividend preference shares, issued by split-capital investment trusts.

How zeros work

Zeros are a special type of preference share (or 'pref'). Prefs are simply shares that typically pay a fixed, rather than variable, dividend. This sets them apart from so-called ordinary shares.

Also, prefs usually don't get voting rights but do rank above ordinary shares in the queue for repayment should an issuer go bust. As such, they are a hybrid a share with features similar to a standard corporate bond.

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What makes zeros different from normal prefs is that they pay no dividend at all. So an investor makes all of their return assuming there is one as a capital gain.

This is the difference between the price on purchase and the fixed repayment promised by the issuer when the share is bought back ('redeemed'). This gain is then subject to capital gains tax (CGT) rather than income tax, which, given the new regime, means "the theory behind zeros makes more sense than ever", as Hugh Adlington of Rathbones tells the FT.

What can go wrong?

You don't get something for nothing, and in this case, the beneficial tax treatment is offered in return for you taking some risk. Many zeros are issued by so-called split capital investment trusts. These are investment firms typically with their own shares listed on the London Stock Exchange. Zeros may be just one of several types of share that a split-cap issues (hence the name, 'split capital').

These companies face two problems that have kept them off many investors' radar. They are not allowed to advertise individually, so even finding out about them can be tricky. And after the dotcom bubble popped in 2000, many went bust.

They made two big mistakes.

First, as companies, they could borrow to fund investment. This enhances returns in a bull market but has the reverse effect in a crash.

Second, many of the trusts that went bust did so because they had invested in other highly geared trusts.

Because large numbers of the trusts had invested in tech stocks, when share prices plunged, a chunk of the split-cap sector followed. Investors who had paid for zeros ended up with nothing (because any remaining capital has to go to banks before shareholders), rather than the lump sum they had hoped would one day pay for school fees or fund an extension. The bad press was felt across the investment trusts sector and the impact lingers on today.

But while there's no guarantee that such a fiasco couldn't be repeated, "I think we've all learned that even a zero can go bust", says Daniel Godfrey, director of the Association of Investment Companies. For investors the lesson is: make sure you know what you are buying into before you buy prefs in any specific trust.

How to spot a duffer

No one wants to risk capital unnecessarily during a recession, no matter how good the tax breaks are.

A couple of checks on an investment trust could save you a lot of grief later.

First check 'cover' (or ask your broker). This is how many times the firm's assets (these could be cash, property, shares, bonds, indeed almost any investment) cover the value of outstanding zeros. The higher the better. As a rule of thumb, don't settle for anything below two or three if you want to sleep at night.

A similar method is to look at the 'hurdle rate'. This measures how far the trust's assets could fall in value each year before there is a risk that the zeros won't be repaid. Investment trusts generally take a medium to long-term view and can weather a dip if it isn't too severe. But in the current climate, you should view a hurdle rate below 10% with caution.

What to buy

A number of fund managers are planning to launch zero split caps in the near future, so you may want to wait to see what's available in the coming weeks.

For anyone investing now, Mick Gilligan at Killik & Co likes the new £60m Ecofin Water & Power Opportunities (LSE: ECW) with cover of 4.5 times and a hurdle rate of just under 20%. If you buy the zero prefs, you can expect an annual return of around 7% over seven years, says Alice Ross in the FT. That's a repayment of just over £1.60 per £1 invested, with the gain taxed at just 18%. Not bad, given the Bank of England base rate is only 0.5%.

The FT also tips JZ Capital (LSE: JZCP), a trust that invests in US micro-cap (very small company) buyouts. Although it promises 8% a year over seven years, the underlying investments are riskier and the trust offers lower asset cover. One for the brave.