4 Tax treatment

All income (dividends and interest) and all capital gains are tax-free.

From 6 April 1999, advance corporation tax (ACT), payable by companies when they paid dividends, was abolished. Previously, under the imputation system of taxation, recipients of a dividend were entitled to a tax credit which reflected the payment of ACT by companies. This tax credit reduced the amount of tax that was payable by the recipient of a dividend and, where the recipient's tax liabilty was less than the tax credit, the excess could be reclaimed (particularly by non-taxpayers, such as charities, pension funds and PEPs).

From April 1999, companies have not been required to pay ACT, and dividends are accompanied by a 'notional' 10% tax credit. The ability of certain non-taxpayers to claim a repayment of this 'notional' tax credit was phased out from 6 April 1999 to 5 April 2004, effectively removing some of the originally tax-free status (although higher-rate taxpayers have no further liability which they would do on dividends held outside an ISA). The result is that a fund primarily used for income rather than capital growth is far less tax efficient (especially for non higher-rate taxpayers) when placed in an equity fund, whereas a fund based exclusively on other asset classes (such as bonds) continues to be tax-free in terms of income as well as capital growth.

The government has guaranteed that ISAs will continue to have tax-free status in all other respects until 5 April 2010, although they may be continued beyond that date.

5 CAT standards

In April 1999, the Government introduced a voluntary CAT standard for ISAs (standing for "Charges, Access, and Terms") to make them easier for inexperienced customers to understand and with the proposed intention that lower costs would attract more investors. It does not guarantee the investment performance or that investors would buy or be sold the wrong type of investment. Many products comply with the CAT standard and there is some controversy as to whether or not the CAT standard alone would reach out to many more people who would not have otherwise chosen to save.

Cash ISAs have nevertheless been beneficial to savers through providing instant access savings that require little investment, meaning that the first £3,000 of any cash savings each year will be in a tax-free environment. By way of contrast, only the interest could be withdrawn from a TESSA before its five year period had finished or the tax free status would be lost Further, due to competition cash ISAs continue (as at September 2004) to offer the highest rates of interest, irrespective of tax status, often meaning £1 in an ISA gains a higher rate of gross interest than many thousands invested in another account with the same provider. The market is further advanced as non-taxpayers still benefit from the use of cash ISAs due to the favourable interest rates.

Many equity funds also meet the CAT standards, but the restriction on costs generally means that these funds are tracker fund s which require little management and simply follow a given index, such as the FTSE 100. There is however a division of opinion as to whether managed funds out perform tracker based investments.

Supporters of tracker funds claim that:

1. only a minority of managed funds outperform their chosen index;
2. those that do may not do in the future especially if the performance is linked to a single manager who leaves;
3. others fail to reach the required performance to offset their additional charges; and
4. a managed fund can be more of a lottery thus indicating that low cost trackers might as well be used.

Opponents to this argument claim that:

1. the results to make the case above include a multitude of large institutional managed funds that, by their nature and size, must be closet trackers but with a higher charge and should not be compared to bona fide managed funds;
2. a portfolio itself should be managed in order to change funds when they become less appropriate (such as a key manager leaving);
3. the results examined include the bull markets of the late 1990s, when nearly everything rose and trackers benefited from passive management with low charges and one might expect a different scenario in future;
4. increasingly indexes are disproportionately affected by a few companies or sectors with the largest stock capitalisation and the ability to be selective will play more of a part in the future;
5. tracker funds cannot make use of investments outside its restrictive remit when it might be beneficial such as using mid-cap or even smaller-cap companies in contrast to a fund limited to a set index such as a FTSE 100 fund

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