Many ETFs are fond of distributing yield of the underlying securities (such as dividends or coupon payments) back to investors in the form of dividends. The downside is that income tax is payable on the dividends.

Is there a way to transform the dividend payments back into capital gains? One thing that comes to mind, but not sure whether this works, is to hold your investments in a company and the investor owns shares in that company. The company does not pay dividends but can buy back shares to release capital. Do there exist funds that already do something along these lines for the investors? Any ideas welcome, this is just something that came to mind but may not actually work.

Assume that I have maxed out my ISA.

  • 2
    Some of these funds have so called accumulating share classes (as opposed to distributing share classes), which, as the name indicates, accumulate the dividends within the fund instead of distributing them.
    – assylias
    Dec 28 '16 at 13:01
  • Do such share classes exist for ETFs?
    – SMeznaric
    Dec 28 '16 at 13:02
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    For some ETFs yes, but not for all of them. It should be indicated on the ETF documentation.
    – assylias
    Dec 28 '16 at 13:03
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    @assylias: Note that accumulation units don't magically transform income to capital gains, for tax purposes; see monevator.com/income-tax-on-accumulation-unit and monevator.com/income-units-versus-accumulation-units-difference
    – timday
    Dec 30 '16 at 13:06
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    You could look at using Zero's Investment trusts that have different classes designed for those that want dividend income and those that want capital Feb 19 '18 at 18:44

Some investment trusts have "zero dividend preference shares" which deliver all their gains as capital gains rather than income, even if the trust was investing in income yielding stocks.

They've rather gone out of fashion after a scandal some years ago (~2000). Good 2014 article on them here includes the quote

"Because profits from zero dividend preference shares are taxed as capital gains, they can be used tax efficiently if you are smart about how you use your annual capital gains tax allowance."

  • Does this include fixed income funds? I read that the income from bonds is treated as interest rather than dividends even if held in an ETF (ouch, there goes the dividend allowance).
    – SMeznaric
    Dec 30 '16 at 13:17
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    If you want to convert interest payments to dividends you should definitely look at investment trusts: as I understand it a company which makes profits from interest still pays good old dividends (e.g bond specialist TwentyFour's Income Fund, for example). I assume the same applies to trusts with ZDPs.
    – timday
    Dec 30 '16 at 13:37

US Perspective

In the US, dividends have special tax treatment similar to, but not the same as Capital Gains. No easy way to transform one to the other, the very fact that you invested your money in a company that has returned part of your capital as income means it is just that, income.

Master Limited Partnerships

Also in the US, you could invest in Master Limited Partnerships. These are companies that make distributions that are treated as a return of capital, instead of dividends. Throughout the life of the investment you receive tax forms that assign part of the operating expense/loss of the company to you as a tax payer. Then at the end of the investment life you are required to recapture those losses as Capital Gains on sale of the stock.

In some ways, these investments do exactly what you are asking about. They transform periodic income into later capital gains, basically deferring tax on the income until the sale of the security.

Here is an article I found about MLPs coming to the UK through an ETF: Master Limited Partnerships in the UK

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