Kick-out plans have become increasingly popular in recent years, partly because the combination of low interest rates and volatile stockmarkets has made it more expensive for protected plan providers to build traditional protected plans that simply match index growth (you can read more about protected plans in our investment section). So this news has potentially significant consequences.
What are kick-out protected plans?
They're like conventional capital protected plans in that they usually protect your initial investment and link investment returns in some way to a stockmarket index over five or six years. However, they also allow the provider to end the plan early, typically on an anniversary, if the index hits a certain level.
For example, a kick-out plan might offer a return of 8% a year for five years with the caveat that it will end before then at the end of any year where the FTSE 100 has risen. So if the FTSE rises over the first year the plan will close and you get back your original investment plus 8%.
Why the problem?
HMRC ISA rules state that an ISA manager must not hold securities (i.e. shares, bonds and other underlying investments) that are required to be repurchased or redeemed within five years of purchase. This means, for example, that corporate bonds due to be redeemed within five years cannot be bought within an ISA.
HMRC's view is that kick-out plans may have broken this rule because there's a chance they'll end before the five years are up. If this happens the underlying security used to build these plans is effectively redeemed.
Have the providers done wrong?
It's difficult to say at this stage. The providers' view seems to be that the rules can be interpreted as 'the security won't definitely have to re-paid within 5 years' and/or that simply passing the security back to the issuing bank if kick out does occur is ok as it's not then technically repurchased or redeemed. Whereas HMRC seems to be saying this isn't the case.
Why hasn't HMRC highlighted this issue before?
This is a grey area and my guess is that HMRC has been fairly relaxed in the past as most kick-out plans looked fairly likely to run their full course of five years or more. However, most of the recent plans have terms that make kick-out after just a year a two quite likely, which appears to be against the spirit of the rules, prompting HMRC to clamp down.
Which providers might be affected?
In theory any provider that has sold kick-out plans within an ISA, which would include the likes of Barclays, Santander, Morgan Stanley, Investec, Legal & General, Meteor and Blue Sky Capital. However, I must stress that at this stage it's not clear whether any of these companies has done anything wrong or have any offending ISA plans.
Will I lose out?
Unlikely. When HMRC announced last year that some Keydata ISAs did not comply with the ISA rules they sought to recover outstanding tax from Keydata and then the Financial Services Compensation Scheme (given Keydata was in administration), rather than investors. They also allowed affected investors to retain their ISA allowance on maturity or sale of the offending investment.
What happens next?
HMRC says that ISA managers must check their ISAs to see whether any break this rule. However, given the ambiguity over the issue I'm sure ISA managers will in turn seek further clarification from HMRC. I expect we'll find out more over the next few weeks. I'll keep you posted...