Do special dividends count towards the tax-free allowance?

When National Grid paid £3.2bn to shareholders via a special dividend earlier this year – the proceeds from selling part of its business – it also cancelled part of our shareholding.

We received 11 shares for every 12 we had held before, plus the dividend. As a result, we made no financial gain from the transaction. But will this special payment count towards the £5,000 tax-free dividend allowance? The extra dividend could lead us to incur a tax bill, leaving us worse off. TS, VIA EMAIL

For tax purposes, a special dividend is treated like any normal dividend, regardless of whether there has been a net financial gain or not.

Before George Osborne’s overhaul of the dividend tax system, shareholders would normally have been given two options: take the payment as a special dividend, or receive special “B” shares, which would be immediately sold.

That system gave investors a choice between taking income or making a capital gain, and they could take the course of action that best suited their overall tax position. Now, companies nearly always have to make special payments in the form of income.

Everyone has a £5,000 annual tax-free dividend allowance at present, with basic-rate taxpayers paying 7.5pc on any dividend income above that, and higherrate taxpayers paying 32.5pc. Additional rate taxpayers are charged 38.1pc.

Anyone whose dividend income falls within the allowance doesn’t need to do anything. Those with between £5,000 and £10,000 of dividend income need to tell HMRC, and either have their tax code altered or include the dividend income on a self-assessment tax return if they already fill one in. Those with more than £10,000 in dividend income will have to complete a tax return.

The situation is about to become worse. In the latest Budget, it was announced that the tax-free dividend allowance would be cut from £5,000 a year to £2,000 from April 2018.

The best shield against this is to ensure that as many dividendpaying investments as possible are moved into an Isa before the change comes in. have come across an exchangetraded fund (ETF) that has “3X” in its name. What does this mean, and is the fund safe? DM, VIA EMAIL

The ETF you have stumbled across is a so-called “leveraged” fund. The first point to make is that if you don’t understand it, steer clear. These are highly complex investment funds that aim to achieve returns that are two, three or even four times those of the index they track.

For instance, a three times leveraged S&P 500 ETF would in theory return 3pc for every 1pc rise in the S&P 500. The same is true in reverse – a 1pc loss would become a 3pc loss.

There are also “inverse” funds that aim to go up when the index goes down, and vice versa.

These returns are achieved through complicated “derivatives”. Such funds are highly risky, and not aimed at the everyday stocks and shares investor.

They are intended to be used only by sophisticated or professional investors for very short-term trading – their structure means they are not suitable to be held long term.

Such short-termism is not something Telegraph Money advocates for those who don’t know exactly what they’re doing.

The terminology used varies, but watch out for “2X”, “3X”, “ultra”, “pro”, “bull”, “bear”, “short” and “long” in fund names. Where these terms appear, you need to check exactly what it is the fund sets out to do.

However, this doesn’t mean you should steer clear of any funds that use leverage. Investment trusts, for instance, are able to borrow money to invest and amplify returns for their investors.

This is a form of leverage – typically referred to as “gearing” in the investment trust world – and is common practice.

Additionally, many funds make use of derivatives. Absolute return funds, for instance, will often contain investments intended to go up when markets fall.

Some funds also make use of so-called “short selling” to take bets against a stock.

Lastly, income funds that target a high yield often use derivatives to sell a portion of their potential future growth in return for upfront cash used to pay dividends to investors. Such funds go by names including “optimum income” or “income maximiser”.

You should be aware of these features, but not be automatically put off by them.

Our expert reporters answer readers’ questions. This week:

on dividend taxation and ‘leveraged’ funds