A UK unit trust or OEIC can pay its income as an interest distribution only if, at all times in the distribution period, more than 60% of the market value of its investments is in qualifying investments such as cash deposits, bonds and gilts. Interest distributions are taxed as savings interest, paid without tax deducted, and use the Personal Savings Allowance rather than the dividend allowance. Offshore funds and ETFs face a parallel 60% test that turns their dividends into interest.
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What is the qualifying investments test?
For UK authorised investment funds, the rule is in regulation 19 of the Authorised Investment Funds (Tax) Regulations 2006 (SI 2006/964). No amount may be shown as available for distribution as yearly interest unless the fund satisfies the qualifying investments test throughout the distribution period. The test is met if, at all times in that period, the market value of the qualifying investments exceeds 60% of the market value of all the fund’s investments.
Where the test is met and the fund allocates its income for distribution as yearly interest, regulation 18 says the Tax Acts apply as if that amount were payments of yearly interest made by the fund to investors in proportion to their rights on the distribution date. That is an “interest distribution”. Otherwise the fund pays a dividend distribution, which HMRC’s Investment Funds Manual at IFM03350 says is treated like any other UK company dividend.
What counts as a qualifying investment?
Regulation 20 lists eight categories:
- money placed at interest;
- securities;
- shares in a building society;
- qualifying units in another authorised investment fund (and, under category 4A, qualifying units in an offshore fund);
- derivative contracts whose underlying subject matter is wholly within categories 1 to 4A and currency;
- contracts for differences based wholly on interest rates, creditworthiness and currency;
- other derivative contracts that hedge an asset in categories 1 to 4A;
- alternative finance arrangements.
Regulation 21 adds important limits. “Securities” do not include shares in a company, so equities never count. Units in another fund count only if that fund would itself pass the test, looking just at its direct holdings in categories 1 to 3 and 5 to 8, and ignoring cash awaiting investment. A fund of funds cannot therefore turn equity funds into qualifying investments by stacking them.
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Why does “at all times” create risk for mixed funds?
The test is applied continuously, not at the period end. A mixed asset fund that holds about 60% in bonds may pass in one distribution period and fail in the next, so the same fund can pay interest distributions one year and dividend distributions the next. Check the tax voucher for each payment rather than assuming the fund’s label tells you which allowance applies.
How is an interest distribution taxed?
IFM03350 explains that before 6 April 2017 funds normally deducted basic rate tax from interest distributions, but from 6 April 2017 no tax is deducted. The full amount is taxable savings income, and IFM03310 says that for interest distributions the investor is liable to tax at the appropriate rate.
Because it is savings income, an interest distribution can be covered by unused Personal Allowance, the starting rate for savings and the Personal Savings Allowance, which GOV.UK gives for 2026 to 2027 as £1,000 for basic rate, £500 for higher rate and nil for additional rate taxpayers. It does not use the £500 dividend allowance. The order in which these allowances are used is set out in how savings and dividend income stack.
On a Self Assessment return, HMRC’s guide (SA150) tells you to include interest from UK authorised unit trusts, OEICs and investment trusts in box 2 for untaxed UK interest, because these are paid without tax deducted.
Illustration only
Two investors each receive £800 of fund income in 2026 to 2027 and have no other savings or dividend income. One holds a corporate bond fund that pays interest distributions; the other holds an equity income fund that pays dividend distributions.
| Taxpayer | £800 interest distribution | £800 dividend distribution |
|---|---|---|
| Basic rate | Within £1,000 allowance: £0 | £300 over £500 allowance at 10.75%: £32.25 |
| Higher rate | £300 over £500 allowance at 40%: £120 | £300 over £500 allowance at 35.75%: £107.25 |
The dividend rates are those GOV.UK gives for 2026 to 2027. A basic rate investor with no other interest pays nothing on bond fund income, while a higher rate investor pays more on interest than on the same amount of dividends. The gap grows from 6 April 2027, when HM Treasury’s policy paper confirms savings rates of 22%, 42% and 47%; see savings income tax rates from April 2027.
What about offshore bond funds and ETFs?
Many bond ETFs and funds sold in the UK are offshore funds. Section 378A of the Income Tax (Trading and Other Income) Act 2005 applies where an offshore fund pays a dividend and fails the qualifying investments test at any time in the relevant period. The dividend is then treated as interest for income tax purposes. The test is failed if the market value of the fund’s qualifying investments exceeds 60% of the market value of all its assets, excluding cash awaiting investment.
The relevant period is normally the fund’s last period of account ending before the dividend is paid, or 12 months ending on the last day of that period if longer (section 378A(4) and (5)).
For reporting funds, HMRC’s IFM13320 explains that both actual distributions and any excess of reported income over distributions are treated as yearly interest where the fund holds more than 60% of its assets in interest bearing or economically similar form. IFM13326 says the excess is treated as made on the fund distribution date, six months after the end of the reporting period. IFM13320 also says fund managers or advisers should be able to tell investors if a fund is a bond fund, but investors are responsible for determining this. Reporting status is explained in offshore funds reporting status.
What happens when I sell the units?
A disposal of units in an authorised investment fund may give rise to a Capital Gains Tax charge, according to IFM03370. That applies even if the fund holds only gilts. The exemption for gilts in section 115 of the Taxation of Chargeable Gains Act 1992 applies to disposals of gilt edged securities themselves, not to units in a fund that owns them; compare why low coupon gilts are tax efficient.
If you bought units part way through a distribution period, the first payment may include equalisation. IFM02230 explains that returned equalisation is not part of the income distribution; it is a capital receipt deducted from the cost of the units for Capital Gains Tax. Only the income part is taxable as interest. See equalisation payments on unit trusts and OEICs.
Are companies treated differently?
Yes. For an investor within the charge to corporation tax, IFM03326 explains that a holding in an authorised fund whose qualifying investments exceed 60% of its total assets at any time in the investor’s accounting period must be treated as a loan relationship. In practice any holding in a fund that could pay interest distributions is caught, and the company is taxed on the holding under the loan relationship rules rather than simply on the distributions.
What mistakes do investors commonly make?
- Putting interest distributions in the dividends box. That applies the dividend allowance and dividend rates to income that is savings interest.
- Assuming tax has been deducted. Since 6 April 2017 it has not (IFM03350), so tax above your allowances must be paid through Self Assessment or your tax code.
- Relying on the fund’s name. A “strategic bond” or “multi asset” fund passes or fails on its actual holdings at all times in each period.
- Overlooking an offshore ETF’s status. Section 378A converts its dividends, and any excess reportable income, into interest.
- Forgetting the ISA option. GOV.UK confirms interest in an ISA is not usually taxed, so bond funds held in an ISA use neither allowance.
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Related Accountapedia entries
- Transfers between charity funds
- Fixed rate savings bonds: which year the interest counts
- Private fund limited partnerships
- Small capital distributions and CGT
- Can a restricted fund be in deficit
Sources
- legislation.gov.uk: SI 2006/964, regulation 19
- legislation.gov.uk: SI 2006/964, regulation 18
- legislation.gov.uk: SI 2006/964, regulation 20
- legislation.gov.uk: SI 2006/964, regulation 21
- GOV.UK: Manual page IFM03350
- GOV.UK: Manual page IFM03310
- GOV.UK: How much is tax free
- GOV.UK: Tax on dividends
- GOV.UK: Income tax rates
- GOV.UK: Self assessment tax return guide sa150
Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 24 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.