I always find the argument around the suitability of the investment wrapper paramount. Too often I see new clients – who maybe non-tax payers with an investment bond wrapper rather than collective. If this is personally owned I struggle with why someone has chosen to pay Basic Rate Tax when they most likely could have paid no personal tax – admittedly the tax is paid within the fund but all costs will affect investment performance.
OK lets start by getting a bit of jargon out of the way…when I use the global term Collectives, I am referring to anything along the lines of OEICs, Unit Trusts, Investment Trusts, SIVACs, UCITS I, II, III, etc. I am just trying to use an all-inclusive term.
Choosing the most appropriate investment for an individual will depend upon many factors including :-
- personal circumstances
- investment objectives
- current and future levels of income
What factors to consider?
The summary below compares bonds and collectives from the perspective of taking an income, capital growth and various tax and estate planning options. Whilst the choice of investment should not be made for taxation reasons alone it will be a critical factor. Other key factors will include product pricing, charges, investment structure, administration and service, fund choice, asset classes, death benefits and trust options.
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Investment Bonds |
Collectives |
| Taking an income | Taking an income |
| • 5% withdrawals can be taken per annum without incurring an immediate tax charge (deferred but not free of tax) and any unused allowance can be carried forward to future years. • Bonds are a useful way of providing an ‘income’ without any impact on an investor’s personal allowance and/or age allowance, (within the 5% allowance).• If withdrawals exceed the 5% allowance (or higher cumulated amount), tax may be payable depending on the tax position of the investor and whether the bond is either onshore or offshore • Because investment bonds are non-income producing assets there is no need for annual tax returns, unless there has been a chargeable event (such as exceeding the 5% annual allowance) resulting in a chargeable gain (realised profit). | • The income from a collective will be taxable whether taken or reinvested. Non-Equity funds (which hold greater than 60% in cash or fixed interest) have income paid as an interest distribution net of 20% tax (and non-taxpayers can reclaim). Equity funds (which hold less than 60% in cash or fixed interest) have income paid as dividend income with a 10% non-reclaimable tax credit. • Income paid (or reinvested) from a collective will be included in the assessment of an investor’s personal taxation and/or age allowance – although if the collective is held under an ISA wrapper this problem is solved.• Disposal of shares/units to supplement income is a disposal for capital gains tax, although this may be covered by your annual capital Gains Tax Allowance (currently £10,600 in Tax Year 2012/2013). The rate of CGT payable will depend on the allowances and reliefs available to the investor and on their income tax position.• Because collectives produce income they will normally need to be reported each year to HMRC, even if accumulation units or shares are chosen. Capital gains may also need to be reported when a disposal takes place but only if tax is expected to be payable. |
| Capital growth | Capital growth |
| • When the bond is surrendered (this is a chargeable event) tax is assessed and may be payable depending on the personal income tax position of the bond owner. This is true whether the bond is either onshore or offshore.• Switching funds in an investment bond can take place with no tax implications for the investor. (This is not a disposal for tax purposes while the funds remain under the bond wrapper.) | • When shares/units are cashed in, this is a disposal for capital gains tax although this may be covered by your personal Capital Gains Tax (CGT) Allowance. • Losses on disposals can be offset against other capital gains – so can create effective tax planning scenarios.• Taper Relief and Indexation Allowance are no longer available on personal scenarios.• Switching funds within a collective is a disposal for CGT with possible tax and reporting requirements. |
| Tax & Estate Planning | Tax & Estate Planning |
| • Individuals may be able to alter their level of income to reduce or avoid tax on surrender of the bond.Examples – those who have pension income in drawdown can reduce their income received to minimise tax payable; or could use part of the proceeds to help fund a pension, EIS, VCT, etc. so that the tax credit created offsets the tax bill associated with the investment bond encashment. • Gifting the bond (by assigning it nit not for “monies worth”) to a lower or non tax-payer. So an assignment to a spouse or child in further education may not create any liability (depending their personal tax rate) to CGT or income tax. It could reduce or avoid the tax that would otherwise have to be payable by the investor. • Individuals may be able to make a pension contribution to reduce or avoid any further liability to income tax on the surrender of their investment bond.• Gifting the bond to another (i.e. assigning into trust or to an individual) will be a transfer of value for Inheritance Tax and depending the terms of the trust may be covered by an exemption – more commonly though will be treated as a chargeable lifetime transfer.
• Having multiple lives assured can avoid any chargeable event upon death of the bond owner. This is assuming the contract is for encashment on the death of the last life assured. • If a chargeable gain arises in a tax year in which the investor is non-UK resident then there will be no further liability to UK income tax. There may be a tax liability in their country of residence. • A special relief applies to offshore bonds that reduces the tax liability on chargeable gains for individuals who have been non-UK resident for any period of their investment – Time Apportionment Relief. • Investment Bonds, depending on the interpretation by local authority, may not be included within the means test for local authority residential care funding – care is needed as this varies from authority to authority, year-to-year, the circumstances surrounding and prior to the investment and many other factors. |
• Individuals may be able to alter their level of income to reduce the tax rate payable on a capital gain e.g. those who have pension income in drawdown may be able to reduce it, by careful selection of funds within the collective to select the desires level of taxable income.• Transferring the collective to another individual or into trust will be a disposal for CGT purposes although this may be covered by your Personal Annual Allowance to CGT, or an exempt transfer between spouses. If into trust, gift holdover relief may also be available depending on the type of trust.• Individuals may be able to make a pension contribution which in turn could reduce the rate at which they pay CGT.• Transferring the collective to another individual or into trust will be a transfer of value for Inheritance Tax purposes, although this may be covered by an exemption.• No CGT is payable on death.
• Investors who are both non UK resident and ordinarily resident will not be liable to UK CGT on disposal of their collective. However, anti-avoidance legislation means they will need to remain non UK resident and ordinarily resident for five complete tax years for the gain to remain exempt from CGT. • Collectives are included within individual’s assessment for local authority residential care funding. |
| Taxation of Fund | Taxation of Fund |
| Onshore Bond funds’ internal taxation is extremely complex. In general terms it can be summarised as follows:• Interest and rental income are subject to corporation tax at 20%. Dividends are received with a 10% tax credit which satisfies the fund manager’s liability.• Corporation tax is payable on capital gains at 20%. Indexation allowance is available to reduce the gain.• Investors are given a non-reclaimable 20% tax credit to reflect the fund’s taxation.Offshore Bond funds are typically located in jurisdictions which impose no tax upon investment funds, such as Dublin, the Channel Islands and the Isle of Man. And so:
• Interest, dividends and rental income are tax-free while under the bond wrapper. Some non-reclaimable withholding tax may apply to certain overseas income. • No corporation tax is payable on capital gains. • Personal tax position, rates and residence status must be considered carefully as taxation is typically payable at your highest marginal rate when the bond is finally encashed. |
Collectives are only subject to tax within the fund on income received, and so:• Interest and rental income are subject to corporation tax at 20%. Dividends are received with a 10% tax credit which satisfies the fund manager’s liability.• No corporation tax is payable on capital gains within the fund. |
Summary
There is no black and white answer on this – it is all circumstance specific but an understanding of the differences is essential. My belief is only pay tax when required and lawful – so products with an inbuilt taxation are to be used only when necessary, the lesser tax rate or for a specific reason/purpose.
Investors make money through investments with three key principles – fair costs, minimise taxation and investment performance.
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