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20/20 vision

In last week&#39s article, I looked at the change to life policyholder fund taxation and the effect it could have on fund growth. This week, as promised, I will consider the impact of the change on the taxation of chargeable event gains made by policyholders.

For individual investors, the corollary to the 20 per cent rate being applied to life policyholders&#39 funds is that the tax credit reduces to 20 per cent. This has no negative impact for non-taxpayers, starting-rate taxpayers and basic-rate taxpayers, for whom no further tax will be payable on a UK bond.

It is worth reminding you that dividends received by UK life companies were not subject to tax before this change and remain tax-free. Nonand starting-rate taxpayers remain unable to make any tax reclaim in respect of tax suffered by the life policyholders&#39 funds.

So the reduction to 20 per cent makes no difference – positive or negative – in respect of growth driven by reinvested dividends.

Of course, to the extent that the top-sliced gain takes the taxable income of a basic-rate taxpayer over the threshold for higher-rate tax, then a liability would arise. Where a higher-rate tax liability arises, the change to the taxation of policyholders is felt directly by the policyholder as the tax credit is correspondingly reduced to 40 – 20 = 20 per cent instead of 40 – 22 = 18 per cent. This represents an 11 per cent increase in tax for higher-rate taxpayers on the gains made under UK bonds.

Let us have a look at the overall effective rate borne in respect of income and gains on which the full policyholder rate of 20 per cent is borne. On £100 of growth/income, £20 of tax will be paid at life fund level, leaving a gain of £80. A further 20 per cent of this will be £16. The total tax suffered on the £100 will be £36, leaving the investor with £64. The effective rate will be 36 per cent.

This is a very simple example, I know, but it brings out the point that a tax benefit is still secured through the non-necessity to gross up the gain before applying the policyholder tax rate.

If the effective rate of tax borne by the life fund and reflected in unit pricing is less than 20 per cent – and it will vary from company to company depending on the circumstances – the effective rate borne will fall further. A 20 per cent credit (as was a 22 per cent credit) is available to the policyholder regardless of the actual rate of tax suffered by the life fund in any particular case. Of course, in determining the overall appropriateness or value of the UK insurance policy as a wrapper for investments, one needs to take into account other important factors such as charges and the value of compounding of tax-reduced growth.

This is particularly important in respect of reinvested dividend income. It is a very important point that dividends are not taxed at life fund level but this fact does not diminish the policyholder tax credit when taxing gains. So, a dividend of, say, £100 will be reinvested with no further tax payable.

Ignoring the benefit of compounding (and the effect of charges – which, of course, one cannot do in reality), if that £100 represented the policy gains, the policyholder who is a higher-rate taxpayer would pay tax of £20. A net £80 would be received.

If that dividend were received outside the bond wrapper, the £100 would be grossed up to £111.11. Tax at 32.5 per cent would be £36.11. The tax credit of £11.11 would be deducted and an actual liability of £25 would be due – £5 more than via the bond, all other things (including charges) being equal.

As I said before, with the yield and reinvested dividends being a factor of some importance for investors, this fact should not be forgotten.

So, how about other policyholders? Well, trustees have a liability at a flat 34 per cent on any chargeable event gains. The reduction of the policyholder rate to 20 per cent means that their actual liability goes up from 12 to 14 per cent on UK bonds.

UK companies which invest in UK bonds secure no tax credit. Even with the reduction of the internal rate of tax to 20 per cent, one would have to seriously question the tax validity of a corporate investment in a UK bond.

It is also worth mentioning that for any investable sums, private trading companies need to bear carefully in mind the impact of those investments/sums on the availability of business assets taper relief.

Next week, I am returning to the issue of husband and wife shareholdings, anti-avoidance legislation and the latest Inland Revenue tax bulletin on the subject.


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