My last article concerned the tricky topic of the valuation for tax purposes of a single premium bond on the owner's death. Continuing with the bond theme, I now look at another area which can sometimes cause uncertainty when advising clients – the situation where a client has gains under a UK bond which are subject to the “top-slicing” regime and also gains which are liable to capital gains tax.
All advisers should be familiar with the fundamentals of top-slicing relief, where gains are divided by the number of complete years a bond has been in force (or, on a part surrender, the number of years since the last chargeable event) in order to determine the extent of any higher-rate income tax liability.
It should also be well known that an individual's capital gains, in excess of the annual CGT exemption (£7,700 for 2002/03), are treated as the “top slice” of income and charged to CGT accordingly. The rate of CGT therefore depends on the individual's total income.
Capital gains which, when added to total income, fall within the starting rate limit (£1,920 for 2002/03) are taxed at 10 per cent. Gains between the starting rate and basic rate limits (£1,920 to, in general, £29,900) are taxed at 20 per cent, and above the basic rate limit at 40 per cent.
Where an individual has a bond and, for example, a portfolio of shares in Oeics – both of which are showing a gain – the question arises as to which of these gains will be added to the individual's income first if encashments are made from both investments in the same tax year.
In this situation, in calculating the higher-rate tax liability on gains under a bond, any capital gains from the Oeics (or any other chargeable assets) in the same tax year are to be left out of account.
However, in calculating a CGT liability during the same tax year, the top-sliced gain under the bond is included in the individual's income. It is possible therefore that an individual could make a chargeable gain under a bond and pay no tax thereon because the top-sliced gain does not create a higher-rate tax charge, but that any capital gains in the same tax year could, when added to the individual's taxable income including the top-sliced gain under bond, result in a CGT liability at 40 per cent instead of 20 per cent. The example in the box below may help.
A basic-rate taxpayer who holds both bonds and also either equities, unit trusts or Oeics, needs to be very careful about the timing of encashments of each investment to avoid the potential tax trap that may occur if both types of gain are incurred.
It may be advisable in these circumstances to either surrender the bond in the next tax year or to restrict the disposal of chargeable assets so that total income (including capital gains and the top-sliced gain under the bond) does not exceed the basic rate limit.
With the tax system becoming ever more complex, a comprehensive knowledge of all the tax “wrinkles” applicable to bond taxation will be a vital weapon in any adviser's armoury.
An individual has taxable income of £24,500 after deduction of his personal allowance. In addition to this he has a top-sliced gain under a bond of £2,500 and has encashed some shares in an Oeic, creating a capital gain of £5,000 in excess of his annual CGT exemption.
Charge on the gain under the bond
Only the top-sliced gain when added to the individual's income is included in the computation for the tax year, i.e. £24,500 + £2,500 = £27,000. As the basic rate limit is £29,900 for 2002/03 and the individual's “adjusted” income does not exceed this, no higher rate tax is payable on the gain under the bond.
Charge on the gain under the Oeic
As the gain is treated as the top slice of income (including the top-sliced gain from the bond), total income for CGT purposes is £24,500 + £2,500 + £5,000 = £32,000.
The CGT payable on the gain of £5,000 is therefore:
(£29,900 – £27,000) = £2,900 @ 20 per cent = £580
plus (£32,000 – £29,900) = £2,100 @ 40 per cent = £840
The effective rate of CGT is therefore 28.4 per cent instead of only 20 per cent if the bond had not been encashed in the same tax year.