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Battle of the bonds

The future of investment bonds is being questioned again as the capital gains tax changes provoke new debate over their suitability compared with investments in unit trusts and Oeics.

For the past six months, Cofunds has noticed that its sales of investment bonds have been a lot quieter, which it feels is generally reflective of the industry.

Rather than blaming lack of investment in this area on the difficult market environment, Cofunds believes that the drop-off in interest from advisers is due to the recent capital gain tax changes, as the start of this perceived slowdown coincided with the announcement in the pre-Budget report.

The initial CGT proposals were expected to raise the competitive stance of collective investment funds over the use of investment bonds from a taxation point of view. Under the changes, which became a reality on April 6, if an investor buys a fund, CGT moves from 20 per cent for a basic-rate taxpayer and 40 per cent for a higher-rate taxpayer to just 18 per cent. For an investment bond, the rates remain at 20 and 40 per cent respectively.

The Association of British Insurers and the life industry have lobbied hard against this tax change in the past few months and it is considered likely that the slowdown in bond sales could be attributable to uncertainty over whether the planned changes would actually be implemented.

Since the lobby was unsuccessful and the change was implemented, there is now better clarity on the situation. Still, Cofunds does not see sales of investment bonds moving any higher.

Marketing and propositions director Alistair Conway questions how big this market will be in a year or two. He says: “We see the bond market as reshaping, perhaps taking a different space than it once did. Whether it will remain a mainstream product remains to be seen.”

However, Aegon tax and regulation manager for investment products Margaret Jago says its sales do not show the same trend although the company does tend to do more business in offshore bonds than onshore. She wonders if the onshore investment bond market might be more affected by the CGT change as tax benefits for offshore bonds remain largely intact.

Jago notes that the onshore bond market has tended to attract more basic-rate taxpayers, for whom the tax difference between investment bonds and collectives is not as wide.

In the case of higher-rate taxpayers, Jago says the tax on collectives now looks more attractive in the onshore environment although she notes that higher-rate taxpayers have tended to use offshore investment bonds anyway.

Income generated from collective funds is taxed year on year and can impact on means-tested benefits but in offshore bonds that income is accumulated to the point when the assets are brought back onshore, at which time the investor may have moved to the lower tax rate. Of course, the investor is also allowed to take 5 per cent withdrawals from the bond each year, with the tax being deferred. This tax-deferral ability has always been a high selling factor for bonds, says Jago.

She says Aegon has certainly not noted any trend in its sales suggesting that investment bonds will vanish from the industry.

For onshore bonds, while the tax position may be comparable now with unit trusts and Oeics, there remain benefits on bond wrappers such as capital guarantees as well as the traditional 5 per cent tax deferral ability.

Tax advantages in the offshore market include the 5 per cent rule and inheritance tax planning opportunities and Jago says the underlying funds available to these structures may also be attractive considerations for investors.

She says Aegon has noticed inflows into more sophisticated underlying funds, such as hedge funds, which investors might not be able to access directly. Fidelity FundsNetwork, which is about to release a paper on this topic, concurs that anecdotally it would seem that there has been a fall-off in bond sales at the start of the year but points out that there has not been a corresponding increase in mutual fund sales.

Director of tax and trust planning solutions Paul Kennedy says any fall cannot strictly be attributed to the changes to CGT. He admits that in the long term there may be an increase in the use of mutual funds for certain clients and some move away from investment bonds but he does not subscribe to the “one product versus another” debate. He notes that one clear outcome of the tax change is that is should refocus advisers’ minds on the appropriate use of wrappers as a whole.

Kennedy says: “It should not be a one-or-the-other scenario, it should be about understanding which assets work well with which wrapper.”

Jago says the one thing the tax change has done is to bring the bond versus collectives issue to the fore once again. She feels that advisers will now give more attention to highlighting the differences between these two investment vehicles.

She says many life companies, including Aegon, are now working on calculators to help advisers better explain the differences to clients. These tools will cover subjects such as IHT planning, top slicing and tax deferral.

With the debate again raging between the life and investment industries, and with advisers and their clients at the heart of it all, information and education are going to be vital.

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