Continuing my series on tax wrapper choice, in this article I will look at the capital gains tax position at investor level for investment bonds and taxation on yield income.
For a higher-rate or additional-rate taxpaying investor in a UK bond, as well as suffering tax inside the fund there will be a further liability on the realised gain at 20 per cent/30 per cent for higher -rate/additional-rate taxpayers.
The overall rate suffered on capital gains (at life fund and investor level) is likely to be highly dependent on the extent to which the realised gains in the life fund exceed the rate of indexation allowance.
To the extent that there are no real gains, there should be no fund-level tax deduction in pricing the units underlying/ representing the investment. The investor in a UK fund will have a 20 per cent tax credit in calculating any income tax liability on the gain.
Under an offshore bond, there will be no tax on realised gains at fund level and no indexation allowance, there being nothing to be relieved from, and the overall tax rate on any gain realised by the investor will be 40 per cent (or 50 per cent for those with taxable income of over £150,000) – all borne by the investor – with no tax credit.
For a basic-rate taxpayer, there would be no further tax to pay on the gain made under a UK bond, so the comparison to make is between 18 per cent tax on the capital gain made on the collective on realisation by the investor and the effective rate suffered in the life fund with the benefit of indexation allowance.
For these investors, the availability of the annual CGT exemption to shelter a realised capital gain is likely to make all the difference.
With no underlying index-ation allowance and no tax credit, the offshore bond is unlikely to be tax-attractive to a UK-resident and domiciled investor encashing the whole bond while a higher or additional-rate taxpayer. It does deliver (understandably) appealing tax deferment and there are all those lovely extraction strategies to think about. These will also be substantially available in relation to UK bonds.
So much for capital gains but especially at a time of highly volatile capital values and high importance attached to reinvested income, (see the Barclays equity/gilt report for example, which effectively concludes that the long-term case for equity investing can only be made if dividends are reinvested), many investors will seriously consider investments that yield income as well as producing capital growth. It is widely accepted that having yield/income in a portfolio that is reinvested reduces overall risk and, over the long run, is an important driver of growth. In such circumstances, the comparative tax position can change dramatically for the following reasons:
i: Dividend income (from the UK or overseas) paid to a UK insurance company suffers no further tax. There is no possibility of reclaiming the non-payable tax credit of 10 per cent. The clue is in the name. The 10 per cent notional tax is just that. It is not actually paid – unlike in the days of advance corporation tax. Nowadays, a UK company simply pays dividends out of net profits.
ii: Dividend income paid to a UK collective or offshore reporting fund will, after deduction of management expenses, generally be taxed on the investor – even if accumulated – and so while basic-rate and non-taxpayers will have no liability on dividend income, higher-rate taxpayers will have to pay an extra 25 per cent income tax on the net dividend income. This rate will be an effective 36.11 per cent for those with taxable income of £150,000 or more. This extra tax must be taken into account in determining net returns to the investor even though this tax is unlikely to be physically paid out of the reinvested dividends.
If the fund invests as to more than 60 per cent in interest-bearing securities, it can elect for the income to be treated as interest for the investor and taxed as such. This would facilitate a 20 per cent tax reclaim to the extent that the investor were a non-taxpayer.
It is an interesting, important and easily forgotten fact that the dividend (or interest) that is actually reinvested will be treated as additional original capital for capital gains tax purposes. This means that in calculating the tax on any future realised gain, it will be essential to recognise that when there has been reinvested income part of the amount realised (and thus part of the gain over the original investment) will be made up of these reinvested dividends. In calculating the taxable gain, it will be necessary to deduct these amounts.
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