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Not best policy

Last week, I looked at the broad tax and financial implications of investment by companies. I touched on the potentially negative impact that investment can have on business assets taper relief and looked specifically at the tax implications for income and capital gains produced by direct and collective investments such as Oeics, unit trusts and investment trusts.

An investment by a company into a single-premium life insurance policy – an investment bond – can also give rise to a denial of business assets taper relief (I will look at this issue in future weeks) and it is absolutely critical these days that anybody advising a private trading company on investment fully appraises the company of this risk.

On the face of it, at least, an investment bond could offer a private company an administratively simple, potentially tax-effective method of investment. Apart from the many underlying fund choices that are available, the two main outer wrappers open to investing companies are the so-called offshore and onshore bonds. They are distinguished by the residence of the life insurance company underwriting the bond.

The good thing about investing in an investment bond is that the company making the investment has no tax liability until a chargeable event arises. What constitutes a chargeable event is identical to the position for individual investors. This means, for example, that the 5 per cent annual withdrawal allowance is available to companies.

The calculation of any gain, say, on final encashment, also involves the same process as that which applies for individual investors in that, in most cases, the gain will represent the difference between the amount received on final encashment and the amount invested. The amount received will, of course, be the value of the units encashed and this value will be net of the tax deducted or reserved for by the insurer. Where the insurer is a UK-resident company, then no corporation tax will be due on any UK dividends received, savings income will bear tax at 20 per cent and other income, such as rents, will bear tax generally at the corporate tax rate for life insurance companies, which is equivalent to the basic rate of 22 per cent.

Capital gains will be subject to corporation tax, too, when realised. In arriving at the amount of any capital gain, the life company, like any other company, benefits from indexation relief and not taper relief. The investor in the bond, in this case, the corporate investor, then indirectly secures the benefit of this relief. The assessable gain for the life company is reduced and so the amount of corporation tax on the capital gain will also be reduced.

Especially with a fund into which new money is constantly being invested and generated, say, through fund income, it is likely that the life company will not need to encash specific investments to meet liabilities every time a bond is encashed.

However, the company does need some way of ensuring that, when gains are made (as they will be through the holding and managing of investments), the tax burden is borne fairly across all the investors in the fund. For this reason, it is understood that most companies will take account of actual and likely tax liabilities, often making a reserve for potential future tax on capital gains, in pricing the units underlying the bond.

In calculating this tax, account should be taken of indexation relief and its likely impact. Year-to-year account will also have to be taken of deductible expenses (which themselves will reduce unit values) and allowable losses in determining the tax rate.

The point is that, for most companies, the internal rate tax allowed for in calculating unit values will often be less than the full basic rate. For individual investors who qualify for a full basic rate credit in respect of any tax liability arising on a chargeable gain under the bond, this is good news – a tax credit at a rate higher than that actually suffered. Not only that but any higher-rate tax liability is then calculated on the net (not grossed up) gain.

A double win. This is not, unfortunately, the case for corporate investors. No basic-rate tax credit is available for them and so the full gain will be subject to corporation tax at the appropriate rate in the accounting year of encashment. The effective rate suffered then by a corporate investor in a bond underwritten by a UK insurer providing for internal tax at 20 per cent could, as a result, be approaching 40 per cent even though the corporate investor may only be paying the small companies&#39 rate of corporation tax.

For example, if income and gains in a bond combine to produce £10,000 of growth and the life company reserves tax at 20 per cent, the gain reflected in unit values will be £8,000. There is, by the way, no top-slicing relief for companies. If the gain suffers tax at 20 per cent, the investing company is left with £6,400. The total tax lost on the original £10,000 is £3,600 – an effective combined rate of 36 per cent.

For this reason, leaving aside the potential business assets taper relief issue, the merits of investing in a UK bond on tax grounds are extremely questionable.

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