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On the level

Assessing taxation at both the fund level and investor level is important in assessing wrapper choice


In this series of articles on the relative importance of product wrapper choice I am going to look at the tax implications at portfolio or fund level first. This is an area that is most frequently overlooked (or not given sufficient attention) with the greater focus being on tax at the investor level.

In assessing suitability for any particular investor, and especially for more significant investments, it is essential to consider both fund-level and likely investor taxation.

Let’s look at capital gains from the portfolio first.

A key factor in analysing the overall tax position of a particular investment for an investor is to consider how the underlying investment growth arises. If it consists purely of capital growth and no, or little, income the collective (UK or offshore reporting) will, generally, be the better choice on tax grounds.

Any capital gains made inside the investment structure by the fund manager will be tax-free and not assessable on the investor, investor assessment being deferred until a realisation of their shares or units is made which gives rise to a capital gain. And then the investor will usually be able to access their annual CGT exemption and then the lower (than income tax) rates of tax.

In comparison, the investment fund underlying the UK investment bond is subject to corporation tax on capital gains (albeit after the indexation allowance which is set to become more important if predictions for inflation come to pass) and a higher or additional-rate taxpaying investor will then be subject to income tax on the net realised profit (called chargeable-event gain) on encashment.

Any unused annual CGT exemption will not be available for set off against the chargeable-event gain. However, even this analysis is a little light on detail, as we will see.

The actual rate of tax suffered in the UK life fund will rarely be the full 20 per cent of actual capital gains because the insurance company benefits from indexation allowance in calculating taxable capital gains.

There is also the fact that the liability to tax on the annual deemed realisation of underlying collective investments (that is the general rule for UK life funds) is, effectively, spread over seven years.

All this helps reduce the effective rate of tax reserved for in pricing the units representing the insurance bond investment. The availability of indexation allowance for life fund gains at a time when inflation is predicted to increase should not be underestimated.

Offshore bonds will, like collectives, suffer no tax on capital gains at fund level, so indexation allowance is not relevant.

Despite the reduced effective rate of tax for UK life funds and nil rate of tax for offshore bonds, though, the 18 per cent or 28 per cent rate for collective investments when gains are realised by the investor will still usually deliver a superior result, especially for a higher or additional-rate taxpayer who is UK-resident and domiciled in the year of realisation. And the effective tax rate on realised capital gains could be a lot lower (possibly even nil) to the extent that the annual CGT exemption is available to the investor.

For an investor in an authorised collective investment, a consideration of the taxation of capital gains can be confined to a single level that of the investor.

The complete freedom from tax considerations on realised capital gains at fund level (for both UK and haven-based funds) will, in general, help the fund managers invest. Freedom from the constraint of tax consideration is always liberating.

How about tax on capital gains at investor level so to speak? Well, I covered investors in collectives above and also touched on the position in relation to realised gains for investment bondholders above. In my article next week, I will look at the position at investor level for investment bonds in a bit more detail.

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