Onshore bonds are a once-beloved product, now seemingly ignored by many advisers in favour of the supposedly more glamorous international investment bonds or collective investments.
Yes, most onshore bonds don’t have ‘open architecture’ and none deliver exemption from tax on capital gains at fund level or the ability for investors to use their annual exemption from CGT – but does that mean they deserve being dismissed out of hand when it comes to determining the structure of an investment portfolio?
Of course, an ISA, pensions and other tax-advantaged investments should be first port of call – so this article is about clients who have already taken advantage of those products.
The tax-free onshore bond
It is an established fact of the tax legislation that companies get indexation relief on capital gains and it is linked to the RPI (rather than CPI).
This also applies to UK life insurance companies – but not to international life companies or collective investment providers. These, of course, enjoy complete freedom from tax on realised gains at fund level.
But if an onshore bond fund manager disposed of an equity holding in September 2017 having held it for five years, indexation relief of 12.7% is available (source: Office for National Statistics). In addition to the dividends received, which are not taxable, if the equity gain had been 12.6% say, the onshore bond return would have been tax-free at fund level as well!
And unlike an ISA or international bond, it would also have a basic rate tax credit for all the underlying growth.
But so much for theory…
…what happened in practice?
So far, we have just based our article on assumptions and expectations. Let’s now look at past performance.
Pricing Spread: Bid-Bid ● Data Frequency: Daily ● Currency: Pounds Sterling
Total Return; Pricing Spread: Bid-Bid; Data from FE 2017.
There’s not much difference is there?
This quite remarkable similarity illustrates the effect of fund charges and taxation on the investment return.
We would also suggest that for a basic rate taxpayer, with an annual exemption covering the gain, there is no tax at the end for either a collective investment or an onshore bond.
Better net returns than collective investments
As ever, to demonstrate that an onshore bond can compete on tax grounds with a collective investment, I have to make various assumptions.
These include the split between equities and bond funds, rates of return, the investment term, availability of CGT exemption and other factors. And to be entirely fair, I am using the independent Technical Connection Wrapper Selector to calculate the results.
This ignores charges so, in effect, it assumes charge “neutrality” between the wrappers. The purpose of this tool is to accurately show the tax drag on various investments. In this example, for a basic rate taxpayer, the returns are:
Assumptions: £100,000 invested over 20 years, no withdrawals, 25% invested in fixed interest / 75% in equities, basic rate taxpayer using annual CGT allowance each year and includes the dividend allowance. Yield and growth assumptions available on request.
So in this example the onshore bond produces a marginally better return than the collective fund, even taking into account the dividend allowance and capital gains tax annual exempt amount. Charges would have to be taken into account to ascertain the actual returns for an investor and these will include wrapper charges for the bond or platform, specific fund charges and any adviser charges.
And before you say it, yes these figures are based on assumptions, but the point we are making is that wrapper choice depends on the circumstances, both at the time of the investment and on exit. Equally, you cannot make an arbitrary statement about which is the best investment without bearing in mind the asset allocation, the rate of return and personal tax details of the investor.
Using the annual exemption each year
One of the advantages of collective investments is that you can bed & breakfast them every year to use the annual CGT exempt amount. Although nowadays you have to wait 30 days before reinvestment or reinvest in different holdings to use that facility and this can make this exercise difficult and possibly costly in practice. Considerable ongoing portfolio management is required to use this oft-touted advantage, which may not be appropriate for the smaller investor.
Higher rate taxpayers get a tax cut
What rate of tax do higher rate taxpayers pay on their onshore bond returns? 40% of course?
Well, not exactly. Because the life company pays corporation tax in the fund and then the policyholder pays tax on the net surrender value at 20%. The overall effective rate suffered by the investor investing through an onshore bond is thus made up from the tax on non-dividend income and gains at life fund level plus a further 20% personal tax on the gain realised net of any life fund tax. This will often be significantly less than 40%.
For example, to the extent that the growth in the value of the bond is contributed to by dividends there is no tax at fund level and 20% on the net gain realised. For other income, it’s 20% in the fund plus 20% personally on the net realised gains driven by this income. And for capital gains, it’s 20% on the gain realised from the bond but the net gain contributing to the realised gain will have benefited from indexation relief at fund level.
The effective overall rate of tax suffered by even a higher rate taxpaying investor on the gain realised under an onshore bond can thus, depending on the circumstances, be significantly less than that suffered through direct investment.
You can’t top-slice a capital gain
For many investments, tax planning is all about deferring or minimising ongoing taxation and then having a tax-efficient exit strategy.
And investing through collective investments and onshore bonds is no different. But one difference between them is that the capital profit on encashment can be averaged throughout the life of an onshore bond – to get an effective tax rate – but can’t be for collective investments.
So, for example, a client with a fully available annual CGT exemption and income £10,000 shy of the higher rate tax threshold and a capital gain of £51,300 would be taxed as follows:
So the total tax bill is £7,000 and the net return is £44,300.
But if the investment had been in an onshore bond with a gain of £45,500 say (to reflect the tax on the fund), the top-slice could easily fall into the basic rate band and the total tax bill be zero – so £45,500 net. A superior return.
Assumptions: £100,000 invested over 7 years, no withdrawals, collective investment growth rate of 6.1%, no income reinvested, onshore bond growth rate of 5.5%.
Horses for courses
Hopefully, this article has demonstrated that it would be wrong to adopt a broad-brush approach to product selection and proves that it is dependent on each individual client’s circumstances. In practice, it would probably be appropriate for clients to have holdings in a variety of tax wrappers. Then they could take advantage of whichever tax break is most appropriate – annual exemption, top-slicing or others – when they needed to cash-in investments.
Canada Life offers a range of wealth management solutions, including retirement income planning, estate planning and investment solutions from a choice of jurisdictions, including the UK, Isle of Man and Republic of Ireland.