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Advisers should pay careful attention to detail on partial encashments of bonds or collectives.

Last week, I reminded you all, as if you needed reminding, of the adviser dilemma (or opportunity – depending on how you look at it) that is the bonds v collectives debate.

Since the radical changes to capital gains tax announced in the pre-Budget Report and confirmed in the Budget and
ensuing Finance Bill, much attention has been given to the 18 per cent v 20 per cent/40 per cent “fight” in respect of the tax on the final encashment of an investment.

Less attention seems to have been paid to the difference in the tax treatment of partencashments/withdrawals from collectives and bonds respectively. That is odd when you consider that a reasonable number of investors will probably not hold their investment (in the shape of a bond or collective) and then cash it in all at once.

Those who do, however, will need to be aware of all the tax planning strategies that are capable of being employed
to minimise tax. I will look at these another time.

This week, I would like to take a look at the rules for partial encashments from bonds and collectives and try to draw out some highlevel conclusions.

The ability to draw regular sums with nothing to report on a tax return has obvious appeal

The 5 per cent bond withdrawal rule is often highlighted as one of the features of investment bonds which direct investment in collective funds cannot offer.

Most investment bond brochures would identify this as a simple way to draw down benefits from the bond with no tax charge – at the time of withdrawal at least.

The ability to draw regular sums with nothing to report on a tax return has obvious appeal. The ability to do this, for up to 20 years, may seem
like tax nirvana for many. Of course, this “tax-free income” is likely to turn out to be tax-deferred income but, especially those who expect to live for less than 20 years, may just think “never mind”.

The rules for part-encashment of collectives are less well known and certainly less well understood, which could have something to do with the
fact that they are slightly more complicated.

Despite this, though, in practice, regular partencashments of collective funds will rarely produce gains that need to be reported on a tax return and which will rarely give rise to any tax liability. The basic rule for reporting gains is that you only need to do so if:

● You disposed of chargeable assets which were worth more than four times the annual exemption (£38,400 in 2008/09), or
● Your chargeable gains before losses are more than the annual exemption (£9,600 in 2008/09), or
● You want to claim an allowable capital loss or make any other capital gains tax claim or election for the year.

For 2007/08, the chargeable gains that trigger reporting are those after the indexation allowance but before taper relief, both of which are abolished from 2008/09.

But how about the calculation to ascertain whether a taxable gain arises – and whe ther it needs to be reported?

For a partial encashment in 2008/09, the calculation of the gain is:

Amount realised – { Amount realised } x (capital and reinvested income remaining)

{Current value }

For example, if an investment of £100,000 is made and after one year it has grown to £105,500, including £1,500 reinvested income, then a £5,000 withdrawal would produce a gain of:

£5,000 – { £5,000 } x (£100,000 + £1,500) = £189.57 {£105,500 }

The balance of the payment – £4,810.43 – would be treated as a partial return of capital and reinvested income.

The tricky bit then is to ascertain which part of the amount taken should be treated as a non-taxable return of the originally invested capital. That is what the above calculations are all about.

In year two, if the same 5.5 per cent overall investment return is achieved, the investment would be worth £106,028 of which £1,508 would be reinvested income and the CGT calculation for another £5,000 encashment would be:

£5,000 – {£5,000} x (£100,000 + £1,500 – £4,810.43 + £1,508) = £369.26 {£106,028}

So what we see over a period of regular withdrawals is a gradual erosion of the original capital base with the result that an increasing amount of
a fixed withdrawal is likely to be taxed as gain.

Unless Parliament decides otherwise, the annual capital gains tax exemption is automatically increased in April each year by RPI inflation
to the previous September, with the result rounded up to the higher £100. On a 2.5 per cent inflation assumption, that means the exemption will
be £16,300 in 20 years time.

The sting in the tail of regular withdrawals from a collective is that, on final encashment, there can be a big capital gain because much of the original capital and reinvested income has been accounted for in earlier withdrawals.

In the above example, the value of the holding immediately after the 20th withdrawal would be £117,434 and the capital gain would be £56,142.

Most of this gain would attract 18 per cent CGT.

However, if the investment is held until death, then all gains are washed out. This factor is a very important one for those considering investment in a dynastic sense.

This CGT wipeout on death can really complement IHT planning when collectives are used, say in combination with trusts, to minimise or avoid inheritance tax – possibly even retaining some kind of IHT-inoffensive access to settled funds for the settlor.

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