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Strike up the bond

In last week&#39s article, I considered the importance of reinvested income to investment returns. The importance that the market places on the dividend yield from shares has always been evident but now more than ever. If evidence of that was needed, the market response to even a hint that dividends from a leading insurer may not continue to increase should provide it.

But this column is not the place for a considered and worthwhile discussion on investment issues. So I am not going to disappoint you.

The point I started to develop last week was the simple but, I believe, increasingly important one that, in times when the investment horizons of many investors are lower and the parameters within which they are prepared to invest are narrower, with a significant number unwilling to look beyond cash or safe guaranteed structured products, the importance of tax planning to the net return for investors has never been greater.

This is a point that must not be lost on advisers and product manufacturers. In the process of selecting the most appropriate investment for an investor, the time and attention spent on ensuring that the outlying structure minimises tax can have a tremendously important impact on the bottom line.

As I said last week, the exempt, approved pension and Isa wrappers (especially the latter, with a 10 per cent dividend tax credit reclaim possible until April 5, 2004) are obviously tax-attractive homes for reinvested dividends, in that the dividends received get reinvested with no further tax on them. With Isas, the tax is not even deferred.

It is a shame (understatement of the decade) that pension funds can no longer reclaim the tax credit on dividends – a significant contribution to the savings gap – but that is water under the bridge.

So what else offers a tax-attractive home for dividends? Well, believe it or not, in today&#39s insurance-unfriendly environment, I believe it is worth looking at the good old investment bond. There is a really simple reason why – dividends received by a UK life fund bear no further tax.

See, I said it was simple. So what? Well, it means that, for a higher-rate taxpayer, the dividend income reinvested will effectively be greater (it not being tax-depleted) than it would be if received and reinvested outside the insurance wrapper.

Now, I know that, in practice, a dividend reinvested from, say, a collective investment or portfolio management service owned by a higher-rate taxpayer would be reinvested in full, that is, without the investor deducting his or her own tax liability from it, so to speak. However, a liability will arise, to be paid on January 31 of the tax year following that in which the dividend was paid.

So, it is entirely fair, I think, that any comparison of relevant structures for holding dividend-producing shares should take account of the tax leakage that will be suffered by the investor, even though the liability may not arise until some time after the dividend is paid and the tax will, in practice, be paid from other income.

If you agree with this assumption and all other things (that is, charges) being equal, then it is not hard to see that, at least to the extent of the reinvested dividends, the insurance investment bond offers a more tax-favourable wrapper than a collective for the higher-rate taxpayer.

But wait a minute. How about the “latent” tax charge? You know – the one lying in wait for the investor when he cashes in the bond. Doesn&#39t that have to be taken into account in a fair comparison? Of course it does.

But even if you look at a single dividend in a single year, you can see the benefit, even without the benefit of compounding.

Take a dividend of £80 received by a higher-rate taxpayer, say, from a share or a collective. This would be grossed up to £88.89. Tax on this at the rate of 32.5 per cent would be £28.89. The tax credit of £8.89 would be deducted, leaving a net tax liability of £20 and a net dividend of £60.

But the £80 received inside a life fund would stay at £80. If this were realised as a gain by a higher-rate taxpayer, tax at a flat rate of 18 per cent for a UK bond would be payable, that is, £14.40. This would leave £65.60. That is £5.60 more than if a dividend was received from a share or collective – a 9.33 per cent improvement.

This percentage improvement increases over the years as dividends continue to be reinvested and we secure the benefit of compounding. I would reiterate that this assumes that investing through the UK bond does not involve the investor in any more costs than the structure with which the bond is being compared.

There is also the important fact that, if there is any capital growth (that is, not driven by reinvested income), the life fund will provide indexation relief but will not deliver any taper relief or capacity for the investor to use his or her annual capital gains tax exemption.

I believe all this proves that, for those wishing to secure the best returns possible in a very difficult market, there is a real role for tax planning to play.

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