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The income conundrum

In constructing any portfolio, the provision of income may feature quite prominently. For higher-rate taxpayers, the provision of taxable income will require tax to be paid at 40 per cent in respect of savings income and 32.5 per cent in respect of dividend income.

Is there a more tax-efficient way of achieving income objectives? The answer is to use wrapper arrangements such as insurance bonds and mutual funds to alter the tax status of the underlying investments.

I am not seeking to prove that any particular solution is ideal in every set of circumstances but simply trying to illustrate the tax considerations that need to be taken into account for each type of product.

Single-premium bonds

The tax implications of single-premium bond investments are well known.

Single-premium bonds do not produce true income as they are non-income-producing assets but all IFAs will be familiar with the 5 per cent tax-deferred entitlement which is available over 20 years, based on the original purchase price.

To obtain regular income by direct payments into a bank account, all that is generally necessary is to ask for this on the application form. As long as the 5 per cent limit is not exceeded, there is no need for a UK resident to consider tax at all. Nothing need be entered on a tax return until a chargeable event gain is triggered.

For higher-rate taxpayers, any chargeable event gain is assessed without having to gross up the gain (for a policy issued by a UK-based insurance company). This can be a very important aspect for wealthy clients in mitigating the eventual tax liability.

Also for higher-rate taxpayers, the deferral of tax on chargeable event gains until such time as perhaps the investor is no longer a higher-rate taxpayer can be very beneficial.

Bonds allow possible use of a with-profits fund where this is desirable – a similar facility does not really exist with mutual fund investment.

Sometimes it may be simpler to use single-premium bonds when trying to ensure a client retains age-related allowance(s) or the new children&#39s tax credit although appropriate mutual fund investment could also help here.

Mutual funds

In this category, I am referring to unit trusts, shares in Oeics, investment trusts and, in particular for spread of investment risk purposes and capital gains tax deferral, fund of funds investments which in themselves are unit trusts. Many mutual funds do, of course, produce true income by way of dividends or interest but I have assumed that no such income is produced.

The method of producing income is by way of disposal of units. Disposal is very much the key word as CGT has to be considered. A very tax-efficient income can be generated by using the annual CGT exemption each year.

In the table (above), I have assumed that the purchase price is £400,000, growth is 7 per cent a year compound, the annual exemption (which is always available) increases by 3 per cent a year compound rounded to the nearest £100 and it is desired to take income of 6 per cent a year (£24,000). No allowance has been made for any charges.

Each disposal will be treated as a part disposal under section 42 of the Taxation of Chargeable Gains Act 1992 and the relevant gain will be calculated using the statutory formula A ÷ (A+B) where A is the amount or value of the consideration and B is the market value of the remaining property. Each disposal will be reduced by the purchase price multiplied by the result of the formula.

Looking at the end of year one in the table, A = £24,000 and B = £404,000. The gain on the part disposal is therefore shown in the table to be £1,570. A similar set of calculations has to be done in respect of each later year.

It can be seen from the table that, based on the assumptions made, the gain will not exceed the available annual exemption in the first seven years. In later years, the impact of non-business assets taper relief on the gains in years eight, nine and 10 will mean that the remaining gains will again be within the available annual exemption.

To get a wide spread of risk, a fund of funds should be seriously considered. Remember that, the longer the unit trust is held, the greater will be the taper relief – at least until the 10-year mark is reached. Of course, if the investment is fully encashed, CGT will be relevant. However, the point that some of the gain will have been washed out annually on the part disposals with no tax liability should not be overlooked.

If, on the other hand, the investment is retained until death, it would be deemed to be disposed of and reacquired at its then market value with no charge to CGT (the CGT death uplift – see section 62 TCGA 1992). This can be another extremely important issue for older clients considering investing for income. If the client in the table fell into this category and the CGT death uplift applied to his gains, then it might be possible for all his gains to be free of CGT.

There is no right or wrong answer to the income conundrum but it is clear that the provision of income either by means of taking withdrawals from bonds or by encashing units from unit trusts should be seriously considered by those advising wealthy clients.


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