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Tony Wickenden: The advantages of investment bonds for re-invested income


Last week I started my look at UK bonds and their appropriateness (or otherwise) post the RDR. Unsurprisingly for someone from Technical Connection, I am concentrating on the taxation aspects of the investment decision making. Of course, there are other aspects to consider in determining the suitability or otherwise of the UK bond as a tax wrapper – these other factors include access to appropriate investment funds and charges.

I have looked at the fund taxation of capital gains and would like to start this week with a look at the taxation of income generated by the investments in the UK life fund.

In relation to income produced by the investments underlying the UK life fund then the main thing to appreciate in relation to such income is that it is that of the insurance company, not the investor. Especially for higher and additional rate taxpayers this can represent a very real tax deferment (and, possibly, legitimate tax-reducing) feature of the UK bond.

UK dividend income paid to a UK insurance company suffers no further tax and can thus be fully reinvested by the life company. In this respect the UK bond is every bit as good a tax-effective home for dividend income as an offshore bond; and the UK bond will, of course, also entitle the investor to a basic rate tax credit on encashment.

As stated above, this can deliver attractive and valuable tax deferment for higher and additional rate taxpayers who would have a tax liability to meet on this income if received outside of the “protective” wrapper of an investment bond. A similar position would hold good for most overseas dividends received by a UK life fund through appropriate double taxation agreements.

In the current volatile investment markets, fixed interest/cash funds can have an appeal from a risk management standpoint despite continuing low interest rates. For these investments, interest paid to a UK life fund will be reinvested after 20 per cent tax at life fund rates. This too can represent a real tax benefit for higher and additional rate taxpaying investors.

As a rule of thumb, therefore, all other things being equal (including respective charges) for capital growth driven by capital gains a collective looks ‘tax best’ (because of the ability, for most, to use the annual CGT exemption and the lower CGT rates). And for reinvested income in relation to higher and additional rate taxpayers, the investment bond looks ‘tax best’. And where there is a mix, well it all depends and advice is essential. And this, quite obviously, is a very important point.

So, having looked at fund taxation, let’s now consider investor taxation.

As well as the taxation of income and gains at fund level (and for income generated by collectives it is, naturally, necessary to consider investor tax on this as it arises whether it is paid out or reinvested), it is also necessary to consider the investor’s current and likely future tax profile in assessing the tax quality or otherwise of the UK bond.

For higher and additional rate taxpayers, and especially where the underlying investments are expected to deliver a relatively high level of yield (interest or dividends), the tax-deferring qualities of a UK bond will be particularly valuable. This is especially so for larger investments over the longer term.

For a higher or additional rate taxpaying investor in a UK bond, as well as suffering tax in the life fund (or a reserve for it taken into account in pricing the units underlying the investment inside the fund) there will be a further liability on any realised chargeable event gain at 20 per cent or 25 per cent as appropriate. The gain, however, will not be ‘grossed up’ to take account of the tax suffered at fund level and this benefits the higher and additional rate taxpayer.

And as well as the ability to draw funds from the bond within the relatively well known 5 per cent rule, there are a number of “exit strategies” that can be considered to minimise the tax on final encashment. These include the use of ‘top-slicing’ relief combined with encashment in a year of lower income and/or assignment to a lower or non-taxpayer.

In relation to the growth in the bond’s value that has been driven by capital gains the overall rate of tax suffered by the investor (at life fund and investor level) is likely to be highly dependent on the extent to which the realised or deemed gains in the life fund exceed the indexation allowance. To the extent that there are no ‘real’ gains there should be no ‘fund level’ tax deduction.

In relation to growth driven by reinvested dividend income the internal rate suffered will have been nil and only 20 per cent on reinvested interest.

Despite these low rates of internal tax and the no ‘grossing up’ of the gain, the investor will have a 20 per cent tax credit in calculating any income tax liability on the gain. For a basic rate taxpayer, this would mean that there would be no further tax to pay on the gain made under a UK bond provided the top-sliced gain did not take the investor’s income over the higher rate tax threshold.

For a higher or additional rate taxpayer there would be a charge but the effective “overall ” rate suffered ( taking account of fund level and investor taxation) on a gain made under a UK bond is highly likely to be, possibly significantly, below 40/45 per cent.

Tony Wickenden is joint managing director at Technical Connection

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