As I said last week, it is essential to keep in mind that the change proposed is one to CGT and this means the tax on realised capital gains. When comparing collectives under the current and proposed new regimes, it is essential to factor in the impact of taper relief which, under the current regime, applies before application of the annual CGT exemption.
In some cases, as I made clear last week, the investor may not be better off under the new regime. This tends to be the case for gains at the lower end of the scale and for basic-rate taxpayers who realise gains above the annual exemption that currently qualify for taper relief that would result in the reduction of the effective rate of CGT on these excess gains to less than 18 per cent.
For example, where an investor has held assets for 10 or more years and as a result qualifies for full taper relief so that the gain is reduced by 40 per cent, the effective rate of tax under the current regime will be 12 per cent. This is as a result of applying the 20 per cent basic rate of capital gains tax to 60 per cent of the gain.
Then there is the fact that not all investment portfolios are driven entirely by capital gains. Where there is any income from dividends or interest, then a little more thought is required. For a basic-rate taxpayer, any dividends or interest distributions from the UK, whether paid out or automatically reinvested, will come with a tax credit that will prevent any tax liability arising for the investor. A non-taxpayer will not be able to make a tax reclaim of the tax credit on a dividend but could in connection with an interest distribution. UK dividends received by a UK life fund will not be subject to tax on receipt but interest will be subject to tax at 20 per cent. The basic-rate taxpaying investor will therefore see no tax difference in the net income reinvested.
Not so the higher-rate taxpayer. All dividends produced by the collective will be assessed on the investor on an arising basis. This means that there will be a liability to higher-rate tax whether or not the dividend is paid out or reinvested.
The dividend will carry a tax credit of 10 per cent. The first step is to gross up the net dividend to reflect the tax credit. The grossed-up dividend will then be assessed at the special rate of 32.5 per cent. The 10 per cent tax credit is then deducted from the resulting liability to deliver the final liability due to be paid.
For example, if the net dividend is £900, the grossed-up dividend will be £1,000 and 32.5 per cent of this sum is £325. Deduct the tax credit of £100 and you are left with £225 to pay. This represents 25 per cent of the net dividend. So the shorthand method of calculating the additional tax due on a dividend arising to a higher-rate taxpayer who has invested in a collective is to take 25 per cent of the net dividend.
In most cases, the additional tax due on a dividend will be payable from other income and will not be deducted from the dividend itself. So in most cases the dividend will be reinvested with no further tax deducted. However, in comparing the impact of tax on dividends inside a bond and a collective for a higher-rate taxpaying investor, I think it is reasonable to take account of the higher-rate tax due on the dividend in calculating reinvested income.
If you accept that comparisons need to be made on this basis, then it will be self-evident that in relation to reinvested dividends, the UK or offshore investment bond represents a more tax-efficient home than a collective as UK dividends received in the life fund will not be subject to any further tax liability.
Interest distributions from a collective will also be subject to higher-rate tax. Interest received in a UK life fund will only bear 20 per cent tax. No tax will be due inside an offshore bond.
All these factors are important in comparing the tax treatment of bonds and collectives. Broadly, gains are treated more favourably with collectives but income is better in a bond.
Remember, only capital gains in excess of the indexation allowance are subject to corporation tax inside the UK life fund and there is no tax on realised gains inside an offshore bond. Of course, it will be important in this connection to avoid the penal tax charges under the personal portfolio bond charging regime. A deemed gain of 15 per cent of the initial investment plus previously chargeable amounts under the personal portfolio bond regime is definitely to be avoided.
Whether a collective will yield a better net return for an investor than a UK or offshore investment bond will naturally depend on many variables including the balance between yield and growth in the portfolio, the investment period and the investor’s tax rates.
Where does this leave us? For growth-oriented portfolios powered by capital gains that are realised by investors, the new 18 per cent tax rate should deliver a strong benefit for those investing through collectives but this has always been the case, especially for those with their annual CGT exemption intact and a high or maximum amount of taper relief available.
There is indexation allowance for life company gains which can operate to narrow the tax gap between capital gains on collectives and UK bonds but it will rarely be enough to say that bonds are best on pure tax grounds. Of course, all other things being equal, the offshore bond will deliver a good gross tax position but on encashment there is no scope to use the annual CGT exemption, taper relief or the proposed new 18 per cent rate.
To the extent that growth is powered by reinvested dividends and/or interest, the picture becomes less clear, depending on amounts and term and the balance between income and growth. It is essential to consider the position before investor tax (the fund position alone) and after investor tax. This is especially important where the investor believes that there is a strong chance that the investment will not be encashed in full.
There are also the non-tax factors to take into account such as administrative simplicity, withdrawals, switching, the tax return process and the ability to hold in trust. Collectives have an additional benefit in respect of built-up but unrealised capital gains, namely, that they are effectively wiped out on the death of the investor.
What is the key message? Choosing the right product wrappers or combination of wrappers to surround a portfolio can affect the net benefit received significantly. There are many variables to take into account and advice is essential.