Investment Taxation and Financial Planning
The change to CGT introduced in the last Budget means that that all chargeable gains on investments are now taxed at 18%. There is some partial relief for entrepreneurs selling their own company shares for example, but in all other cases, an investment gain in a tax year over and above the annual allowance (£9,600 in 2008/09) will be taxed at the flat rate with no allowance for the time an investment has been held.
There are winners and losers under the new rules. (Winners are those investors who make a quick profit and sell, who will now pay 18% rather than 40%. Some might say that’s an odd thing for a government to encourage!).
When the change was introduced a number of commentators suggested this “improvement” for directly held investments was an advantage over those investments which are held within an investment bond. Some insurance companies began to shed tears that their golden goose could be heading for the scrap heap and unsuccessfully petitioned government for another U-turn.
This briefing is to try to outline the position for those that are interested. As with all matters of taxation, you should consider your position with your professional tax adviser, but first some background:-
By Investment Bond we are talking about a “tax wrapper” which can hold collective investment funds. It is a concept created by insurance companies who over the years have sold many different varieties such as Property Bonds and With-profit Bonds. For an insurance company bent on selling a product, they have been a great way to sell simplified investments. Because they are a form of life assurance, they have benefitted from peculiar tax treatment which can be summarised as follows:
Investment funds within a Bond can be sold and purchased (ie switched) without giving rise to CGT.
The insurance company pays a special tax on the funds it holds which can vary according to the types of assets held. Generally, it is reckoned the tax charge is always a little lower than 20%, but an investor receives a tax credit equal to the basic rate – ie 20%.
A Bond is considered to be a “non-income producing asset” – so however the value is increased (either by growth, dividend income or interest), the bond can be held without the investor being subject to any immediate income tax. It is not “tax-free” but “tax-deferred”.
Withdrawals of up to 5% of the invested sum may be taken each year without any tax charged to the investor.
When the Bond (or part of it) is finally en-cashed, or if a withdrawal greater than 5% is made – this is deemed to be a “chargeable event”. Through a process known as “top-slicing” the value of the gain is assessed and added to the investor’s income. If this income is subject to higher rate tax, then a tax charge at the marginal rate (ie 40% less 20% = 20%) can be made against the whole gain.
Insurance company sales-blurb will explain that actually paying higher rate tax is unnecessary, because the encashment can be managed over a period of time to avoid it, or the bond can very easily be assigned to a non higher rate tax payer such as a spouse or child.
So, the argument used to be that a Bond could be better than a directly held investment because the tax on a Bond would be either a little less than the lower rate or at worst, a little less than the higher rate of income tax. A directly held investment on the other hand could be subject to either income tax or CGT at the highest marginal rate.
The argument was then always clouded by other issues such as the charges on Bonds being generally much higher than on direct investments. Not using direct investments could “waste” a valuable CGT allowance, and the range of funds available under a Bond was not as extensive with direct investments.
As clients will know, our approach has always been rather more pragmatic. Our MasterTrust Account is able to hold all types of tax-wrapper – be they Bonds, ISAs, Pensions or Direct Investments – and there is no limit to the range of funds available. Because no traditional insurance company is involved, the differences in costs are minimal, and so we have advised clients to invest in a way which was most likely to benefit them. In many cases, especially given most clients’ need to spread risk and diversify, the advice has been to make full use of as many wrappers and tax regimes as possible.
It would seem that this approach has been vindicated given the recent changes!
This approach will continue. Despite the changes, there will be cases when a Bond will be right and others where direct investments will be. There is never one answer for all clients and careful selection of the investment vehicle is crucial. That said, it does appear that for private investors, the balance has moved a little in favour of direct investments – at least from a taxation perspective. For trustees, there is still a strong argument in favour of bonds, given their simplicity, their status as non income producing, and the ability to assign to non or lower income tax paying beneficiaries.
So, in summary, here follows a brief review of the different tax treatments that apply to Bonds (both onshore and offshore) and directly held investments. As always, we would be delighted provide more detail or answer any specific queries.
GIA (Directly Held)
Gains Bare TrustCapital gains generally assessed on the beneficiary who can use their own annual capital gains tax allowance.
Trustees to pay 18% CGT on any gains realised. Annual exemption allowance (currently £4,800) is half the individual’s allowance (currently £9,600).
Settlor liable to income tax on any gains unless deceased in which case UK Trustees are liable. If no UK trustee then beneficiary is liable.Tax charged at marginal rate after allowing for notional 20% credit. Settlor liable to income tax on any gains unless deceased in which case UK Trustees are liable. If no UK Trustee then beneficiary is liable.Tax charged at up to 40%.
Tax Deferral N/A Up to 5% pa of original investment can be withdrawn without incurring an immediate potential income tax charge.
Income Bare- Taxed as that of the beneficiary except where a parent creates a bare trust for a minor where any income is deemed to be the parent’s for income tax purposes, although this rule is not applied if the gross income is less than £100pa.
Flexible – Trustees are liable for income tax at basic rate. Where distributions are received with a tax credit no further tax is payable. Any income passed to a beneficiary carries a tax credit and will be taxed at the beneficiary’s own rate.
Discretionary – Distribution received with 10% tax credit. A further 22.5% is payable by Trustees. Income received with 20% credit so a further 20% is payable by Trustees.
Dividends Received with 10% tax credit, no further tax to pay as income treated as growth.
Income received net of 20% income tax, no further tax to pay as income treated as growth.
No tax payable(Note any tax deducted at source from UK income funds cannot be reclaimed).
GIA (Directly Held)
Gains 18% CGT Payable on gains of more than £9,600 during a tax year. Gains subject to income tax for higher rate tax payers (basic rate tax is paid by the fund. Gains subject to income tax at policyholder’s marginal rate.
Gains can be top-sliced to determine if higher rate tax applies.
Tax Deferral N/A Up to 5% pa of original investment can be withdrawn without incurring an immediate income tax charge.
Income DividendsReceived with 10% tax credit, higher rate taxpayers pay an additional 22.5%. Dividends Received with 10% tax credit, no further tax to pay as income treated as growth. No tax payable.
(Note: any tax deducted at source from UK income funds cannot be reclaimed).
Interest Income received net of 20% income tax, higher rate tax payers pay an additional 20%. Interest Income received net of 20% income tax, no further tax to pay as income treated as growth.
This is but a summary of the tax position, and it must be stressed that personal professional taxation advice should be taken before investing or withdrawing from any investment. This is our understanding of the position as at June, 2008 and of course may be subject to change by HMRC in the future.