When advising a client about a lump sum investment, one of the things an adviser will do is identify the client’s objective; such as generating income, potential capital growth or for trust and estate planning purposes.
Although there may be exceptions, in most cases it is considered good practice to make full use of any available ISA allowance. Once this has been exhausted one of the key decisions is which tax wrapper or wrappers should be used for any remaining investment.
For the majority of clients an investment bond, an offshore bond or a collective investment, such as a unit trust or open-ended investment company (OEIC) will be suitable.
It is not unreasonable to expect some investors to utilise all of these tax wrappers to some extent, depending on their objectives, personal circumstances and investment horizon. Such an approach can provide a very flexible portfolio for a client should they want an income or release capital in the future as each utilises different allowances and exemptions.
Let us look at the three options and consider the differences.
Onshore investment bonds
An investment bond is non-income producing and therefore an investor can benefit from tax deferral as there is no tax charge until a chargeable event arises. If the client is a basic rate tax payer at that time then there may not be any tax liability and tax-relief can help spread any gains over a number of years.
Within an onshore bond the underlying fund pays 20% corporation tax on any interest it receives and also on any capital gains and it does still benefit from indexation relief on any gains. Dividend income is paid net of 10% income tax with no further liability.
HMRC treats the combination of this internal taxation as the equivalent of basic rate tax, even though the total tax suffered is usually less than 20%. The actual rate is difficult to calculate as it will depend on the underlying assets. For example an equity income fund should pay lower tax that a fixed interest fund as dividends are tax at 10% and it benefits from capital gains indexation. Generally it is accepted that a life fund will pay tax around 16%-18%, but it is treated as 20% by HMRC.
On final encashment any gains in the hands of the investor are taxed as income. As basic rate tax has already been paid a basic rate taxpayer has no further tax liability. Higher rate taxpayers will have an additional 20% income tax liability on the net gains. Additional rate taxpayers will have an additional 25% liability.
As the additional liability is on the net gains, a higher rate taxpayer is effectively paying 36% tax and an additional rate taxpayer 40%.
When calculating any additional tax liability, if an investor goes into a higher income tax band, top-slicing relief is available to help spread the gain over the whole investment term helping to minimise or remove any additional liability.
Offshore investment bonds
An offshore bond is very similar to its onshore relation, although the only tax suffered in the fund is any withholding tax on the underlying investment. No credit is given for this so if a gain arises this is chargeable at the client’s highest rate of income tax.
Again, top-slicing relief is available to help minimise the effect of any chargeable gain.
The advantage of not having any internal taxation is gross roll-up. The investment benefits from compound growth on the gross amount and all things being equal should provide a better return than other investments.
Collectives
Under a collective any capital gains realised by the investor are subject to capital gains tax (CGT). After using the annual exemption allowance and any losses carried forward, gains are taxed at 18% for basic rate taxpayers or 28% for higher and additional rate taxpayers. As these rates are lower than the 40% and 45% rates of income tax many focus the choice of product wrapper on the access to the lower rates of tax.
When compared like this it seems clear that a collective is preferable from a tax position but this is a very basic analysis, considering only the potential capital gains. A recommendation could therefore be unsuitable for a client as it does not take into account the potential income that may be generated and the exit strategy, which you would have discussed with the client.
Investment bonds offer more flexibility
Investment bonds are able to defer a potential tax liability and with an effective exit strategy, can deliver, in some instances, greater tax savings.
As an example consider a client who is a higher rate taxpayer (who would therefore have an ongoing tax liability under a collective as distributions arise) and has a final capital gains tax liability.
If they were expecting to be a basic rate taxpayer when any money was needed, an investment bond would allow them to defer the tax until that time and potentially allow lower rates of tax. As life policies, bonds can also be assigned and any subsequent tax calculation will be based on the tax position of the recipient. This can be advantageous when the person receiving the bond pays a lower rate of tax than the original owner and could potentially pay less tax.
From a trust- and estate-planning perspective, as an investment bond is a non-income producing asset it helps reduce the work for the trustees. The ability to assign also allows the trust to gift the policy to the beneficiaries.
It is essential to consider all the potential tax wrappers when formulating a recommendation and, if appropriate, even split the lump sum across both solutions. A client could then have a choice about which funds to realise, and when, enabling them to maximise the advantages of each during the period of investment.
Neil Jones is Technical Project Manager at Canada Life
