Investment bonds are predominantly used as tax-efficient wrappers to defer and avoid higher rates of tax. That is, it is anticipated the investor will pay a lower rate of income tax on final encashment of the bond than they would otherwise normally be liable to during the period of ownership.
Investment bonds provide the policyholder with much greater control over their tax point; the charge to tax can be deferred until full surrender. Flexibility on the time of surrender is given either by including a number of lives assured (life assurance bonds) or by pushing out the maturity date to, say, 99 years (capital redemption bonds).
Onshore and offshore bonds
Onshore and offshore bonds adopt a similar structure. The 5 per cent tax-deferred allowances and top-slicing apply to both bonds insofar as the policyholder is deemed to be UK resident. Time apportionment relief, whereby the chargeable gain only applies to the portion of UK-resident ownership, has historically applied to offshore bonds only.
Onshore bonds are taxed internally within the life fund. The UK-resident policyholder receives a basic rate tax credit to offset further tax liabilities. UK bonds are therefore generally unsuitable investments for non-taxpayers as they will be unable to reclaim the life fund taxation.
Life fund taxation is levied broadly as follows:
• 10 per cent dividend credit is non-reclaimable,
• 20 per cent tax charge on fixed interest income
• 20 per cent less inflation indexation on capital gains.
However, the administration of a UK bond is more complicated due to the tax reporting and there may be additional implicit costs borne by policyholders.
Offshore bonds defer tax on both fixed interest distributions received and capital gains, save any applicable withholding taxes, but still suffer the loss of the dividend credit.
The UK resident policyholder pays full marginal rate income tax on any chargeable gains.
As such, due to this potential double taxation of dividends with offshore bonds as well as indexation relief on capital gains, onshore bonds are relatively more tax-efficient for equity holdings.
Offshore bonds still generally offer a wider fund universe but the difference is less than it was a decade ago.
Tax-efficient withdrawals
The policyholder can withdraw 5 per cent of the original capital investment per policy year and defer further tax until a ‘chargeable event’ occurs, at which point any growth is taxed under the income tax regime based on their residency.
An investor who ceases to be UK resident before surrendering a bond will not be liable to UK tax. They may however be liable to tax in the country in which they are resident at the time of encashment.
The 5 per cent allowance is cumulative up to 100 per cent of the original investment amount. For example, if £100,000 was invested and no withdrawals were taken for the first four years £25,000 could be withdrawn in the fifth year without triggering a chargeable event.
Similarly, a client may choose to withdraw a smaller amount for a longer period, such as 4 per cent per annum for 25 years. Adviser charging may reduce the available 5 per cent allowance where the charge is taken from the bond.
Chargeable events
A chargeable event is triggered on:
• Maturity or full surrender of the investment bond
• Partial surrender in excess of the 5 per cent allowances
• Assignment of the bond for money or money’s worth
• Death of the last life assured
The chargeable gain on partial surrenders is counted as being received at the end of the policy year therefore it may be counted against a different tax year than when it was actually realised. The chargeable gain on full surrenders is counted as being received immediately for tax purposes.
Investment bonds are often segmented into sub-policies and their tax treatment is the same as the overall bond.
Top-slicing relief
Top-slicing is a mechanism to ensure that when the bond has been held for a number of full years, the investor is not penalised for taking all the gain at once. It is used where adding the full gain to the investor’s income for that tax year would push them into the higher (40 per cent) or additional rate (45 per cent) tax band. personal pension contributions may for example reduce taxable income and remove the individual from higher rates of tax).
To top-slice the gain, the total gain is divided by the number of complete years that the bond has been in force. The resulting figure is then added to the investor’s income for the current tax year to establish what tax rate the bond growth falls into.
Top-slicing applies to chargeable gains on both onshore and offshore bonds.
An example of tax liabilities arising from full surrender of an onshore bond is outlined in Box 1.
Segmentation
A more efficient way of arranging investment bonds is to invest into segments, typically of £100 or £1,000. An example of how this can work in practice is illustrated in Box 2.
This gives the policyholder more flexibility when surrendering part of the bond.
Surrendering whole segments will proportionately reduce the 5 per cent allowance available in future years. For example, if 20 segments are cashed in and the initial investment was £100,000 spread across 100 segments, the 5 per cent allowance will reduce from £5,000 a year to £4,000 a year (80 segments with an original cost of £1,000 each = £80,000 x 5 per cent = £4,000).
Danny Cox is chartered financial planner and head of financial planning at Hargreaves Lansdown
