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Cuts to annual CGT exemption and dividend allowance over the next two years will have an impact on the net returns from OEICs and unit trusts. While these changes have undoubtedly narrowed the tax gap between OEICs and offshore bonds it is unlikely to be significant enough to challenge the current status quo.

That's largely because offshore bond gains are subject to income tax at 20% or 40% (45% for additional rate) and the rates for capital gains on OEICs remain at 10% and 20%. But that's only part of the story and there are  many other factors which may influence wrapper choice.

In this article we will crunch the numbers to look at the returns on a comparable investment into OEICs and offshore bonds. But we will also look at the other investment considerations and why there is an argument to have both wrappers in your client's investment portfolio.

The changes

The Autumn Statement last November announced that the current annual allowance for capital gains tax of £12,300 would be cut to £6,000 for the 2023/24 tax year and then £3,000 from 2024/25.

This could see investors' capital gains tax bills rise by up to £1,860.

The dividend allowance will reduce from £2,000 to £1,000 and £500 over the same period. This follows confirmation that the increased dividend rates of 8.75%, 33.75% and 39.35% for the basic, higher and additional rates respectively will continue to apply.

With none of these changes affecting offshore bonds, do collectives still hold a competitive advantage? Or should a client consider both in their investment armoury?

The tax differences

Bonds and collectives such as OEICs and unit trusts are taxed very differently.

Income and gains from the underlying investments in an offshore bond are not taxed as they arise, but are subject to income tax when a client withdraws funds and a chargeable event gain arises. The downside to this is obviously that the rates of income tax are currently much higher than the rates paid on capital gains and dividends.

For example, a higher rate taxpayer will be paying 40% on chargeable event gains they make on an offshore bond, but will only pay 20% (28% on disposals of residential property) on capital gains realised and 33.75% on any dividends arising.

The upside for offshore bond owners is that they can control when the taxable event happens, and if this is in a year when they have no other income, by design or otherwise, it may be possible to extract profits completely tax free by keeping gains within their personal allowance, the savings starting rate and the personal savings allowance, currently totalling £18,570.

It is true that investors holding collectives can also control when they make a disposal, but none of the allowances available to an offshore bond can be used against capital gains. So once the annual exempt amount has been exceeded (remember, this will only be £3,000 from 2024), CGT will be payable. With regards to dividends, these are taxed in the year they arise, even if they are 'accumulated' - taxpayers have no control over this.

Crunching the numbers

So how does each tax wrapper stack up on a like for like basis?

Let's assume that the smaller CGT and dividend allowances have been used up each year, meaning that both gains and dividends on a proposed OEIC investment will be fully taxable - a worst case scenario for the collective option. The underlying investments are the same in each wrapper.

Assumptions:

• The annual yield (net of charges) of 5% is made up of 3% capital growth and 2% dividend income
• Gross dividends are reinvested into the OEIC annually, and income tax is paid separately by the investor each year
• Assumes all gains and dividends taxed fully at rates applicable to a basic rate taxpayer or higher rate taxpayer (in practice gains and dividends may straddle the higher rate threshold)

The table confirms that collectives remain a credible choice even if there are no allowances to set against OEICs capital gains and dividends. Crystallising capital gains each year up to the reduced annual exempt amount if available would further increase the net returns available to the OEIC.

In reality, gains on bonds and collectives may fall to be taxed partly at basic rate and partly at the higher rate. This scenario may favour bonds, as top slice relief may wipe out any higher rate liability.

Similarly, the balance could be tipped in favour of the offshore bond if gains could be taken in a year when the client has little or no other income. For example, a client in pension drawdown could switch off their income for a year and take gains of up to £18,570 without paying any tax.

Other considerations

Pure number crunching only paints part of the picture. There are many other factors to consider which will likely be driven by the client's long term investment goals.

Gifting

Offshore bonds can be easily gifted by assigning to a another individual or to a trust without a tax charge arising on the policy. In most cases the bond provider will supply the necessary documentation for the transfer. This can also be useful if the transferee is a non-taxpayer and gains can be realised tax free, for example transferring an offshore bond to a child to help fund their university education.

Collectives can also be 'gifted' to another adult individual, but the transaction will be regarded as a disposal for CGT, taxable on the transferor. Collectives may also be gifted into and out of a trust, and provided it is to a relevant property trust (and one that is not settlor interested) an election may be made to 'holdover' the gain to the transferee. This effectively defers the taxation of the gain until a future disposal date.

Losses

Investment losses made on the disposal of collectives can be used to offset gains in the same tax year or carried forward to use against future gains.

Investment losses on bonds cannot be set-off against same year or future gains on other bonds. In certain circumstances there may be some limited relief for a loss on surrender under the corresponding deficiency relief provisions, but this would only be available in the year of surrender and will only relieve other income subject to higher rate income tax.

Death

Gains accrued on collectives will not normally be subject to CGT on the death of the holder. The gain is effectively wiped out and the recipient, whether this is the executors or an estate beneficiary, will receive the shares at their value at the time of death. This is commonly referred to as 'market uplift'.

There is no equivalent treatment for bonds when the bond owner dies. The gain will always be subject to tax at some point, whether this is on the deceased as sole life assured, or on the executors or subsequent beneficiary where there are multiple lives assured.

Future changes in legislation

Future changes in legislation could also have a greater impact on one wrapper over the other. Looking back over the last 25 years, CGT has seen the top rate fall from 40% (when it was aligned to income tax rates) to 20%, the abolition of indexation relief, the introduction and abolition of taper relief and a basic rate of 10% brought in.

Ultimately, the tax position when funds are withdrawn is what matters, but we can only be guided by what they are today. We know tax legislation will change, but we don't know how and when. The solution, as ever, may be to hold savings in multiple wrappers to ensure that clients can adapt to future changes.

Summary

There is a stark difference in the way offshore bonds and collectives are taxed. While the changes made to the CGT allowance and dividend allowance will have brought the two wrappers closer together in terms of net returns, each have their merits and much will depend on a client's individual circumstances.

Future changes to legislation could also impact on returns, and maybe the solution is not one or the other, but to hold both to give clients the flexibility to make the most of the current allowances and rates, and hedge against the future.