Techzone

Speculation that the Chancellor may align Capital Gains Tax (CGT) with income tax rates when she unveils her first Budget on 30 October has been rife. Following hot on the heels of cuts to the CGT annual exemption and dividend allowance the spotlight is once again focused on the bonds v collectives debate.

Since 2008 when CGT rates were cut to their current rates of 10% and 20% collective investments have very much been the clear winner. But if the headline rates are aligned it brings other factors into play when determining wrapper choice.

Headline tax rates compared

Investment gains on collectives are currently taxed at 10% and 20% depending on the income tax status of the client. Dividends are also taxed at the lower rates of 8.75%, 33.75% and 39.35% depending on a client's marginal rate of income tax. In contrast, bond gains are taxed at the income tax rates of 20%, 40% and 45%.

If the chancellor was to equalise CGT rates with income tax rates that brings bonds and collectives much closer together. But equity-based collectives would still hold a slight edge due to the lower rates of tax applied to dividend income.

Allowances will also play a part in the net returns for clients, although the capital gains tax exemption has been slashed to £3,000 this year, barely a quarter of the 2022/23 level, and the dividend allowance is now only £500 – just 10% of what it was in 2017/18.

While these have improved the argument for bonds, it should not be forgotten that offshore bonds already have their own allowances and reliefs to boost net returns, and which are not available to collectives. Namely any unused personal allowances, the £5,000 starting rate band for savings and the personal savings allowance of up to £1,000. And not forgetting the benefits of top slicing relief which can dramatically reduce the amount of tax paid.

So all is not what it may seem. The effective rates of tax taking everything into account could be significantly different to the headline rates.

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. During the investment period they effectively benefit from 'gross roll-up' in much the same way as ISAs. 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.

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. If this can be achieved, the returns will be very much like an ISA.

While it is true that investors holding collectives can also control when they make a disposal, dividends are taxed in the year they arise, even if they are 'accumulated' - taxpayers have no control over this. Additionally, gains are taxed in the year they arise and have no averaging mechanism similar to top slicing relief enjoyed by bonds.

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. The underlying investments are the same in both the offshore bond and OEIC.

Assumptions:

• The annual yield (net of charges) of 6% is made up of 3% capital growth and 3% 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)

Taken at face value the table shows that collectives remain a credible choice even if there are no allowances to set against OEICs capital gains and dividends.

However, the actual tax on the offshore bond may be reduced by top slicing and any unused allowances, increasing the net return to the client. However, this conclusion can be turned on its head in favour of offshore bonds if the gains can be taken tax-free when the client has little or no other income. This can be achieved provided the gains when added to other income do not exceed £18,570.

Applying this thinking to the figures above, a client with no other income could take a tax-free withdrawal of just over £42,000 from their bond while keeping gains below £18,570.

There are many situations where the bond holder may have little or no income meaning gains can be taken tax-free.

The number of retirees with DC pensions who can flexibly access their pension benefits is on the rise. That means many clients may be able to turn off their pension income to make themselves a non-taxpayer in a tax year in which bond gains are taken.

Even those who may have fixed retirement incomes such as a DB pension or state pension may be able to use an offshore bond as a bridging 'pension' between retirement from work and accessing pension benefits. This means that pension benefits can remain invested in a tax beneficial environment for longer and may even facilitate early retirement.

Where the investment is not needed to support retirement, a bond can be an ideal way of funding university costs for children at a time they have little or no income. Bonds can be assigned to a child once they have turned 18.

This potential to extract gains completely tax-free is not possible with an onshore bond. Unlike an offshore bond income and gains do not roll up tax-free within the bond and are subject to corporation tax. The bond holder will receive a 20% tax credit for the tax deemed to have been suffered.

This tax credit may often be greater than the actual tax suffered within the fund but because the tax credit in non-reclaimable it means non-taxpayers will have suffered tax on gains which would otherwise have been tax-free if they had invested in an offshore bond.

Other considerations

The numbers only tell part of the story when recommending tax wrappers. There are other factors to consider which will likely be driven by the client's long-term investment and planning 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.

There is also a CGT disposal when collectives are transferred into and out of relevant property trusts. Provided the trust is not 'settlor interested' an election can 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

Currently, 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.

Summary

There is a stark difference in the way offshore bonds and collectives are taxed. While aligning CGT with income tax rates will have brought the two wrappers closer together in terms of net returns, each have their merits beyond these measures, 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.