Facts and analysis
Assuming that ISAs and pensions are always considered first, a common choice for retail investors with capital to invest is between investment bonds and collective investments, such as unit trusts and open-ended investment companies (OEICs). There are UK and offshore versions of both. Capital gains realised by investors from collectives (UK or reporting offshore collectives) are subject to CGT but capital gains realised by the investor when encashing an investment bond are subject to income tax.
Investments that allow the investor to access the CGT regime will also permit the use of the annual CGT exemption, which is £11,700 for the 2018/19 tax year. An investor will pay CGT at 10% for gains that, when added to their taxable income, fall below the higher rate tax threshold and 20% for gains that are in excess of the threshold.
UK investment bonds, on the other hand, suffer a 20% internal tax on capital gains but, provided the “top-sliced gain” from the bond remains (when added to other taxable income) below the higher rate tax threshold there is no further tax paid on the gain by a basic rate taxpayer.
Offshore bonds suffer no direct “internal” tax (although they are likely to suffer withholding tax on source income) but the UK investor will be assessed on the gains with no tax credit. For the basic rate taxpayer this means paying 20% tax on any gain.
It is absolutely essential to approach the choice of investment wrapper for a particular client with an open mind and commitment to making the decision that delivers the best outcome for the client taking account of all the factors, including (but not restricted to) fund and investor taxation.
Here are some of the key tax factors relevant for the UK basic rate taxpaying investor that can impact on the relative attraction of the investment bond and collectives.
Dividend Allowance and Personal Savings Allowance
A new dividend allowance of £5,000 was introduced on 6 April 2016. This allowance was reduced to £2,000 for the 2018/19 tax year. This means that an investor won't have to pay tax of the first £2,000 of dividend income each tax year.
A new personal savings allowance was also introduced on 6 April 2016, which means that a basic rate taxpayer can earn up to £1,000 each tax year in savings income tax-free (a higher rate taxpayer is able to earn up to £500).
If income from an investment is within the dividend and/or personal savings allowance the collective will generally be the better choice on tax grounds for the basic rate taxpayer.
A key factor in analysing the complete tax position for a basic rate taxpaying investor is how the underlying investment growth arises. If it consists purely of capital growth and no, or little, income the collective will generally be the better choice on tax grounds for the basic rate taxpayer if the annual CGT exemption is available. For couples, of course, there would be the ability to effectively double the use of the annual exemption for a “combined” investment.
While capital gains look tax attractive, at a time of highly volatile asset values many investors may consider capital growth oriented investments to carry a higher (and potentially unacceptable) degree of risk. It is widely accepted that having yield/income in a portfolio that is reinvested reduces overall risk and, over the long run, is an important driver of growth. To the extent that there is income in the portfolio, the basic rate taxpaying investor needs to consider the following:
- UK dividend income paid to a UK insurance company suffers no additional tax and can thus be fully reinvested.
- Dividend income paid to a collective will, after deduction of management expenses, generally be taxed on the investor – even if accumulated. A basic rate taxpayer will have no further liability on dividend income if it falls within the dividend allowance of £2,000, which is the same as the life fund –from a tax standpoint. If dividends are in excess of £2,000 however, a basic rate taxpayer will be liable to tax at 7.5%
- In the current volatile investment markets, money/cash funds continue to have an appeal. Here, interest paid to a UK life fund will be reinvested after 20% tax at life fund rates. Interest distributions received by basic rate taxpaying collective investors will suffer 20% tax year on year. The difference is that interest payments within the available personal savings allowance can be reclaimed by a collective investor but not a UK life fund investor. Again, no tax difference. Interest accumulating in an offshore bond will suffer no tax within the life funds (although withholding tax may have been suffered at source) and consequently there will be no tax credit for the investor when an encashment takes place and a gain is made. The basic rate taxpayer would thus have a “latent” 20% liability possibly higher if the gain is realised in a year where the gain (or part of it) falls above the higher rate threshold after top-slicing relief. The personal savings allowance can be used by an investor when calculating any tax due.
As a rule of thumb, therefore, all other things being equal (including respective charges) for capital growth driven by capital gains a collective looks “tax best” for a basic rate taxpayer, especially if the annual exemption is available. For reinvested income where the investor has available dividend and/or personal savings allowance available the collective again looks 'tax best'.