Are onshore bonds back in vogue?
John Haley, technical consultant AXA Wealth, takes an in-depth look at onshore bonds and their uses as an alternative investment or supplement to the general investment account
It seems that wealth management is like fashion: it goes round in circles. As we have seen, bond sales have suffered somewhat since the changes to the capital gains tax regime in April 2008. However, in my experience, more and more advisers seem to be looking ?to use onshore bonds as an alternative investment, or at least a supplement, to the general investment account for certain clients. The question is, why?
Technically, an onshore bond?is a non-qualifying whole of ?life policy. As the bond is a life assurance contract, the investor is not normally liable to pay capital gains tax or the starting and basic rates of income tax on any growth in the bond, as the fund(s) concerned have already settled any liability in the form of corporation tax.
The corporation tax rates applied within the onshore life funds are laid out below, and these rates effectively settle any basic rate taxliability with respect to the investor’sposition.?The tax paid onincome and gains within the fund is reflected in the funds’ unit prices. Note that regardless of the individual’s tax status, they will not be able to reclaim any of this tax from HMRC. For this reason, onshore bonds are almost certainly not suitable for non or starting rate tax payers.
However, a higher or additional rate tax payer can invest in?an investment bond with no ongoing tax liability outside of the wrapper on any income produced within the funds. Contrast this directly with income/dividend yielding collective funds, where the individual concerned would need to declare any income generated (there is obviously no difference here between income and accumulation units) andpay further income tax via self- assessment. It could be argued therefore that any income yielding assets in your client’s portfolio could be invested in bonds to protect them from an ongoing income tax liability as a higher or additional rate tax payer.
If the investor is a higher or additional rate tax payer when they take money from the bond, they may need to pay income tax on any chargeable gains – the tax is currently limited to the difference between either the higher and basic rate (currently 20%) or the additional and basic rate (currently 25%), depending on which category they fall into. This ‘credit’ also makes onshorebonds a great place to hold equity funds that provide a?good dividend yield. In contrast, where dividend yielding equity funds are held within an offshore bond there is no credit for any withholding tax already paid, which can lead to double taxation on encashment for a UK resident. The same could also occur with interest yielding funds, albeit gross or offshore funds should be purchased in the first instance to prevent this occurring.
If tax is potentially payable following a chargeable event, another option is to assign segment(s) of the bond to another individual, such as the spouse. Assignment of a bond for money or money’s worth constitutes a chargeable event, with any chargeable gain being assessed on the assignor. However, an assignment by way of gift does not trigger a chargeable event. Gains arising on subsequent chargeable events will then be assessed on the assignee and would be treated as if they had owned the segments from initial investment for top slicing relief purposes, if applicable.
How many of your higher and additional rate tax paying clients also have spouses that are higher or additional rate tax payers?
The other consideration around assignment is connectedwith inheritance tax (IHT) planning in the future and the use of trusts. If an IHT issue becomes apparent and the client is willing to make a gift of the bond, ?it can simply be placed into trust with no chargeable event occurring.
Contrast this with collective investments, where CGT on disposal into the trust becomes a real consideration. Holdover relief is there as a possibility, but this would only apply to relevant property trusts that are not settlor interested, meaning that the settlor’s spouse and any minor children cannot be included as beneficiaries.
Investment bonds are classed as non-income producing assets, which makes them enormously valuable in such areas as preserving personal allowance, age allowance and child benefit entitlements. For example, you could be faced with a client whose investment income is pushing their total adjusted net income over the £100,000 threshold. They? would then be losing £1 of? their personal allowance for every £2 they are in excess of £100,000. The use of a bond could mean that adjusted net income does not exceed £100,000 per year as the investment income is generated within the bond itself.
Although open architecture ?is relatively unusual within onshore bonds, most offerings now provide a wide fund range that should cater for most clients. If your investment offering for the client is particularly active, funds can be switched with no consideration required around disposals and tax, as is the case with collective investments and shares.
5% tax deferred allowance
The investor can withdraw up to 5% per year of the initial amount invested in each individual policy for a period of 20 years, or if they take less than 5% per year, until the value of the original investment amount has been fully withdrawn. Provided this amount is not exceeded, there will be no income tax payable ?at the time of each withdrawal as tax on these amounts is deferred until final cash-in. The 5% allowance is cumulative, which means, for example, that 4% per year could be withdrawn for 25 years; or if the 5% withdrawal is not used in one year, the investor could withdraw 10% in the following year with no immediate tax liability, regardless of their tax position.
Any adviser charges taken from a bond count towards the 5% annual withdrawal allowance. This means there may be an immediate tax liability if the withdrawals, combined with any adviser charges, are above 5% of the initial amount invested.? If ongoing adviser charges are taken as a percentage of the bond’s value and that value increases, the actual amount of the ongoing adviser charge will also increase.
Where tax is paid at the rate applicable to trusts (RAT)?- broadly discretionary and accumulation and maintenance trusts – the trust will pay income tax at either the 45% rate or 37.5% rate where dividends are concerned, in respect of all trust income in excess of the basic rate band of £1,000.
With the use of a bond, trustees can also be protected from an ongoing income tax position, in much the same ?way as an individual higher? or additional rate taxpayer. Obviously, consideration would need to be given to chargeable events in the future, as tax would currently be payable on gains at a rate of 25%. Again, assignment would be available to any beneficiaries of sound mind and aged 18 or over to improve the tax position on encashment.
There are also considerable tax challenges connected with trusts of this type receiving dividends and then distributing them to beneficiaries. The trustees are required to account for 45% taxon the amount distributed, and cannot use the notional tax credit to help with the tax charge. This means that, unless the trustees have credit in a pre-existing tax pool or are prepared to encash investments, they must generally take the net dividend received and deduct 45% tax from that amount, before income can be paid to a beneficiary. So, if a net dividend of £1,000 was received, the trustees can normally pay out only £550 to a beneficiary. Thisis obviously much lower than the £694 they would accumulate in the trust after tax outside of a bond investment, or the £1,000 if the dividend were received into a fund inside an onshore bond!
The 5% per annum tax- deferred withdrawal facility under the bond would obviously be available to the trustees if they wish to make payments to or for the benefit of the beneficiaries. Such withdrawals are technically of a capital nature, but the trustees would normally have a discretionary power over capital as well as income. The possibility of inheritance tax exit charges should be borne in mind for, in general, larger trusts.
The Charging for Residential Accommodation Guide (CRAG) confirmed in March 2010 that onshore bonds were to be included under the definition ?of life assurance products for local authority means testing purposes, which was always a grey area before this point. This means that the value of any onshore bond should be excluded from any capital means test, although the 5% withdrawal is deemed as income in this regard.
I have obviously concentrated on the broad benefits of onshore bonds today. All of the available investment routes have their particular advantages and disadvantages: the correct choice should be driven by a thorough understanding ofthe client concerned and their ultimate aims and objectives.
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