Bonds or Collectives

by on 27·04·2016

The recent changes to Capital Gains Tax rates and the introduction of the changes to dividend taxation taking effect from 6 April 2016, give rise to the question of which offers the best value for your clients - Bonds or Collectives.  On consideration of the pros and cons, the result may be the same as your existing views, however it is definitely worth taking a look at in light of the changes.

The new CGT rates (28 down to 20% and 18 down to 10%) are only half of the rates that apply to taxable income for basic rate and higher rate taxpayers, and even lower for additional rate taxpayers.  There's also the fact that the first £11,100 of capital gains realised in a year are exempt.  On the "income" front, though, apart from the personal allowance (likely to be used up by other income e.g. earnings or pension for most investor clients of advisers) there is the £5,000 dividend tax allowance and the £1,000 (basic rate taxpayer) or £500 (higher rate taxpayer) personal savings allowance for interest.

For most investors the relative importance of these "tax fundamentals" will depend on the portfolio selected as opposed to driving the type of portfolio selected as suitable for a particular investor. In most cases, portfolio construction should be based on investment grounds first with tax efficiency operating as an important "contributing" factor.  Tax should not be the main driver of portfolio construction - even when gains are taxed at half the rate applicable to taxable income.  This conclusion is strengthened by the fact that, for many, the £5,000 dividend tax allowance will mean that the yield from their portfolio is either tax free or taxed at a lower overall rate than at present.

Clearly, when considering the tax characteristics of a portfolio you have to consider the taxation of both income and capital.  For most investors there is an improvement in both in relation to unwrapped investments (e.g. direct investment into collectives) so any thought of basing a portfolio decision on the reduction in the rates of capital gains tax or the dividend tax allowance alone would probably result in an unbalanced conclusion.

Most equity-based portfolios would produce income and capital growth.  We are often reminded of the importance of the former (through reinvested dividends) and the volatility of the latter.  These facts haven't changed, only the tax treatment of income and gains from equities.  And for both income and gains, the picture has become even brighter.

So it may be that the question to consider is not so much "growth or income?" (essentially you want both but if you had to choose, reinvested dividends offer a little more certainty than capital growth) but whether the portfolio should be wrapped in a UK or offshore investment bond to deliver the optimum tax outcome for the investor.

For capital growth the CGT annual exemption and a rate of 10% or 20% outside of the bond make it hard to argue a case for the tax deferment qualities of an onshore bond unless the investor has used their annual exemption, is a higher rate taxpayer and the life company concerned reserves for tax on realised (or deemed realised) capital gains at a rate substantially lower than 20% - which it may well do.

Also, the fact that it is only gains in excess of the increase in the RPI that are subject to tax in the UK life fund. At the current rate of inflation this relief is not terribly significant.  Offshore bonds have no tax liability at life fund level on realised or unrealised gains so if capital gains are expected to be significant and the deferment period is likely to be long then the offshore bond may offer some attraction - though not as powerfully as it would have before the CGT rates reduction applicable in 2016/17.

As a rule of thumb, when dividends would fall within the tax free dividend allowance (i.e. an investor's total dividends in a tax year do not exceed £5,000 - £10,000 for a couple) there can be no income tax benefit in holding the equities producing the dividends inside a bond.  Above that level, though, the tax rates have increased by 7.5% and so the tax deferment qualities of a UK or offshore bond might then start to look attractive.  Don't forget though that there is no tax at UK life fund level on dividends but there is a basic rate credit.  There is no such credit for gains realised on encashing an offshore bond.  For multi-asset funds, it's worth remembering that unless the underlying investments are more than 60% in basically fixed interest, the income paid from the fund will be dividends eligible for the £5,000 allowance.

As ever, the longer the investment period and the greater the dividend the more powerful is the tax deferment case for a bond - and provided you can access the investments you want, a UK bond would seem to be preferable for individual investors.

So much to consider then.  It's not (and never was) cut and dried but if you want a rule of thumb, in a balanced portfolio unless the dividends exceed £5,000 per annum and capital gains exceed the annual exempt amount, the tax case for an investment bond may be hard to make.