Collectives v Bonds

After the ‘excitement’ of the Autumn Statement and everything that preceded it, where do the various tax changes and reversals leave the ‘Collectives v Bond’ decision?

Firstly, there has been no lessening to the tax attractiveness of the “no brainers” of pensions and ISAs. For that the financial planning community breathed a collective (pun intended) sigh of relief.

Once we get beyond those, are collectives or bonds more tax attractive?

In this article we will crunch the numbers to look at the returns on a comparable investment into collectives and bonds. But we will also look at other investment considerations and why there could be an argument to have both wrappers in an investment portfolio.

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A quick note on the terminology.

By collectives, I mean collective investment fund, so think unit trust, OEIC, ETF, investment trust and mutual fund (for our US readers, yes incredibly there are some!). I use the term collectives since I never make recommendations on individual share holdings however the tax analysis her holds true for direct share holdings as well. To confuse matters, you can hold various collectives, inside the aforementioned ISAs, pensions and indeed bonds.

What I mean when I say collective, is an investment not held within a wrapper but held directly and not protected from direct taxes. But that’s a mouthful so let’s use collective.

By bonds, I don’t mean cash bonds, corporate bonds, gilts or any other type of fixed interest security.

I mean an investment bond, a single premium ‘life insurance’ policy (because a portion of your ‘life insurance’ policy can be paid out upon death), but they're really an investment product…a type of tax wrapper that have fallen out of favour due to the low rates of capital gains tax and previous generous capital gains tax allowances. Investment bonds can be both onshore and offshore. We will primarily consider offshore bonds unless specifically noted.

OEIC = open ended investment company ; ETF = exchange traded fund

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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 bonds, do collectives still hold a competitive advantage? Or should you consider both in your investment armoury?

The Tax Differences

Bonds and collectives 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.

For those techies after a complete understanding of the tax differences, head to the end of the article.

Crunching The Numbers

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

Assumptions:

• £100,000 investment, no withdrawals

• 10 year investment term

• The annual yield (net of charges) of 5% is made up of 3% capital growth and 2% dividend income

• 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 underlying investments are the same in each wrapper

• The impact of charges is ignored. In other words, we are concentrating purely on the tax differences

This table (and in fact, most scenarios) shows that collectives remain the preferred choice even if there are no allowances to set against collective capital gains and dividends for both basic and higher rate taxpayers.

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.

[Top slice is not a reference to the results of my golf swing, rather a relief that allows a gain made on a policy to be annualised and could be an article in its own right. It essentially allows the policy owner to pay tax at a rate equivalent to the rate that would have applied if the gain had been taxable in each year it was made.]

This is the point at which I would urge caution for all investors. Offshore bonds are a popular product with life companies and a large wealth managers.

The charges are typically higher and once you are invested, the tax consequences of surrendering normally leads to other types of investment being encashed in their stead…making them a much more sticky and profitable investment product for providers.

It is possible to run the above scenario in a few ways that show bonds in better light.

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

Assuming a 0% tax rate at encashment is also sure fire way of manipulating the numbers for larger investments.

I would posit this would only be applicable to investors who are likely to retire abroad, and in a jurisdiction that would allow a favourable tax free encashment…say Portugal. In this scenario, an offshore bond pips collectives. Push that investment term out another 10 years and the numbers continue to improve.

If you are curious, speak with me and we can run the numbers through our calculator.

Other Considerations

Pure number crunching only paints part of the picture. There are many other factors to consider which will likely be driven by your 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.

In Summary

There is a stark difference in the way 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 your 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 the flexibility to make the most of the current allowances and rates, and hedge against the future.

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

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Technical Corner

The detailed “tax factors” underpinning the collectives v bonds decision making process.

Collectives

Dividends: Equity funds (invested at least 40% in equities)

• Dividend allowance currently £2,000 reducing to £1,000 in 2023/24 and £500 in 2024/25.

• Beyond the allowance: dividends taxed at 8.75% (BR), 33.75% (HR) and 39.35% (AR).

Interest distributions: Fixed interest funds (invested more than 60% in fixed interest and/or cash deposits)

• Personal allowance (PA) and higher rate (HR) tax threshold frozen until end of 2027/28.

• Additional rate (AR) threshold reduced to £125,140 from 2023/24 and frozen until 5 April 2028 (thereby reducing the threshold for the Personal Savings Allowance (PSA), which is not available for AR taxpayers).

Capital gains:

• Annual exemption at £12,300 for 2022/23, but dropping to £6,000 for 2023/24 and £3,000 for 2024/25 and frozen thereafter. Trusts suffer the same proportionate reductions.

• Capital gains beyond the exemption remain generally taxed at 10% below HR and 20% within the HR/AR. Note that, although capital gains are taxed as the top slice of income, they cannot be offset by any unused PA, a factor that becomes more relevant with the lowered annual exemption.

• Tax free “rebasing” still takes place on death, but lifetime transfers are normally taxable disposals for capital gains tax (CGT) purposes.

Onshore investment bonds

• Zero tax on dividends at policyholder fund level (without limit) remains.

• Non-dividend income remains taxed at 20% at policyholder level.

• Capital gains remain taxed at 20% at policyholder fund level. The special rules for taxing and paying tax on deemed gains on collectives held in life fund continue.

• Top slicing relief (with its tax management benefits) continues.

• 5% tax deferred withdrawal rules continue.

• Basic rate (BR) tax credit in determining policyholder tax on realised chargeable event gains continue.

• Lifetime transfers by way of assignment are not income taxable events.

Offshore investment bonds

• Zero tax on all income and capital gains at life fund level (but withholding tax might apply).

• Top slicing relief remains available.

• 5% tax deferred withdrawal rules remain.

• PSA, PA and zero savings starting rate band (SSRB) remain available.

• Chargeable gains (not covered by the PA, PSA, SSRB) taxed at appropriate policyholder rate with no BR credit.

• Lifetime transfers by way of assignment are not income taxable events.

That’s the revision part over. Do the changes announced in the Autumn Statement (and the reversals of earlier tax policy announcements) make any difference to the decision making?

The tax fundamentals of collectives and both types of investment bonds have not changed. So, the essence of decision making hasn’t altered either. However, the many tweaks to the basic tax structure do matter, viz:

• The continuation and extension to 5 April 2028 of the frozen PA and HR tax threshold;

• The reduced threshold for AR tax from 2023/24 to 5 April 2028;

• The continuation of the higher rates of dividend taxation introduced in 2022/23;

• The reduction in the dividends tax free allowance from 2023/24 and again in 2024/25; and

• The materially reduced CGT annual exemption from 2023/24 and again in 2024/25, with no indexation thereafter.