A taxing decision?

July 3rd, 2008

The pre-Budget announcement on 9th October 2007 brought sweeping changes to the capital gains tax system resulting in some winners and some losers. The changes mean that, for disposals of assets after 5 April 2008, any resulting capital gain will now be taxed at a flat rate of 18% rather than either 20% (the basic rate) or 40% (the higher rate), which applied to capital gains made prior to 6 April 2008. However, investors no longer benefit from taper relief, which reduced the amount of gain subject to tax if the asset had been held for more than 3 years.  Taper relief could reduce the ‘effective’ rate of tax to as low as 12% for basic rate taxpayers and 24% for higher rate taxpayers.

The revisions to capital gains tax (CGT) met with particular resistance from the life assurance industry who initially felt that the changes resulted in an ‘unlevel playing field’ between different investments – the main investments available for those who have already used their ISA allowances being unit trusts (gains from which are subject to CGT – now at a rate of 18%) and investment bonds (gains from which are subject to income tax – either 20% or 40% depending on the individual’s tax rate).  As we will explain though, when the issues are considered further the disparity is not necessarily as wide as it appears at face value.

It is important to make clear that there are no direct changes to the way gains from UK investment bonds are taxed.  Higher rate taxpayers need to consider the new 18% rate on gains from investments such as unit trusts against a total tax rate of 40% on gains from investment bonds.  The trouble is that this simply compares the tax on any capital gains made from each type of investment whereas, in reality, many funds generate investment growth from investing in assets that produce income rather than from trying to generate gains from ‘buying’ and ‘selling’ assets.  An investment bond may have a tax advantage here for higher rate taxpayers as it can ‘shelter’ this income from higher rate tax, whereas a higher rate taxpayer has a total liability of 32.5% on dividend income from unit trusts.

It is perhaps also misleading to state that higher rate taxpayers pay tax equivalent to 40% on gains from investment bonds – the rate of internal tax applicable to funds within UK investment bonds is deemed to be 20% and, although higher rate taxpayers have an additional 20% liability to tax, this is based on the net gain.  In other words, if gains within the investment total £10,000, after 20% tax has been paid by the fund manager, the net gain is £8,000.  On encashment this leaves the investor with a tax liability of £1,600 (20% x £8,000) resulting in total tax of £3,600 or an effective rate of 36%.

What about basic rate taxpayers?  The decision here is perhaps less clear cut.  The deemed internal tax of 20% on funds in investment bonds meets a basic rate taxpayer’s personal liability to tax on surrender.  The effective rate of tax paid internally by the fund manager can actually be slightly lower than the 20% mentioned earlier, due to the continuing availability of indexation when calculating gains made within life funds.  This contrasts neatly with the position for unit trusts which internally pay no tax on capital gains, but the individual is liable for capital gains tax at a rate of 18% on gains over the annual CGT exemption when they dispose of the investment.

As you can see, the analysis of which type of investment is the most tax-efficient is not a straightforward one! It will depend on factors such as your tax position (not only now, but when you encash the investment), the type of fund(s) you are going to invest in, whether you are making use of your annual CGT exemption (currently £9,600 for 2008/9), and the amount you have to invest.  It may also be the case that it is not simply an ‘either/or’ decision and that unit trusts are an appropriate vehicle for some funds within your portfolio and that other funds are best held in a bond.  Of course, use of your allowances for tax efficient investments such as an Individual Savings Account (ISA) should always be considered first.

For clients who already hold investment bonds it is important to stress that the changes do not mean that these investments are no longer suitable. Nothing has changed in respect of the tax treatment of investment bonds as tax ‘wrappers’ although for those making future investments the new rate of CGT means that a closer comparison of all the alternatives is warranted.

As always, tax is not the only consideration – for example charges will reduce overall returns (and vary widely from product to product) and it is also just as important to pick the right funds when building a portfolio. It is therefore essential to take professional advice before making any decisions.

The levels and basis of and reliefs from taxation are subject to change and their value depends on the individual circumstances of the investor.