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Canada Life Article - Avoid an inheritance tax bill while still generating an income

Selecting a wrapper

In the past, some advisers have avoided the use of onshore investment bonds, and some still do. The image of bonds may have been tarnished in the past, however, the days of high allocations and commissions are gone.


It is important to put these factors aside and look objectively at the benefits onshore bonds can provide. They are a valuable planning tool and a good addition to a professional adviser’s portfolio of investment solutions.

 

The desire for transparency over recent years has led many bond providers, such as Canada Life, to adopt a simple charging structure allowing clients to see clearly what they are paying and to whom. Platform providers now also provide transparent unbundled charges too.


The new transparent world makes it much easier for advisers and clients to compare the cost of different tax wrappers. 

 

The Select Account uses a single tiered product charge based on the value of the investment, similar to some platform providers. So, for example, a £250,000 investment has a monthly charge equal to just over £900 a year, or 0.36% of the investment. This is very competitive when compared to buying a collective on some platforms, where the annual platform charge can go up to 0.50% or even higher.


Internal tax


With onshore bonds the gains and income achieved by the underlying life fund is subject to tax, paid by the provider and, whilst some may consider this a disadvantage, it can be very beneficial as it allows personal tax to be deferred. This can actually help an investor pay less tax overall which is not necessarily a bad thing.

 

To understand this, the tax paid within the fund is as follows:

  • Any interest and rental income received by the provider is subject to corporation tax at 20% although any UK dividend income received is not taxed.
  • Any realised capital gains are also subject to corporation tax of 20% and for equities, equity-based investments and gilts, this is after indexation relief in line with the retail prices index. There is no indexation for other fixed interest holdings.

 

From an investor’s perspective, this tax is deemed equal to basic rate tax, despite the fact that the actual tax paid is generally lower than 20%. It could potentially be a lot less, depending on investment performance and economic conditions.

 

Personal tax for your client


As there is no ongoing personal tax liability for the policyholder, a bond is easy to administer and a lot less hassle than some other forms of investment. This can be attractive to clients and especially to trustees who want to keep the ongoing administration to a minimum.


A tax calculation is only required when a gain is realised on a chargeable event. This could be when the last surviving life assured dies, the policy is fully surrendered, there is a withdrawal in excess of the cumulative 5% tax-deferred allowance or if the bond is assigned for money or money’s worth. It can also occur on maturity but most bonds do not have maturity dates.

 

Let us look at an example of how this works. Eric is aged 50 and he invested £100,000 over a period of 8 years and his annual income when he surrenders the investment is £30,000. For simplicity let us assume that the money is invested in a growth fund.

 

Investment bond Unit trust/OEIC

 - The bond grows to £148,000 and when surrendering the bond a gain of £48,000 is realised.

- Adding the gain increases the income to £78,000.

- As the total gain takes the client into the higher rate tax threshold, top slicing allows the gain to be spread over the number of years it has been made.

- £48,000 growth over 8 years gives an annualised gain of £6,000 each year.

- Remember, their tax position in the year of the gain is treated as being their tax position in each year of the investment.

- Adding the top-sliced gain to their income in the final year, gives income of £36,000.

- After allowing for the personal allowance, their income remains within the basic rate tax threshold of £45,000 and, as basic rate tax has already been deemed to have been paid, then there is no additional tax to pay

- As there would not be any tax within the fund, let us assume the growth is slightly higher than a bond and the investment is worth £153,000.

- On final encashment, a gain of £53,000 is realised

- After deducting the annual exemption of £11,300, the taxable gain is £41,700.

- When added to the client’s income, £15,000 falls within the basic rate tax threshold and is taxed at 10%, or £1,500.

- The balance of the gain is £26,700 and will be subject to 20% tax, being £5,340.

- The total liability to the client is £6,840, leaving a net gain of £46,160, less than that achieved by the bond.

 

 

This is quite a difference in the tax position for a simple example. Some will say that, with a collective portfolio, the client could use the annual capital gains tax (CGT) exemption each year to reduce the potential CGT liability and this is prudent planning. But this involves calculating the capital and growth of each disposal from each fund. This will come at a cost and may not actually be done each year.

 

Let us look at how much a client needs to realise to fully use their annual CGT exemption.

  • Joan invests £100,000 and this increases in the first year to £120,000.
  • When she takes a lump sum from a collective fund then part of this is a return of capital and part is growth.
  • When calculating a part disposal, to value the amount of capital being returned HMRC use the following formula:

Capital in the investment
X Amount being realised
(Original capital less any previous capital withdrawals)

Amount being realised + remaining value

 

The balance of any payment is therefore growth and potentially chargeable.

  • To realise the full £11,300 exemption, this client would have to sell £67,800 of the investment and reinvest it without breaching the bed and breakfasting rules. This means they would not be able to reinvest in the same fund for at least 30 days, but can choose a similar one, which potentially adds diversification but does mean another CGT calculation the following year.


Over a period of time, more and more of the original capital is returned to the client and then reinvested, leaving the client with numerous funds each with their own CGT calculations, adding complication and additional work to the management of the investment.


Any unused CGT exemption is not carried forward so if insufficient capital gain is realised then some of the exemption will be lost.

 

Deciding factors

Arguably, many will view charges and tax as being the main factors when considering different tax wrappers, but as well as offering simplicity, especially from CGT calculations, a bond can offer other features, including:

  • Tax-efficient switching. When the underlying investment is switched, no tax liability arises on the client (unlike a collective investment).This makes managing the investment easier and clients are able to switch to help meet their changing objectives, for example if they approach a time when they are planning to take an income.

  • Accessing the investment. A bond allows different ways in which a client can access their money, either by using the 5% tax-deferred annual allowance, by surrendering one or more of the individual policies that make up the bond, or by a combination of both. This allows you and the client to choose the method that is the most tax-efficient.

  • The 5% tax-deferred allowance. A client can access regular or periodic lump sums without any immediate tax charge. Each year they can withdraw an amount equal to 5% of the original investment without an immediate tax charge and for tax purposes, these withdrawals are treated as a return of capital. It is a cumulative allowance so any amount unused rolls over to subsequent years.

    Any amounts taken do come into the tax calculation when the bond is either fully surrendered, assigned for money or money’s worth or when the last surviving life assured dies. This is why it is referred to as tax-deferred.

  • Assignability. Whilst assigning a bond in return for money or money’s worth is a chargeable event, assigning it as a gift is not. The ownership of a bond can change and there is no tax liability. The new owner is then treated as owning the bond from outset. This allows them to make use of the available 5% tax-deferred allowance or even surrender the bond using their own tax position. Ideal if the new owner pays a lower rate of tax than the assignor and where an investor may want to pass on wealth to a trust, onto younger generations, or if trustees want to distribute money out of a trust.


The important message here is that onshore investment bonds should not be dismissed simply because there is tax within the fund. Every client will have different objectives. In some instances, a collective investment may be more beneficial than a bond and vice versa. Some clients may be better served by investing in both tax wrappers offering even more flexibility.

 

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Canada Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.

Canada Life International Limited and CLI Institutional Limited are Isle of Man registered companies authorised and regulated by the Isle of Man Financial Services Authority.

Canada Life International Assurance (Ireland) DAC is authorised and regulated by the Central Bank of Ireland.

Stonehaven UK Limited and MGM Advantage Life Limited, trading as Canada Life, are subsidiaries of The Canada Life Group (U.K.) Limited. Stonehaven UK Ltd is authorised and regulated by the Financial Conduct Authority. MGM Advantage Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority.