From April 2016 the government will remove the Dividend Tax Credit and replace it with a new tax-free Dividend Allowance of £5,000 a year for all taxpayers. This will ensure that ordinary investors with smaller portfolios and modest dividend income will see no change in their tax liability – and some will pay less tax.
This will also apply to collective investment funds which hold UK equites and make distributions as dividends*. So how does this affect the traditional comparison between collective investments and investment bonds?
*When more than 40% of the fund is invested in equities, the fund will be classed as an equity fund and all income distributions (whether accumulated or not) will be taxed as dividends.
Dividend tax rates
From 6 April 2016, irrespective of the rate of income tax that an individual pays, there will be an allowance of £5,000 of dividends each year that will not be taxed.
The 10% tax credit with a UK dividend payment will no longer exist. Of course, numerous countries around the world have withholding tax on their dividends and this situation will continue for shareholdings in foreign companies.
If the dividend income exceeds the £5,000 allowance, the income tax rate on the excess is 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.
So a higher rate taxpayer receiving £6,000 of dividends will pay tax of £325 in 2016/17, which is actually considerably less than this year.
However, those people who receive significant dividend income will pay more tax – for example, due to large share portfolios or being a director taking a large portion of their income as dividends. But that is a subject for the next article; in this article we are just looking at collective investments and investment bonds.
In the absence of any further detail it would seem that the proposed changes to dividend taxation just relate to individuals (and trustees). But what about companies, especially life companies?
Currently, any dividends (franked investment income) a UK company receives from a UK shareholding are not taxed. The rationale being that they have come from profits that have already borne corporation tax (in theory) at the same nominal corporate tax rate.
There is no indication at all in the information released by the government that the proposed new dividend tax rates will apply to companies. So it would appear reasonable to assume that their tax position will be unchanged.
‘Bonds vs unit trusts’
In the old days, when an investment was being ‘sold’, we were often drawn into a ‘bonds vs unit trusts’ debate. Thankfully, those days are long gone and people can appreciate that both collective investments and investment bonds (including offshore bonds) can be valuable elements of an integrated financial plan.
In the next tax year, as well as the existing capital gains tax (CGT) annual exemption, starting rate for savings income and tax deferred withdrawals, we will also have this new dividend allowance and the new Personal Savings Allowance for the financial planner to take into account.
As an aside, we should acknowledge there are many non-tax factors to take into account in determining the investments to include in a portfolio; such as charges and range of available funds and model portfolios. But for now, we will concentrate on tax.
If comparing like-for-like UK equity fund links, the new rules on dividends will tip the balance in relation to the tax effectiveness of accumulating dividends in favour of the investment bond. This will be particularly so if (as expected) there remains no tax on UK dividends received by life companies.
Accumulating dividends inside a bond, UK or offshore, for a higher or additional rate taxpayer (who would suffer a 32.5% or 38.1% tax charge over £5,000 a year) will look attractive. This assumes they have large equity portfolios.
Also, take the example of a basic rate taxpayer who has £250,000 invested in a portfolio of UK equity income accumulation funds, yielding dividends of 3%. At present, they pay no additional tax on this investment.
From next April, they will be paying £187.50 tax a year. This is the dividends of £7,500 less the allowance of £5,000 taxed at 7.5%. Not a huge amount admittedly, but sheltering £50,000 of the portfolio in an equivalent investment bond fund would avoid that bill. Assuming the costs of the transaction and the CGT position makes such a switch viable.
And when the bond is surrendered, if an onshore bond there is the basic rate tax credit on the chargeable gain and if an offshore bond, exit strategies may help to avoid or reduce tax (remembering that offshore investment bond chargeable gains are classed as savings income).
As ever, much depends on the facts and the client’s circumstances: now and as far as can be predicted on exit from the investment.
One thing is certain, with the new tax allowances from next year, informed advice will be essential.
One should firstly consider tax-advantaged investments when planning recommendations to a client about their investments.
But the raft of tax allowances available to investors next year effectively puts some taxed investments into the same category.
Careful and accurate planning of investment income and the timing of chargeable gains could lead to substantial tax savings.