Bonds vs collectives: How to invest capital tax efficiently

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

Well, we know that there has been no diminution to the tax attractiveness of the so called “no brainers” of pensions and ISAs; investors and the financial planning community, no doubt, breathed a collective (no pun intended) sigh of relief. Other more specialist tax planning vehicles survived unscathed too, with some even gaining a few enhancements. 

So, once we get beyond all of those, are investment bonds or collectives more tax attractive and if the former, then UK bonds or international/offshore bonds? This consideration will proceed on the basis that, whatever investments are to underlie the investment bond or collective, they are freely available in both structures, and the impact of charges is ignored. In other words, we are concentrating purely on the tax differences.

Let’s remind ourselves of where we are in relation to the key “tax factors” underpinning the bonds v collectives 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% (basic rate (BR)), 33.75% (Higher rate(HR)) and 39.35% (Additional rate(AR)).

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

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

UK 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 tax credit in determining policyholder tax on realised chargeable event gains continue.
• Lifetime transfers by way of assignment are not income taxable events.

International 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.

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.

Together, these changes will impact on the level at which investment bonds should be considered as a tax deferment/tax management vehicle instead of unwrapped collectives.

To the extent that income and capital gains from collectives are likely to be tax free (all other things being equal) there is no tax reason for an investment bond. With a £500 dividend allowance and £3,000 annual gains exemption, from 2024/25, consideration of the tax free thresholds will become relevant to many BR taxpayers for the first time.

Beyond the thresholds, let’s consider income first. Tax freedom will still be possible in 2023/24 and 2024/5 and beyond for dividends from an equity fund to the extent that they fall within the reduced allowance of £1,000 or £500 respectively. However, the halving of the allowance in 2023/24, and its halving again in 2024/25, will mean that the value of an investment that could be made, on the basis that dividends will be tax free, will be 25% of what it would be this tax year.

Based on the current FTSE All-Share Yield (approximately 3.6%), the value of a shareholding needed to exceed the relevant tax year’s dividend allowance is:

• £55,600 in 2022/23;
• £27,800 in 2023/24; and
• £13,900 in 2024/25

These figures can be doubled for married couples and civil partners with joint holdings. Of course, as values change so do yields and actual dividends vary with disposable profits and reinvestment/distribution decisions.

A similar dynamic applies to tax free capital gains with the annual exemption falling by over 50% in 2023/24 and then halving (and freezing) in 2024/25.

In theory, the bar above which investment bonds could be considered for tax effiency will fall by about 50% in 2023/24 and by a further 50% in 2024/25. In other words, the entry point for considering bonds will be materially lower for all taxpayers. After that, the factors to take into account to determine the appropriate product will be much as they are now. The UK bond represents a tax efficient income for accumulating otherwise taxable dividends, as in both structures the dividends will accumulate tax free. For dividends, the international bond remains generally unattractive because of the eventual full income tax charge on accumulated dividends rather than the lower dividend tax rate (please see the table below).

Capital gains will be taxed or reserved for at a maximum rate of 20% in a UK bond. As now, the international bond will, all other things being equal, deliver the best gross returns – not being diminished by any internal life company tax. But on encashment there will be no BR tax credit and a greater tax liability than under a UK bond, except to the extent that a PA, PSA or zero SSRB can be used.

When comparing the methods of holding a fund that is invested more than 60% in fixed interest/cash investments, the dividend allowance is irrelevant. However, the frozen thresholds and reduced AR tax threshold (with its knock-on effect to the PSA) may be relevant. And of course, there’s also the reduced CGT annual exemption.

The marginal overall effective tax rates on income and gains beyond the relevant allowances and exemptions is summarised in the following table.

Marginal income tax rate	Nil	Basic	Higher	Additional
	%	%	%	%
Equity dividends:
Collective fund	0	8.75	33.75	39.35
UK bond	0	0	20	25
International bond	0	20	40	45
Equity gains:
Collective fund	10	10	20	20
UK bond*	20	20	36	40
International bond	0	20	40	45
Fixed interest distributions:
Collective fund	0	20	40	45
UK bond	20	20	36	40
International bond	0	20	40	45
Fixed interest gains:
Collective fund	10	10	20	20
UK bond**	20	20	36	40
International bond	0	20	40	45

**Assumes full 20% tax rate within life company. Actual reserving rate for collective-based life funds may be marginally lower (e.g. 18%) to reflect deemed annual realisation with tax spread over seven years.

*Loan relationship rules apply within a UK bond.

There is one other administrative tax factor that needs to be borne in mind, although it does not change the mathematics; self-assessment returns. When the Office of Tax Simplification (OTS) looked at CGT reform in its first reportreport, it included a graph, sourced to HMRC and based on a 2021/22 projection for individuals only, which suggested that:

• A £3,000 exemption would mean about 225,000 people being dragged into self-assessment for the first time; and
• About a further 110,000 newly having to complete the CGT section of their return.

As anyone who has completed the CGT supplementary pages (SA 108) will know, not only do the gains have to be set out in somewhat tortuous detail, HMRC also require computations sheets for each asset disposal.

The HMRC TIIN on the exemption reduction, published four days after the Autumn Statement, had some rather different estimates. It says ‘…it is estimated that for the year 2023 to 2024 around 500,000 individuals and trusts per year could be affected, increasing on a cumulative basis to 570,000 in 2024 to 2025. Of this group, by 2024 to 2025 it is estimated that 260,000 individuals and trusts will be brought into the scope of CGT for the first-time.’ A comparison with the earlier OTS report numbers is complicated by the fact of another CGT change, not announced in the Autumn Statement.

The current rule that requires the SA 108 to be completed if proceeds exceed four times the annual exemption regardless of whether any CGT is due will be amended, from 2023/24, to a new cash threshold of £50,000, i.e. much in line with today’s current figure of £49,200. The inclusion of trusts makes little difference – there were 22,000 CGT-paying trusts in 2021/22 against 301,000 individuals.

A similar reporting issue could arise because of the cuts to the dividend allowance. Again, a delayed TIIN was issued on this subject. It said ‘It is estimated that [the dividend allowance cuts] will affect 3,235,000 individuals in the year 2023 to 2024 and 4,405,000 individuals in the year 2024 to 2025. Around 46% of those with taxable dividend income will be unaffected by this measure in the year 2023 to 2024, falling to 27% in the year 2024 to 2025.’

The current HMRC stance is that there is no need to complete a self-assessment form if dividend income does not exceed £10,000, but there is a requirement to contact HMRC if the dividend allowance is exceeded to arrange payment of the tax due. For some investors, a bond that incurs marginally more tax than a collective investment but does not require contacting HMRC, filing a tax return, and/or CGT pages to be completed, may be the preferred overall option.

In conclusion, as for now, on tax grounds, if the income and capital gains from the underlying investments are likely to be tax free from unwrapped collectives then the collective will “win” and there is no need to consider a bond for tax deferment. From tax year 2023/24 though, the point at which this “win” ceases will be lower, so bonds (UK or international, as appropriate) need to be considered at a correspondingly lower monetary investment entry point. That will continue to require consideration of a wide variety of factors including the balance between income and capital gains on the underlying funds – please see the above table– and the tax reporting already undertaken by the investor. Advice will continue to be absolutely necessary.

Please contact your usual TPO Adviser if you would like more information.

The information in this article is correct as of 13/12/2022.

Please note: The information contained within this article is for guidance only and does not constitute advice which should be sought before taking any action or inaction.

Investment returns are not guaranteed, and you may get back less than you originally invested. The Financial Conduct Authority (FCA) does not regulate cash flow planning, estate planning, tax or trust advice.