The Internal Taxation position of the main types of UK Investment Products.

A forgotten tax?

The rates of personal taxation (and tax reliefs) applicable to individuals who hold products such as ISA’s, Unit Trusts or Personal Pensions is quite widely known, and is frequently a deciding factor when choosing to use one product rather than an alternative product.

However, a factor that is often ignored or understated is that many investment funds held within different product wrappers also suffer internal taxation within the fund itself. Like personal taxation, the rates and types of taxation applicable differ between different types of products (surprise, surprise).

As we had difficulty locating a comparison of these products, we decided to create a comparison matrix from scratch.

As you will see, there are some differences between Life Insurance Funds (accessible via Investment Bonds), Unit Trust & OEIC Funds, Investment Trusts and Personal Pensions. This ‘hidden’ layer of taxation will impact the returns that you receive and/or the amount of capital growth within the specific investment fund.

In general, Life Funds suffer the heaviest taxation, while Offshore Bonds and Personal Pensions suffer the least internal taxation. However, does this mean that you should invest all your spare cash in Offshore Bonds and Personal Pensions? Not quite, as this ignores the personal tax liabilities that could be applicable to a holder of one of these plans. In reality, even an onshore bond can be a suitable investment for a certain class of taxpayers in certain circumstances.

(1) With effect from 1 September 2009, investment trusts that invest in interest bearing assets will have the option of reclaiming corporation tax they pay and passing on the tax liability to the shareholder.

Under the previous tax rules, investment trusts were liable to corporation tax on any interest income that they receive. This has not changed, but optional tax rules were introduced that allow an investment trust that invests in interest bearing assets to receive a tax deduction for any interest distributions made. This will effectively remove any corporation tax liability that would otherwise arise on distributed interest type income.

Where an interest distribution is made by an investment trust it will be treated in the hands of the shareholder as if it was a payment of yearly interest.

Further details can be found in BN27 available on HMRC website.

Pensioners entitled to age allowance should be aware that dividend or income payments from Unit Trusts / OEICS / Investment Trusts to calculate will be taken into account to check whether the income limit is exceeded. 5% withdrawals from Investment Bonds are not taken into account when calculating age allowance income limits, but any chargeable events resulting from Investment Bonds are assessed against the limits.

Capital Gains Tax

From the above products, only Unit Trusts / OEICS / Investment Trusts are liable to a Capital Gains Tax charge in the hands of individuals.

 

From the 2008/9 tax-year, a major overhaul of the Capital Gains Tax regime came into effect. Instead of the complicated system of indexation and taper-relief (depending on when you purchased the asset), there is a single flat rate of 18% on all Capital Gains, irrespective of the length of time that you owned the asset.

The aim is to simplify the previously complicated regime, and whilst on the whole this is largely a good thing, there will be winners and losers. This depends upon factors such your current highest marginal tax rate and the length of time you have held assets (i.e. whether you have taken advantage of taper relief, or trade assets on a regular basis).

The main changes involved:

  • The withdrawal of taper relief (there is no retrospective exemption for assets held before 6 April 2008)
  • The withdrawal of indexation allowance (this only affects assets that were acquired before 6 April 1998)
  • The removal of the ‘kink test’ (this rule stipulated that assets held on 31 March 1982 were valued for CGT purposes at their market value as of that date.)
  • Streamlining of the share identification rules. From 6 April 2008 all shares of the same class in the same company will be treated as forming one single asset (known as a ‘share pool’), regardless of when they were originally purchased or acquired.

However, the same day rules and “bed and breakfasting” rules remain unchanged, and shares will be identified under those rules before they are identified with shares in the share pool.

The Annual Exemption remains in place. The first £10,600 of an individual’s net gains realised during the tax year is free of CGT. (For Trustees, the Annual Exemption is £5,300 ). Any gains above this amount will face the flat rate CGT charge of 18%.

However, from 23 June 2010, instead of one flat rate, there is now two band of Capital Gains Tax charged at basic and higher rates (or three if you take into account the rate charged to trustees and representatives of deceased persons).

Instead of the old system of charging at the highest marginal rate of income tax and using taper relief, we know have the following bands:

  • A flat rate of 18% for any chargeable gains that fall within the basic rate band of income tax.
  • A flat rate of 28% for any chargeable gains that fall within the higher rate band of income tax.
  • A flat rate of 28% for any chargeable gains realised by trustees and representatives of deceased persons.

For most basic rate taxpayers who make small gains (such as by selling shares), the basic rate will most likely apply. However, things get more complicated if large gains are realised, i.e. by the sale of a second home. This is due to a quirk in the tax rules that state that income and total capital gains are added together to determine the relevant tax rate. This could drag a basic rate taxpayer into the higher rate bracket.

If a large gain is realised by a basic rate taxpayer, the total gain is added to taxable income. The portion of the gain that falls below the higher rate tax threshold will be taxed at 18%, while the portion of the gain that falls above the higher rate tax threshold will be taxed at 28%. Effectively this has the effect of top-slicing the gain, and the effective rate of CGT will be in the range of 18% – 28%.