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Bonds V Unit Trusts

There are many occasions where comparisons are sought between the taxation of unit trusts and the taxation of bonds as advisers try to determine the best route for a client’s investment.

Although the taxation issues are an important part of any decision there will always be other aspects of a client’s circumstances which may alter the process to decide which type of investment is most suitable. With that in mind, we have put together the summary comparison table below that shows, at a high level, the tax implications for individuals holding bonds and unit trusts.

This is not comprehensive and should be used only as guidance. This table assumes a basic understanding of the products and taxation issues. Other articles are available on the Knowledge Direct website which discuss the taxation of bonds and unit trusts individually and in greater detail.

Scenario

Unit trust

Bond

General taxation

Income: Subject to income tax at the client’s highest marginal rate. If a non-tax payer they may be able to reclaim tax deducted from interest received.

Capital Gains Tax (CGT): Will apply to gains over the appropriate personal allowance at 18% for non and basic rate and 28% for higher and additional rate tax payers.

Gains on Investment Bonds are generally subject to Chargeable Event Rules and are chargeable to income tax.

Onshore bond: Corporation tax is suffered by the Life Office on the underlying investments within the bond. Any chargeable gains receive a credit for the tax that has been suffered. This meets the liability for a basic rate or non-tax payer.  This tax is not reclaimable under any circumstances.

Higher rate and additional tax may be applicable (with a 20% credit).

Offshore bonds: No life company taxation suffered therefore there will be a liability to basic rate tax as well as higher and additional rate where appropriate.

Basic rate tax payer - no income and fund growth

Income: Where no income is generated no declaration required. 

Where income is received, even if reinvested, there should be no further tax to pay if investor remains a basic rate tax payer.  . 
Tax deducted from interest received may be reclaimable if non-tax payer.

CGT: Fund growth and disposal or fund switching will cause a capital gains tax calculation.

Using the CGT individual exemption should mean that there is no further tax to pay.

No taxation on fund growth until asset disposed of.

Onshore bond: Underlying bond assets taxed under life company taxation.

Offshore bond: No life company taxation suffered therefore basic rate tax liability arises on chargeable event. A higher rate tax may be payable if gain moves tax payer into higher or additional rate tax.

Switches and rebalancing within either bond are not subject to any form of taxation applicable to the client.

Higher or Additional rate taxpayer - no income and fund growth

Income: Where no income is generated no declaration required.

Where income is received, even if reinvested, the investor will have further tax to pay at 20% or 25% for income and 32.5% or 37.5% for dividends.

CGT: Fund growth and disposal or fund switching will cause a capital gains tax calculation. Using the CGT individual exemption may mean that there is no further tax to pay.

No taxation on fund growth until asset disposed of.

Any gains or income will have to be accounted for by self-assessment each year.

Onshore bond: Underlying bond assets taxed under life company taxation.  
No further tax liability until the client wishes to disinvest.

Offshore bond: No life company taxation suffered therefore a full higher or additional rate tax liability arises on the whole gain.

Top slicing may be applicable if the gain moves a higher rate tax payer from higher into additional rate tax.

Basic rate taxpayer - wanting natural income*
* If a specified amount of income is wanted this is generally done by unit encashment and will be classed as a disposal for CGT purposes.

Depending on the client’s other streams of income it is unlikely to affect the client’s tax status and no further actions need to be taken or tax return made.

Withdrawing natural income is not a disposal for CGT purposes.

Income will fluctuate with performance of investments and so not certain.

If further income is required this can be achieved by unit disposal and will count towards CGT limits.

Bonds do not produce true income. Client can take up to 5% of the original investment each year (up to a maximum of 100% as a cumulative total) as a tax deferred allowance. This amount is cumulative and so if not fully used each year the balance can be carried over.

As deferred tax, there is no tax liability to consider each year except where the withdrawals exceed the available allowance which will result in a chargeable gain.
Upon final surrender of one or more policies a chargeable event calculation will be required to determine whether a tax liability will arise.

Higher or additional rate taxpayer  - wanting natural income*
* if a specified amount of income is wanted this is generally done by unit encashment and will be classed as a disposal for CGT purposes.

Any natural income produced will be assessable for income tax and must be recorded and reported by self-assessment.

Withdrawing natural income is not a disposal for CGT purposes.

Income will fluctuate with performance of investments and so not certain.

If further income is required this can be achieved by unit disposal and will count towards CGT limits.

Bonds do not produce true income. Client can take up to 5% of the original investment each year (up to a maximum of 100% cumulative total) as a tax deferred allowance. This amount is cumulative so if not fully used each year the balance can be carried over.

As deferred tax, there is no tax liability to consider each year except where the withdrawals exceed the available allowance which will result in a chargeable gain.
Upon final surrender of one or more policies a chargeable event calculation will be required to determine whether a tax liability will arise.

Basic rate taxpayer – gifting the asset

Any gifting of the asset will be deemed to be a disposal for CGT purposes. 
Gifts between spouses/civil partners are made on a no gain/no loss basis and the recipient is deemed to have acquired the asset at its original cost for CGT purposes.

Fund switches can be made to utilise any CGT allowances on an annual basis.

In cases where CGT is applicable it will be based at 18% assuming the client remains within the basic rate tax band.

Gifting will also create a Potentially Exempt Transfer (PET) or a Chargeable Lifetime Transfer (CLT) for inheritance tax purposes.

The act of gifting by assignment will not in itself create a chargeable event calculation whereas an assignment for “money or monies worth” would.

After gifting, any subsequent chargeable event will fall on the recipient of the gift as the new owner.

Top slicing relief may be applicable

Gifting will also create a Potentially Exempt Transfer (PET) or a Chargeable Lifetime Transfer (CLT) for inheritance tax purposes.

Higher or additional rate taxpayer  – gifting the asset

Any gifting of the asset will be deemed a disposal for CGT purposes.

Gifts between spouses/civil partners are made on a no gain/no loss basis and the recipient is deemed to have acquired the asset at its original cost for CGT purposes.

In cases where CGT is applicable it will be based at 28%.

Gifting will also create a Potentially Exempt Transfer (PET) or a Chargeable Lifetime Transfer (CLT) for inheritance tax purposes.

The act of gifting by assignment will not in itself create a chargeable event calculation whereas an assignment for “money or monies worth” would.

After gifting, any subsequent chargeable event will fall on the recipient of the gift as the new owner.

Top Slicing Relief may be applicable.

Gifting will also create a Potentially Exempt Transfer (PET) or a Chargeable Lifetime Transfer (CLT) for inheritance tax purposes.

Basic rate taxpayer – on death

CGT is not applicable on death as the asset will form part of the client’s estate for IHT.

The units held will be rebased at date of death for CGT purposes which effectively wipes out any previous gains.

If executors sell the units at a later date any gain made between the point of death and the sale will be generally taxed at the executor’s rate (equivalent to basic rate).

If investments are passed on to a beneficiary of the estate this is not a disposal and the beneficiary will acquire the funds at the value at date of death of the client.

A bond is not automatically encashed upon death of the bond owner but rather on the death of the last life assured on the bond.

The value of the bond will form part of the deceased bond owner’s estate for IHT purposes but there will be no chargeable event calculation if additional lives assured remain on the bond.

If the bond is encashed by the executors (i.e. the deceased owner was not the life assured) then a chargeable event will occur.

Onshore bond: There is no tax liability on the executors on encashment but there may be tax implications for the ultimate beneficiary/ies.

The bond could be assigned to beneficiaries before encashment. The beneficiary/ies would inherit the bond history fully and be able to use the full term of the bond and investment amount(s) for any future chargeable event calculations.

Top slicing relief may be applicable.

Higher or additional rate taxpayer  – on death

CGT is not applicable on death as the asset will form part of the client’s estate for IHT.

The units held will be rebased on date of death for CGT purposes which effectively wipes out any previous gains.

If executors sell the units at a later date any gain made between the point of death and the sale will be generally taxed at the executor’s rate (equivalent to basic rate).

If investments are passed on to a beneficiary of the estate this is not a disposal and the beneficiary will acquire the funds at the value at date of death of the client.

A bond is not automatically encashed upon death of the bond owner but rather on the death of the last life assured on the bond.

The value of the bond will form part of the deceased bond owner’s estate for IHT purposes but there will be no chargeable event calculation if additional lives assured remain on the bond.

If the bond is encashed by the executors (i.e. the deceased owner was not the life assured) then a chargeable event will occur.

Onshore bond: There is no tax liability on the executors on encashment but there may be tax implications for the ultimate beneficiary/ies.

The bond could be assigned to beneficiaries before encashment.  The beneficiary/ies would inherit the bond history fully and be able to use the full term of the bond and investment amount(s) for any future chargeable event calculations.

Top slicing relief may be applicable.



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