Taxation Of Bonds

Taxation Of Bonds
abrdn x Finimize

7 months ago16 mins

  • Investment bonds offer a wide choice of funds but have their own distinctive taxation treatment.

  • Deferment of tax and simpler administration for the investor can make these investments attractive to individuals looking for a tax-efficient 'income', or to pass on wealth.

  • The bondholder only pays income tax on bond income and gains when certain taxable events happen, known as chargeable events. This can give more control over who pays tax and when than holding the bond fund investments directly.

  • Bonds are often structured as a series of mini-policies ('segments') to give more control over the taxation of any gains.

  • Top-slicing relief can reduce the tax on gains where a gain takes an individual into the higher or additional tax bracket.

Investment bonds offer a wide choice of funds but have their own distinctive taxation treatment.

Deferment of tax and simpler administration for the investor can make these investments attractive to individuals looking for a tax-efficient 'income', or to pass on wealth.

The bondholder only pays income tax on bond income and gains when certain taxable events happen, known as chargeable events. This can give more control over who pays tax and when than holding the bond fund investments directly.

Bonds are often structured as a series of mini-policies ('segments') to give more control over the taxation of any gains.

Top-slicing relief can reduce the tax on gains where a gain takes an individual into the higher or additional tax bracket.

Who pays the tax?

The owner of the bond at the time of a taxable event (known as chargeable events) will usually be subject to income tax on any profits the bond investment has made.

The majority of investment bonds (excluding capital redemption bonds) are written on a life assurance basis. This means a small amount of life cover will be paid on the death of the life or lives assured, in addition to the investment value. The lives assured are not liable for tax on any bond gains unless they're also the owners. 

Special rules apply to trusts.

Calculating the gain

The main chargeable events that can result in a tax liability are:

  • taking more than the 5% tax deferred allowance (also known as an 'excess event')
  • fully cashing in segments or the whole bond (full surrender)
  • death of the last life assured
  • maturity of a capital redemption bond
  • assignment for consideration (money or money's worth)

The calculation of the taxable amount (also known as the 'chargeable gain') will depend on the event that triggers it.

Part surrenders

Up to 5% of the amount invested can be withdrawn each policy year without creating a chargeable event. This tax deferred allowance runs from the start date (or its anniversary) of the bond and any excess is determined on the last day of the policy year.

If the tax-deferred allowance is not fully withdrawn in the policy year, any unused amount can be carried forward for future use.

If more than this cumulative tax-deferred amount is withdrawn, the excess is taxable as a gain, regardless of any actual growth or loss within the bond's investments. Any taxable amounts are assessed in the tax year that the 'policy year' ends. This may be a different tax year from the one where the withdrawal took place.

Once the cumulative total of tax deferred withdrawals (i.e. those within the 5% allowance) is greater than the amount invested, all future withdrawals will be fully taxable. For someone, who has been taking 5% withdrawals from the outset this will mean withdrawals taken after 20 years will result in a chargeable gain.

If the bond is incremented the added funds will have their own 5% allowance in addition to the allowance available to the original funds. This additional allowance will run from the policy year (based on the original investment) which the increment was made. 

Large withdrawals across the bond in excess of the 5% allowance can result in gains that are not in line with the bond's investment performance. The bond owner can apply to HMRC to have the calculation of these gains adjusted where they're 'wholly disproportionate'. However, it will generally be preferable not to make large gains in this way.

Example

Peter invested £100,000 in a life assurance bond on 1 June 2018. In September 2022 a part surrender of £35,000 was taken across the bond, when his bond was worth £95,000. There were no other withdrawals.

The taxable amount was calculated on 31 May 2023 (the end of the 2022/23 policy year). Each year Peter could have taken £5,000 of his £100,000 investment. So an accumulated amount of £25,000 was available.

An excess gain of £10,000 was assessed in the 2023/24 tax year. This is despite the fact that, at the time of the withdrawal, Peter's bond was worth less than his initial investment and the withdrawal was actually made in the 2022/23 tax year.

Full surrenders

When a bond (or individual segments) is fully surrendered, any profit the investment has made (known as the 'chargeable gain') will be assessed to income tax. The calculation of the gain will sweep up any additional amounts invested, plus any amounts previously withdrawn across the plan (including a deduction for any previous gains).

The tax charge will be assessed in the tax year of surrender.

Example

George invested £100,000 in an investment bond on 1 June 2015. In September 2019, a part surrender across the plan of £35,000 was taken and this resulted in a gain of £10,000. There have been no other withdrawals. In May 2023, the whole policy was surrendered for £95,000.

The chargeable gain = proceeds + withdrawals - amount(s) invested - previous gains

= £95,000 + £35,000 - £100,000 - £10,000

= £20,000 taxable amount in the 2023/24 tax year.

Death

The chargeable gain is calculated in the same way as a full surrender, with the proceeds being the surrender value at the date of death, not the death benefit that's actually paid. This is assessed in the tax year of the death of the last life assured.

If the bondholder dies, but there are still surviving lives assured on the bond, this is not a chargeable event and the bond can continue. When the last life assured dies, the bond must come to an end, and any gains on the bond will be taxed at that point. This is often why other people are added as 'lives assured' so that the investor's heirs will have the choice of whether to cash in the bond on the investor's death or to continue to hold it.

There is no chargeable event on death for capital redemption bonds as there are no lives assured. If the bond owner dies, the bond continues, ownership passes to any surviving joint owner or the deceased's personal representatives (PRs). If the PRs take ownership they can choose to surrender or assign ownership to a beneficiary of the estate.

Maturity

A capital redemption bond has a guaranteed maturity value when the bonds ends, typically after a fixed term of 99 years. The chargeable gain is calculated in the same way as a full surrender with the proceeds being the higher of the bond cash-in value at the maturity date or the guaranteed maturity value.

Assignments

The most common example of assignment is a gift either between individuals, or from trustees to an adult beneficiary. This type of assignment is not a chargeable event. Generally, for income tax purposes, the new owner will be treated as if they have always owned the bond.

Assignments for money/money's worth are less common. These are chargeable events and there are specific rules around how the assignment is taxed and how the bond is taxed in the hands of the new owner.

Calculating the tax

Investment bonds are subject to income tax on any chargeable gains. There are some differences between how onshore and offshore bonds are taxed. This is because onshore bonds pay corporation tax on income and gains within the fund and offshore bonds enjoy gross roll up with no tax payable on income and gains within the funds.

Onshore bonds are taxed as the top part of income, so after dividend income. They benefit from a non-reclaimable 20% tax credit, reflecting the fact that the life company will have paid corporation tax on the funds.

This tax credit will satisfy the liability for non and basic rate taxpayers. Further tax is only payable if the gain when added to all other income in the tax year falls in the higher rate band and above.

Offshore bond gains are aggregated with all other savings income and taxed after earned income but before dividends. As there's no UK tax on income and gains within the bond, there's no credit available to the bond holder. Gains are taxed 20%, 40% or 45%. Gains will be tax free if they're covered by an available allowance:

  • personal allowance (2022/23 - £12,570)
  • starting rate for savings (£5,000)
  • personal savings allowance (£1,000 BRT or £500 HRT)

The 'personal savings allowance' is available for savings income including bond gains.

Top slicing relief

Individuals do not pay tax on their bond gains until a chargeable event occurs. This tax 'deferral' is one of the features that sets bonds aside from other investments.

However, when a chargeable event does occur, a gain will be taxed in the tax year of that event. This can lead to a larger proportion of tax being paid at higher rates than would have been paid if gains had been assessed on an annual basis.

Top slicing relief is a remedy for this. It only applies when the full gain takes an individual into the higher rate or additional rate bracket. There is no top slicing relief given to keep a gain within the personal allowance. The relief is an amount deducted from the final tax liability, and is based on the difference between the tax on the full gain and the 'average' gain (or 'sliced' gain). Both the gain and the relevant number of years to calculate the slice will be listed on the Chargeable Event Certificate.

Number of years

The number of years will depend on how the gain has been made. Where time apportionment relief is available, it's reduced by the number of complete years the individual has been non-resident.

Full surrender (and full surrender of individual segments)

Divide the chargeable gain by the number of complete years the bond has been in force, even if further premiums have been paid since the start of the bond.

Gains on death and full assignment for consideration also use the number of complete years.

Part surrender (in excess of the 5% allowance)

The period used for top slicing will depend upon when the bond was taken out and whether it's an onshore or offshore bond.

  • Offshore bonds established before 6 April 2013 will have a top slicing period dating back to the inception of the bond provided that they've not been incremented or assigned after that date.
  • All onshore bonds will have the top slicing period shortened if there have been any previous chargeable events as a result of taking more than the cumulative 5% allowance. This also now applies to offshore bonds which commenced (or were incremented or assigned) after 5 April 2013. The period used will be the number of full years between the current chargeable event and the previous one.

Gains on part assignment for consideration also follow these rules.

Top slice relief

Top slicing relief is a deduction from an individual's total income tax liability. This is how it will appear on calculations issued by HMRC and other accountancy software packages.

Changes were included in the Budget 2020 which affected the availability of the personal allowance in the top slicing relief calculation. HMRC have agreed by concession that these changes will apply to all gains from  2018/19 onwards. Those who submitted tax returns 2018/19 or  2019/20 on the old basis will receive a tax adjustment and refund if tax has already been paid.

Both the personal allowance and the personal savings allowance are based on total income plus the sliced gain when determining the 'relieved liability' (Step 2b below). The full gain continues to be used to determine the personal allowance and the personal savings allowance  both step 1 'total tax liability' and step 2a 'total liability'.

For gains which arose before 6 April 2018, HMRC's guidance is that the availability of the personal allowance will be based on adding the full bond gain to income in all stages of the bond gain calculation.

The personal savings allowance entitlement in all stages of the calculation is be based on total income including the full bond gain for gains arising before 2021/22.

In addition, it has been clarified that it is not possible to set income against allowances in the most beneficial way for the taxpayer when calculating the amount of top slicing relief which may be available. Bond gains have  always formed the highest part of income for this purpose.

The shorthand method

Most people are more familiar with the 'shorthand' method to gauge the impact of top slicing relief. This method calculates the amount of tax payable on the bond gain, rather the amount of relief, and gives the correct amount of tax in some circumstances.

The 'sliced' gain is added to income to determine if any higher rate tax may be payable.

  • Gains below the higher rate threshold will be taxed at basic rate. For onshore bonds no further tax will be due as any liability will be covered by the non-reclaimable 20% tax credit for tax paid within the fund. Offshore bonds will be subject to tax at 20% after deduction of any unused allowances.
  • If the sliced gain exceeds the higher rate threshold, higher or additional rate tax may be due. The excess above the threshold is taxed at 40%, or 45% on any part which exceeds £125,140 (£150,000 2022/23) and then multiplied by the number of policy years determine the tax on the bond gain.

However, this method does not work where:

  • there are offshore bond gains and dividend income in the same tax year
  • some of the top slice would fall within the personal allowance or savings rate band
  • there is unused personal savings allowance
  • the full gain when added to income results in the tapering of the personal allowance but the sliced gain plus income does not

In these circumstances it's necessary to complete the full HMRC method to ensure the correct amount of tax (and top slicing relief) is calculated.

Multiple gains

The sum of all chargeable gains is aggregated where there are multiple chargeable gains in the same tax year.

If the total gains plus the investor's other income exceeds the higher/additional rate tax threshold then top slicing may be used to reduce the exposure to higher/additional rate tax.

Pension and gift aid contributions

Pension contributions

The payment of a pension contribution can help to reduce or eliminate any tax due on a chargeable gain.

Paying a contribution to a personal pension (including SIPP) has the effect of extending the tax bands by the amount of the gross contribution. If the top sliced gain when added to income is below the extended higher (or additional) rate threshold, there may be no higher (or additional) rate tax to pay on the bond gain.

Example

In 2023/24 Gordon has taxable income (after the personal allowance has been deducted) of £40,200. This includes savings income of £500. He then makes an onshore bond gain of £40,000. He held the bond for 10 complete years.

Income tax on bond gain = £40,000 x 20% = £8,000.

Suppose Gordon pays a personal pension contribution of £5,200.

Gross contribution = £6,500Basic rate band = £44,200 (£37,700 + £6,500)Taxable income, including top sliced gain = £44,200 (£40,200 + £4,000)Tax on onshore bond gain = £0

Gordon has paid a net contribution of £5,200 (£6,500 Gross) into his pension to save tax of £8,000 on his bond gain. In addition, he benefits from a gross pension contribution of £6,500.

A contribution made to an occupational pension scheme which operates a net pay arrangement will have a similar effect because, although the contribution won't extend the basic rate tax band, the contribution will reduce the individual's taxable income.

Gift Aid

Gift Aid donations also have the effect of extending the tax bands by the amount of the gross payment. But unlike pension contributions, the extended basic rate band can't be used to calculate top slicing relief for an investment bond.

Example

In 2023/24 Gordon has taxable income (after the personal allowance has been deducted) of £40,200. This includes savings income of £500. He then makes an onshore bond gain of £50,000. He held the bond for 10 complete years.

This time Gordon pays £5,200 to a charity rather than a pension.

Charity reclaims tax @ 20%, so gross donation = £6,500Basic rate band = £44,200 (£37,700 + £6,500)Tax saved on other income = £500

Tax on bond gain = £9,200

No top slicing relief because the charitable donation hasn't extended the basic rate tax band for this purpose. So only £4,000 of the gain avoids higher rate tax.

Interaction with other allowances and charges

Income tax

The full gain rather than the reduced 'top slice' is always used when determining an individual's eligibility for:

  • the personal savings allowance
  • the income tax personal allowance
  • the high income child benefit charge
  • the married couple's allowance.

Capital gains tax

Bond gains are not normally subject to CGT but can have an impact on the rate of CGT applicable on the disposal of other assets. The rate of capital gains tax is based on the amount of an individual's taxable income. The top-sliced gain is added to other taxable income to determine whether any capital gain is taxed at the basic or higher rate.

Time spent abroad

Generally there's no UK tax to pay if a chargeable gain arises in a tax year in which the bond owner is non-UK resident. There may of course be tax to pay in the current country of residence.

Temporary non-residence

An anti-avoidance measure applies where an individual takes a gain from a bond when resident outside the UK for a short time. The gain will be taxed on return to the UK and will apply where an individual:

  • has been resident in the UK for a period of at least four of the last seven tax years, and
  • becomes resident again within five years of leaving.

Time apportionment relief

An investor who is UK resident when a chargeable gain arises but has been non-resident for part of the investment period can claim a reduction against the chargeable gain. This is known as 'time apportionment relief'.

This relief is available to all offshore bondholders and was extended to onshore bonds that start after 5 April 2013, or existing onshore bonds that are assigned or incremented after this date. The gain calculated can be reduced by the total number of days of non-UK residence as a proportion of the total number of days the investment bond has been held.

Example

Charles took out an offshore bond 10 years ago. He has spent exactly five years as a non-UK resident. This means the chargeable gain can be reduced by 50%.

The number of years used for top slicing relief will also be reduced. And if there's a 'loss' on the bond, the amount of any corresponding deficiency relief available will be reduced.

Relief from losses

There's no relief for losses incurred as a result of investment performance. It's not possible to offset a loss on one investment bond against a gain on another or to offset the loss against any other income.

However, there is a limited form of loss relief for investment bonds where there's a loss on full surrender as a consequence of an earlier part surrender.

Corresponding deficiency relief reduces income subject to higher rate tax (not additional or basic rate tax) and can be claimed by individuals (not trustees or companies) when:

  • there's a loss on the full surrender (or death of the life assured) of a life assurance bond, and
  • that same bond had gains in the past which happened when a partial surrender had been taken (across the whole plan and not by surrender of individual segments), and
  • the owner of the policy is a higher or additional rate taxpayer.

The amount of relief is capped at the lower of:

  • the amount of the previous excess gain(s) on the bond, and
  • the amount of the loss.

Reporting gains from investment bonds

Reporting gains from investment bonds
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