Taking account of capital gains tax in investment decision making beyond pensions and ISAs

Learning Objectives:

• Taking account of capital gains tax in investment decision making beyond pensions and ISAs
• To understand the current fundamentals of taxing investment income and capital gains.
• To apply that understanding in making effective and appropriate investment wrapper choice decisions.
• To understand when investment bonds could be a tax efficient investment choice.
• To know when and why it might be appropriate to consider “wrapper allocation” to diminish tax risk.

We’ll start with a statement of the obvious - the two key drivers of investment performance are income and capital growth.

Investment income can be taken (and probably spent or possibly given away – otherwise why would anyone take it?) or reinvested.  Either way it’s taxable.  And, for many investors, the amount lost to taxation has increased.  Why?  Well, if the income generated is dividend income, then the amount that can be taken tax free by virtue of the dividend allowance has reduced to £1,000 p.a. this tax year, from £2,000 p.a. in 2022/23.  And it drops again to £500 in the 2024/25 tax year.  And the rate of tax on the dividend, once the allowance has been exhausted, recently increased to 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers and 39.35% for additional rate taxpayers.  And, remember, the threshold above which the additional rate is payable dropped in 2023/24 to £125,140, while the higher rate threshold remained frozen at £50,270 and the threshold above which the basic rate is payable remains frozen at £12,570.  As a result, more and more investors are suffering higher taxes on their dividend income.

Tax due on a dividend (at whatever rate) is not taken from the dividend before it’s reinvested, so the tax still has to be paid by the investor.  If the income is taxed as interest (e.g. where the investment is a deposit, a fixed interest investment, or a collective investment where more than 60% of the fund is in fixed interest) then the tax will be at the appropriate tax rate of the investor once the personal savings allowance of £1,000 (for higher rate taxpayers) or £500 (for basic rate taxpayers) has been exhausted.  The personal savings allowance is not available to additional rate taxpayers.  There’s also the £5,000 0% starting rate band for savings income, but this will probably not be available to most investors as it’s cut back by £1 for every £1 of non-savings income (broadly pensions income, employment income, self-employed profits, rental profits, etc.) that exceeds the personal allowance.  So, essentially, it’s gone once the individual’s income reaches £17,570 p.a. of non-savings income.

So, how about capital gains?  Well, the headline rates are generally lower than those for income – 20% for higher and additional rate taxpayers (strictly, capital gains that fall above the basic rate ceiling when added to taxable income) and 10% for gains falling below that ceiling, i.e. below the threshold above which higher rate tax becomes payable.  Of course, there’s also the 28% rate for gains made on the disposal of residential property that is not the individual’s main residence.  And, on top of all of this, the annual capital gains tax (CGT) exemption has reduced from £12,300 p.a. in 2022/23 to £6,000 p.a. in 2023/24 (this tax year) and will fall again to £3,000 p.a. next tax year.  Big changes!

So, that’s where we are now.  What impact do those tax facts have on investment decision making?

If direct or collective investments are held “inside” a collective investment (e.g. in an OEIC or unit trust) then any capital gains made on disposal of the underlying investments by the “structure” would not give rise to any tax liability.  The individual investor would only be potentially liable to CGT on a disposal of the shares in the OEIC or units in the unit trust.  So, very useful and tax efficient (non-contentious) tax deferment.

All of this said, it’s fair to say that, while the fundamentals of investment wrapper decision making haven’t changed, the dramatic reduction of the dividend allowance and the CGT annual exemption have combined to make the so-called tax “no brainers” of ISAs and pensions even more attractive.

So, how about investment bonds?  Well, either an international (offshore) bond or a UK bond provides the investor with a robust shelter from personal CGT.

Those tax changes described here have effectively combined to lower the investable “threshold” above which investment bonds should be seriously considered for their tax deferment and tax management qualities.  This is especially so in relation to dividend income within the life fund (which will be tax free without limit at fund level regardless of the tax position of the insurance company or the policyholder/investor) but may be less so in relation to any capital gains realised by the insurance company in managing investments on behalf of the policyholder/investor.  So, what rate does the insurance company pay on capital gains realised within the life fund? 

Well, if the investments are held inside an international bond, the rate is zero.

If the gains are realised inside a UK life fund, then the rate of tax suffered inside the life fund is nominally 20% but is discounted because there is tax on annual deemed gains on collectives held inside a UK life fund, payable in equal instalments over seven years.  (Where there is an actual disposal inside a UK life fund, the chargeable gain or allowable loss is not spread.  The gain or loss is calculated with reference to the last deemed disposal.) 

But, for both the international and UK investment bond, it’s necessary to also factor in the potential tax payable on any extraction of money from the bond to ascertain the overall tax suffered. In this regard, top-slicing relief could be very important for bonds held over a number of years to avoid, or minimise, any charge to higher and/or additional rate tax. 

So, when comparing the tax effectiveness of holding investments to realise capital growth, all other things being equal (e.g. investments available to be invested in and charges) once the opportunities for tax freedom have been exhausted (e.g. through use of the reduced annual CGT exemption and through tax advantaged investments), it’s necessary to consider the taxation of capital gains at “underlying fund” and investor level in order to have a “true picture” with which to make a valid comparison.  And, for most investment funds, it’s essential to factor in the fund level taxation of investment income generated too.  That’s where an investment bond can really score.

So, as stated above, it’s fair to say that, while the fundamentals of investment wrapper decision making haven’t changed, the dramatic reduction of the dividend allowance and the annual CGT exemption have combined to lower the investment threshold above which investment bonds should be seriously considered for their tax deferment and tax management qualities.

For investing directly, then, it’s mainly only necessary to consider taxation at investor level.  Beyond this, though, (i.e. in considering investment through UK or international investment bonds), as indicated above, there are two tax layers to consider to arrive at an effective “overall rate” in making a comparison.

Essentially, to retain an “open” investment choice in an appropriate investment wrapper beyond pensions and ISAs we are looking at:

1.  Collective investments;
2. UK investment bonds;
3. International investment bonds.

Achieving an optimum post tax outcome will be determined by a number of factors both known and anticipated.  It’s the “anticipated” part that makes the principle of “wrapper allocation” worth considering – to accommodate the inevitable absence of certainty in relation to future taxation - personally (the investor’s tax position) and generally.  And, to do this properly, professional advice is absolutely essential.