It’s a well know fact that as a nation, we are not saving enough. We save less now as a proportion of our income than we did when Gordon Brown became Chancellor in 1997.

Let’s have a look at the incentives and tax treatments available to motivate us to retain some of our hard earned cash.

Investing in shares

Shares pay dividends that are subject to tax at 10 per cent if you are a basic rate-taxpayer or 32.5 per cent if you are a higher-rate taxpayer. Shares are treated as having had 10 per cent tax taken off at source, so a £90 dividend is treated as a dividend of £100 from which tax of £10 has been deducted already. This means that basic-rate taxpayers have no further tax to pay.

On the other hand, a higher-rate taxpayer receiving £90 has a further £22.50 to pay (32.5 per cent less 10 per cent already paid). This is an effective tax rate of 25 per cent on the amount of the cash dividend.

The Chancellor changed the rules in the 1997 Budget, which meant that non-taxpayers could no longer recover the tax already collected on the dividends.
Investors in shares do not, of course, expect to make all their profit from the dividends. They also hope to sell their shares at a profit. We all have a capital gains exemption of £8,800 (tax year 2006/07) and the vast majority of investors are able to sell shares without paying CGT. This means that, at least in tax terms, shares are relatively attractive as an investment for basic-rate and higher-rate taxpayers.

Diversification can be achieved by spreading money through a collective investment such as an open-ended investment company (OEIC), unit trust or investment trust. For tax purposes they are treated exactly like shares in a company on the stock market, where you receive dividends and make a profit on the sale, taking advantage of your annual CGT exemption.

The main difference between them is that investment trusts are actually formed as limited companies and are usually able to borrow as a way of gearing up the fund performance. OEICs also issue shares but cannot borrow money. Unit trusts issue units rather than shares but are still treated as companies as far as unit-holders are concerned.

Insurance bonds

The term ‘bond’ can be used for a wide variety of different investment products, but for retail investors it is normally taken to mean a single-premium, non-qualifying life insurance policy known as an insurance bond. You pay a single lump sum and obtain a share of a managed fund.

The main advantage of an insurance bond is that each year you can withdraw up to 5 per cent of the original sum invested and treat it as a partial withdrawal of your original investment. No tax is paid at this stage. The profit on the insurance bond is ultimately caught for income tax, either when it is encashed or if you withdraw more than 5 per cent a year on a cumulative basis.

Onshore insurance bonds are effectively already taxed at 20 per cent on their profits, but a further 20 per cent can fall on a higher-rate taxpayer, subject to a facility called top-slicing relief.

Bonds can be very useful for people who are higher-rate taxpayers when they are working but basic-rate taxpayers in retirement. You can also arrange for bonds to be transferred between spouses and civil partners to take advantage of this top-slicing relief.

Offshore bonds

Offshore bonds are taxed on encashment and not on an ongoing basis. The charge is to income tax, rather than CGT. During the lifetime of the bond, growth on the assets rolls up virtually free of tax. Often referred to as the ‘gross roll-up’ effect, investments offshore grow free of year-on-year income tax and CGT charges, unlike comparable onshore investments.

Small amounts of non-reclaimable withholding tax may be payable on certain investment funds. If funds are retained offshore for long periods, returns can often be greater if tax is deducted on encashment, rather than on a yearly basis, as a result of the effect of gross roll-up.

Even for higher-rate taxpayers, offshore bonds can have certain tax advantages over directly held investments. Transactions within an offshore bond do not trigger a personal liability to CGT and can therefore provide a potentially more tax-efficient structure for active investment management than both directly held investments and bonds that are held onshore.

As with onshore bonds, there is the facility to defer income tax on withdrawals of up to 5 per cent of the original capital value, which provides a high degree of control over how much, and when, income tax is paid. Investors can choose when a tax charge may occur, for example when they encash some or their entire bond. A chargeable event is a transaction that would trigger a potential UK income tax charge on a bond.

These events include the death of the life assured, maturity, encashment or surrender of the policy, withdrawals in excess of the cumulative 5 per cent a year tax-deferred allowance and assignment for money or money's worth.

As offshore bonds are not income-producing assets, there is nothing for investors to report on their self-assessment form to HM Revenue & Customs unless a chargeable event occurs. This compares favourably with the more complicated requirements for reporting a portfolio of directly held investments.

The range of permitted investments within an offshore bond also includes any UK authorised unit trust, OEIC or quoted investment trust, plus a wide range of non-UK collective investment schemes.

Offshore funds

Like offshore bonds, offshore funds can be tax-efficient for non-domiciled individuals (foreign nationals) living in Britain, as those who do not bring the income from such investments into this country are not liable for UK tax.
Although UK domiciles living here must pay tax on their worldwide income, whether brought into Britain or not, if an investment generates no income there is no liability.

Since 1984, the law has distinguished offshore funds that distribute profits to investors via dividends from non-distributor funds. An investor who sells shares in a distributor fund is normally subject to CGT only. An investor in a non-distributor fund has to pay income tax on his profit, although he or she retains the choice of when a sale is made, and thus when an income tax charge is triggered.
The basic rule is that a distributor fund is one that pays out currently at least 85 per cent of its income as dividends to investors, but there are many sub-rules that help determine whether a fund passes this test.

Distributor status denotes that the fund is obliged to distribute its income. When distributed, the income is subject to income tax, while gains from currency movements are subject to capital gains tax when the gains are realised – when the fund, or part of it, is sold. Non-distributor funds roll up interest along with currency gains. The return on such funds is subject to income tax when the fund, or part of it, is sold.

To discuss your options, please e-mail or contact us for further information.

The value of units can go down as well as up. Past performance is no guarantee of future returns. Levels and bases of, and reliefs from, taxation are subject to change.

Article date: March 2007