Common questions we receive are often about Investment Bonds and Tax. Are Investment Bonds taxed under Capital Gains Tax? What is a chargeable event gain and how is it calculated? How do notional tax credits work? How do Investment Bonds held in Trusts work? Does Inheritance Tax apply?
We delve into Inheritance Bonds and Tax…
What is a bond?
A ‘bond’ is a generic term that describes an investment arrangement where money is placed with a third party, with a legal guarantee to repay it at a maturity date in the future.
Corporate bonds are debts issued by companies to raise funds. These bonds usually carry the right to interest paid periodically and can be tradeable commodities. Qualifying Corporate Bonds (QCBs) are exempt from Capital Gains Tax when sold. Corporate bonds are not discussed in this guide.
Investment Bonds are an investment vehicle or ‘wrapper’ offered by a Life Assurance company. The investment could be for a fixed term, for example, 15 years or have no fixed maturity date.
It is now common for Investment Bonds to be segmented. Instead of £100,000 being used to purchase a single policy, it is used to purchase 100 identical policies of £1,000. This can offer protection against unexpected tax charges when it comes to withdrawing funds from an Investment Bond.
Investment Bonds are subject to their own special rules when it comes to tax. Although they are investments, they are not taxed under the Capital Gains Tax (CGT) regime. Instead, ‘chargeable events’ are subject to Income Tax as income gains.
Up to 5% of the initial amount invested can be withdrawn annually with no tax consequences.
This 5% carries forward if it is unused, so for example an investor could withdraw 25% after five years. For the purposes of counting years, a part-year counts as a full year when looking at how much can be withdrawn tax-free.
The year in question is the policy year, running from the date the investment is made, not the tax year.
Notional tax credit
The funds underlying UK investment bonds suffer life fund tax on their income and gains and so any chargeable event gain is treated as having already been taxed at the basic rate. An investor who makes such a gain is therefore only required to pay additional tax if they are a higher or additional rate taxpayer.
The credit is notional only and is not repayable to the investor in any circumstances.
Offshore policies do not suffer the same life fund tax as UK policies. As a result, no notional tax is deemed to be paid on any chargeable event gains arising from an offshore policy. Investors will be required to pay basic, higher and additional rate tax on the income gains as appropriate, with no deduction for tax already paid.
Accrued Income Scheme
Investment bonds will typically pay interest at fixed times. As the date of the interest payment nears, the value of the bond increases as any prospective purchaser will be in receipt of an income payment soon after purchase. This accrued income can affect how the disposal of a bond is taxed.
- Accrued income on the sale will be added to a seller’s income.
- Accrued income included in the purchase price will be deducted from a buyer’s next interest payment received.
- No adjustment is required if the total nominal value of securities held is not more than £5,000 at any time in the current and previous tax year.
Occasions of charge are:
- Death of the owner of the investment bond.
- Assignment of the bond for money or money’s worth.
- Maturity or full surrender of the investment bond.
- Partial surrender in excess of the 5% allowances.
Amounts withdrawn each year (partial surrenders)
- Up to 5% of the initial investment can be withdrawn each year.
- If less than 5% is taken, the unused balance of the 5% allowance carries forward to the next year.
- If the amount withdrawn in the tax year exceeds 5% (including amounts brought forward), a chargeable event has occurred and a chargeable event certificate will be issued to the taxpayer. This will detail the Chargeable Event Gain (CEG) for Income Tax purposes.
Inheritance Tax (IHT)
- Single owner: The death of the owner of the policy who is the insured person brings an immediate end to the policy and so it is not included in the estate.
- Whether the funds released are charged to IHT or not depends on whether or not those funds are paid into the estate.
- If the policy is written into trust, for example, the funds do not become part of the estate and so there is no charge to IHT.
- Joint owners: If more than one life is assured or if there are multiple beneficial owners, the policy will continue after a single death. In this situation, the policy will become part of the estate on death.
- If the policy is jointly owned by husband and wife, paying out on the second death, then the transfer of the half interest on the first death is exempt under the normal spouse exemption rules.
- If the policy is jointly owned by unmarried individuals, the transfer would not be exempt and the half share of the surrender value immediately before death would be included in the estate, using up some of the nil rate band and potentially increasing an IHT bill.
- Multiple owners: Where there is a jointly owned policy with multiple lives insured, for example, a husband and wife as owners or assured parties and their three children also assured, the policy will commonly pay out on a ‘last survivor’ basis.
- On the death of the first spouse, the policy passes to the other by survivorship and is exempt as an intra-spouse transfer.
- On the death of the second spouse, the policy remains active and its value is included in their estate.
- If the bond is surrendered at that point, the estate will have a CEG taxable at the basic rate and so if it is a UK bond it would be covered by the notional tax credit.
- If instead the policy is passed to the three remaining assured individuals jointly, each of them would be treated as owning 1/3 of the value and would need to include a corresponding amount in their respective IHT accounts.
Where an investment bond is held in trust, any CEGs are taxable in the first instance on the settlor, and not the Trustees.
If the settlor cannot be taxed, for example, if they have died, then the Trustees become liable. They must report the CEG on the Trust Tax Return. Note that top-slicing relief is not applicable to policies held in trusts.
The CEG is always taxable at the trust rate of tax even if the trust is a pre-2006 interest in possession trust, and so where a life assurance bond investment has been made by Trustees, or an investment bond is settled into one, it will generally be more tax-efficient to assign the bond out to the beneficiaries before it is cashed in. The beneficiaries can then cash the policy out in their own name, pay tax at their marginal rate and claim top-slicing relief as appropriate.
Advantages of using a trust
If the beneficial owner of the bond is the trust and not the individual, the policy will pay out into the trust upon the death of the life assured.
This means that the beneficiaries of the estate can potentially access funds immediately as the money does not form part of the death estate and so does not require probate.