The Basics of Investment Bonds

This section will look at the basics of Investment Bonds. 

Investment bonds will simply be referred to as ‘bonds’ in these notes for the sake of brevity.  

However, they should not be confused with bonds which refer to fixed interest investments such as Corporate Bonds (issued by companies) or Gilts (issued by the UK Government).  

Banks and building societies also refer to some of their accounts as bond accounts and again they are not what we are dealing with here.

What are bonds?

The term ‘bond’ as being used in this section describes the general term for a range of investments that are more often known by the type of underlying fund or funds which they offer, e.g.

  • Distribution Bond,

  • With Profits Bond,

  • Property Bond,

  • Investment Bond

  • Capital Investment Bond.

Bonds are investments offered by life assurance companies and it is this that provides them with their unusual tax treatment.  The actual life assurance element will be very small, i.e. usually no more than 1% of the amount invested.

Technically they are ‘single premium whole of life’ policies.  In other words the ‘premium’ is the lump sum investment amount and the investment has no term, rather it can be continued for as long as you want.

Bonds are collective investments in which the investment monies of many individual investors are pooled. This pooling enables relatively small investors to benefit from the economies of scale made available to institutional fund managers.

Bonds enjoy the facility to switch between the underlying funds at no cost or low cost.  Although classed as single premium investments, ‘top up’ facilities are offered, allowing further amounts to be invested.

The Taxes Act 1988 specifies that single premium life assurance policies cannot be ‘qualifying’ policies.  It is not important for the purposes of these notes to go through what a ‘qualifying’ or ‘non-qualifying’ policy is. 

It is the result of the ‘non-qualifying’ designation given to bonds that determines their tax treatment.  The most recent legislation is contained in Chapter 9 of the Income Tax (Trading and Other Income) Act 2005.

The Finance Act 2016 reduced the rates of tax on capital gains for non-property investments and thereby made bonds less attractive when compared to unit trusts and OEICs (Open Ended Investment Companies).

Taxation of bonds

The explanations that follow refer to bonds issued by UK life assurance companies.  The taxation of an offshore bond is different in certain aspects and these will be highlighted later in these notes.

Taxation of the underlying funds – No matter what type of fund is used in a bond the tax treatment of the underlying fund is always the same.

The underlying fund suffers tax on investment income and capital gains.  These ‘policyholder funds’ are taxed separately from the corporation tax applied to the other profits of the company.

HMRC has agreed that as far as the bondholder is concerned, tax equivalent to the current basic rate of income tax in any year (20% for 2022/23) is deemed to have been deducted at source.

Fund switches

The bondholder can switch from one fund to another within a bond without a personal capital gains tax charge arising.

Most bonds available today offer a wide range of internal funds managed by the product provider’s own fund managers together with access, at higher cost, to funds managed by external investment houses.

Bonds that have been in force for many years often won’t allow switches because the investment was only into a with profits fund, distribution fund or property fund etc.

Switches are normally free of charge within a certain number of switches in any one policy year.

Tax treatment in bondholder’s hands

An important feature of the taxation of bonds is that the ‘chargeable gains’ under such products are taxed as income tax rather than capital gains tax.

We refer to ‘chargeable gains’ because not all gains made by a bond are chargeable to tax. 

As already noted HMRC has agreed that the tax suffered by the underlying fund on its investment income and capital gains is roughly equivalent to basic rate income tax. 

Basic-rate tax is therefore deemed to have already been deducted at source, and as such a basic-rate taxpayer will have no further liability to either income or capital gains tax. 

A higher-rate tax payer which in 2022/23 is someone with a taxable income in excess of £37,700, will have a further 20% income tax to pay on all chargeable gains (i.e. higher-rate tax of 40% less tax deemed paid of 20%).

An additional-rate taxpayer which in 2022/23 is someone with a taxable income in excess of £150,000, will have a further 25% income tax to pay on chargeable gains (i.e. additional-rate tax of 45% less tax deemed paid of 20%).

Taking an ‘income’ from a bond

The bondholder can arrange to receive automatic regular withdrawals of capital on a monthly, half-yearly or annual basis.  If these are within the level of growth that is being achieved on the bond, these regular withdrawals of capital will effectively provide ‘income’. 

The bondholder can amend the level of such withdrawals at any time, to suit current income needs irrespective of the actual growth of the bond.

The first 5% a year (as a percentage of the original investment plus any top-up investment) paid as regular withdrawals suffers no tax at that time.  However, the cumulative withdrawals up to 5% a year are deemed to be added back into the value of the bond when it is fully surrendered. 

If the bondholder is a higher-rate tax payer when the bond is fully surrendered, therefore, he or she will effectively pay a further 20% tax on the ‘income’ withdrawals that they have made over the years. 

Even a basic-rate tax payer might find themselves pushed into the higher-rate tax band when the bond is fully encashed and have to pay up to 20% tax on the ‘income’ withdrawals that they have made over the years.  Although the ability to use ‘top slicing’ (more later) reduces this likelihood.

Withdrawals in excess of the 5% cumulative annual allowance will suffer tax at the higher-rate tax band rate of 20% (40% -20%) or 25% (45% -20%) if the bondholder is a higher-rate tax payer at the time, or the withdrawal pushes them into that band.

The maximum cumulative allowance is 100%.  So 20 years of 5%, although any unused allowance can be carried forward beyond 20 years.

The benefits of ‘top-slicing’

Any chargeable gain on a bond will have arisen over a period of years.  In view of this, a measure of relief is allowed rather than simply attributing the whole chargeable gain as additional income in the year of full surrender.  The process is known as ‘top-slicing’.

Top-slicing requires calculation of the appropriate fraction, or ‘slice’ of the chargeable gain by dividing the chargeable gain by the number of complete policy years that the bond has been in force. 

This slice, rather than the whole of the chargeable gain is treated as the top part of the bondholder’s income for tax purposes, and the average rate of tax applicable to the slice (less the basic rate) is calculated. 

The tax rate (which may be zero if the slice did not push the bondholder into the higher-rate tax band) is then applied to the whole of the chargeable gain to determine the actual tax liability on the gain.

The result is that relief is given to the bondholder if the level of their other income would mean they pay tax at no more than the basic rate on the ‘top-sliced gain’, instead of the higher-rate of tax if the whole of the chargeable gain were to be added to their income.

Where the chargeable gain is caused by a partial surrender, top-slicing is determined by dividing the chargeable gain by the number of complete policy years since the last chargeable gain (i.e. over the cumulative 5% pa) caused by a partial surrender. 

Adding to an existing bond

An advantage of making an additional investment to an existing bond is that the number of years used in the top-slicing calculation is still the full number of complete years since the bond’s inception.

The timing of taxation

Bonds are usually segmented so that an investment of, say, £80,000 might actually be set up as 20 separate bonds of £4,000 each.  This gives greater flexibility in order to try and reduce or remove any tax liability.

The tax treatment on the full surrender of a bond can be favourable compared to the partial surrender of a bond.  If a partial surrender is required it might be better to surrender one or more segments.

Where the chargeable gain is as the result of the full surrender of the bond (or complete segments) the gain is treated as arising at the time of the surrender (i.e. in the current tax year).  That could be beneficial if the bondholder’s current year’s income is low for any reason.

Where the chargeable gain arises from a partial surrender, it is regarded as arising at the end of the policy year in which the surrender occurs.   There may be further partial surrenders during that policy year and it makes things tidy for HMRC to have them all regarded as happening on one date. 

The policy year in which a partial surrender is made might end in the next tax year and, if that is the case: 

  • If the next tax year is going to be a high earning year then it might be better to fully surrender segments of the bond and have them taxed in the current year, but

  • Where a higher-rate tax payer is expecting to be a basic-rate tax payer in the next tax year (e.g. due to retirement) it could be better to make a partial surrender.

Problem of a large part surrender

Where the cumulative 5% allowance is exceeded the resultant gain bears no correlation to the performance of the bond. Instead the gain is simply a comparison of the part surrender proceeds to the 5% allowance.

Peter invested £200,000 in a bond on 1 March 2020. He unexpectedly takes a part surrender of £150,000 in September 2021. The chargeable gain bears no relationship to the actual gain on the bond which was worth £215,000 at the date of the part surrender.

  £
Part surrender 150,000
Cumulative 5% allowance 20,000
Chargeable gain 130,000

Legislation introduced in November 2017 allows a person who has made a part surrender giving rise to a large gain to apply to HMRC to have the gain reviewed if they consider it is wholly disproportionate.

Applications must be made in writing and received within four years after the end of the tax year in which the gain arose. A longer period may be allowed if the HMRC officer agrees.

If the officer considers that the gain is disproportionate, then the gain must be recalculated on a just and reasonable basis.

Death of the life assured

The tax situation on the death of the life assured (not always the bondholder) depends on how the policy has been arranged.

  • Single life assured – If there is only one life assured then the chargeable gain at the date of death is calculated as if that person had fully surrendered their bond on that day.  The chargeable gain may be more than the surrender value because of previous withdrawals within the 5% allowance.  Obviously in this case there is no option of choosing a partial surrender to improve the tax situation.  The final value of the bond included in the calculation is the surrender value of the bond immediately before death rather than the lump sum benefit receivable as a result of death which would typically be up to 1% greater.

  • Joint life first death – If there are two lives assured, or indeed more than two lives assured where the contract terms allow, and the policy is set up on a ‘first death’ basis, then the tax situation is the same as for a single life assured i.e. the chargeable gain at the date of death is calculated as if that person had fully encashed their life assurance bond on that day. In the UK, the number of lives assured is often restricted to two individuals, which is adequate for most circumstances (including within trust arrangements) whereas up to ten lives can be accommodated using an offshore bond.  The need for insurable interest is not generally recognised outside the UK and is therefore not usually an issue when a UK resident effects an offshore bond.

  • Joint life second death – If there are two lives assured, or indeed more than two lives assured where the contract terms allow, and the policy is set up on a ‘second death’ or ‘last death’ basis, then there is no chargeable gain on the death of the first life assured.  The bond simply continues with a single (or multiple) life assured.  When the second (or last) life assured dies then the tax situation is the same as for a single life assured i.e. the chargeable gain at the date of death is calculated as if that person had fully encashed their life assurance bond on that day.

It is important to note that death does not relieve the deceased life assured’s estate of paying any income tax due by them to the date of death. 

The chargeable gain is ‘top-sliced’ as usual over the number of complete years that the bond has been in force and the ‘slice’ added to the deceased’s income in the tax year up to the date of death.

This is a disadvantage when compared to capital gains tax on an investment portfolio which is not recoverable from an estate on the investor’s death.

Security of the bond

As life assurance companies issue such bonds, there is usually no question of there being any difficulty in realising the investment.  However, where the underlying investment is in commercial property there may be additional restrictions on surrendering the investment.

Investors in UK authorised insurance companies are covered by the Financial Services Compensation Scheme (FSCS), which provides 90% compensation without limit in the event of the failure of the insurance company.


Links to more information

Important

This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.

Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.

If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.2/23