Investors review onshore stance as 50% rate looms

Investors are being advised to get out of onshore investment bonds in advance of tax changes that will make these investment vehicles less attractive.

This migration, which has seen renewed interest in unit trusts and open-ended investment companies (Oeics) instead, is being recommended by financial advisers, on the grounds that the case for investing in onshore investment bonds has become less persuasive.

From next year, Britons earning £150,000 or more face paying income tax of 50 per cent on yearly gains from investments held within such bonds. By contrast, unit trusts and Oeics will still attract only 18 per cent capital gains (CGT) tax when funds are withdrawn.

Tim Cockerill, head of research at Rowan, the advisory company, says: “It’s a simple case of why pay tax at a rate of 40 per cent this year or 50 per cent in 2010, when the alternative is to pay 18 per cent.”

Danny Cox, an adviser with Hargreaves Lansdown, is even more damning: “My view is that onshore bonds have no appeal at all.”

It is estimated that as much as £4bn is invested by Britons in onshore and offshore investment bonds, following years of overselling by independent financial advisers (IFAs), who have long had the incentive of commissions of 5-8 per cent.

Investors normally make a lump sum payment into these bonds, which are issued by a range of insurance and investment companies, including Prudential, Scottish Widows and Standard Life.

The most popular type has traditionally been the with-profits bond. Slumping equity markets had prompted a resurgence of interest in these vehicles, in spite of poor returns and a recent wave of announcements about cuts to bonuses and final payouts.

Adrian Shandley, managing director of Premier Wealth Management, is sceptical of their renewed appeal. “The uptick in with-profits buying is a short-term fad,” he says.

While the guaranteed death benefit they offer is attractive, extra charges known as market value adjusters (MVAs) can be tacked on upon encashment, while transfer penalties could erode as much as 10 to 20 per cent of their value.

The tax advantages of with-profits bonds and other onshore bonds are also limited. Investors who have used up their allowances for capital gains tax (CGT) can benefit from the products. But for those unlikely to use their full £10,100 CGT allowance for the 2009-2010 year, the benefits are less obvious.

And, while annual withdrawals of 5 per cent of original capital with no immediate liability to higher rate tax are permitted for 20 years, the liability is deferred rather than avoided, making this facility useful for some, but not all, income seekers. “For basic rate taxpayers who use the regular withdrawal facility, bonds could still be attractive, but if the investors’ CGT allowance isn’t being used, the unit trust is still probably better,” argues Rowan’s Cockerill.

However, he admits: “A unit trust cannot be set up with a regular withdrawal facility and the logistics of cashing in units on a regular basis are enough to put anyone off.”

A second disadvantage of onshore bonds is the possible loss of the age allowance benefit for those aged 65 or over. The allowance is dropped when income rises above £22,900 and cashing in a bond can trigger a reduction as any gains are added to income.

“For this reason, many pensioners planning on cashing in, prefer to buy into investments that draw CGT,” explains Shandley. “But if you want a guaranteed death benefit to pass on money to your heirs, with-profits bonds are still appealing.”

Onshore bonds incur tax at 20 per cent within the fund. For basic rate taxpayers, there is no further tax on any realised gains, but higher rate taxpayers pay a further 20 per cent, which will rise to 30 per cent next year. Management fees of between 1 and 2 per cent for onshore funds are also high compared with unit trusts.

In a minority of cases, investment bonds can be useful. The reinvestment of dividends within them is exempt from tax, for example, whereas investors in the highest tax bracket earning income from unit trusts must pay an additional 25 per cent tax on dividends. Also, investors can switch in and out of the underlying funds held within bonds without drawing a tax charge, whereas those with money in unit trusts could face CGT for taking similar action.

Bonds are also popular for inheritance tax (IHT) planning. They are often used to put money into “discounted gift trusts”. These provide a partial, immediate exemption from IHT, with the rest of the sum gaining that status after seven years under potentially exempt transfer rules. Investors in these bonds can continue to take an income from their money, as well.

“Investment bonds are particularly attractive for trustees’ investments because they roll up and don’t generate any taxable income or gains,” says Lee Smythe, director of financial planning with Killik & Co, the advisory company.

The attractions of offshore bonds, issued by investment companies based in the UK, also remains robust as they allow the wealthy to defer their tax liabilities to when they may move into a lower tax band – for example, after retirement. Offshore bonds typically invest in a larger number of funds than those based onshore while the average minimum investment is also larger.

The appeal of these bonds is that they fall under the favourable tax rules governing life insurance. As with onshore bonds, investors can withdraw up to 5 per cent of value from the bonds each year without an immediate tax liability. Bondholders can defer tax until they are cashed – useful if they retire and no longer pay higher rate income tax or if they emigrate to a country with lower taxes.