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Investment Bonds

 
Investment Bonds are collective investments products with similarities to unit trusts and investment trusts, but with the major difference that these are written under Life Insurance legislation, and are in form (if not entirely in substance) life insurance policies.
 
The Life Insurance element of these products is generally minimal (usually 101% of the value of the investment), with the majority of the original investment applied to investment funds.
 
There are several types of investment bonds available:
 

With-Profits Bonds

 
The investment performance is linked to bonuses that are attached to the policy each year, with a terminal bonus that is applied upon maturity / encashment.
 
Policyholders funds are pooled together and invested by the fund manager into a variety of different asset classes (such as UK equities, international equities, goverment securities, commercial property, and Cash instruments) with the aim of managing the return whilst try to avoid any downside risks.
 
A reversionary (also known as annual or regular) bonus rate is declared by the insurance company's actuarial department usually on an annual basis and bonuses at this rate are added to participating policies on a daily basis. The bonus rate is based on an assessment of what the fund is expected to achieve after allowing for all expenses and the retention of some profit to build up the reserves of the fund. Once added the reversionary bonus can not be taken away although it should be appreciated that the reversionary bonus rate is not guaranteed and could be changed at any time. A 'Market Value Reduction' can be applied in periods of adverse market conditions to reduce the amount payable upon switches or surrenders (but not on death). Although this is often viewed as a 'penalty', the purpose is to prevent the value leaving the fund exceeding the value of the underlying assets.
 

Unit-Linked Funds

 
Premiums buy units in funds of the investors choice, in a similar fashion to buying units in a Unit Trust. The investment performance of the bond depends solely upon the funds to which it is linked. Most life offices have a range of unit-linked funds such as:
 
  • Cash Funds
  • Gilt / Fixed Interest Funds
  • Equity Funds (see Unit Trusts for a breakdown of equity sectors)
  • International Funds (invests in a variety of foreign investments)
  • Property Funds
  • Managed Funds (invests in a spread of equities, both UK and overseas, fixed interest stocks, property and cash / money market instruments. The objective is steady long-term gains through a spread of investments whilst avoiding undue risk)
  • Ethical Funds (some life offices offer funds that are screened on various criteria. They may be 'negative' - i.e. avoiding funds that invest in companies that manufacture arms, tobacco or alcohol, or be 'postive' - i.e. companies producing hydroelectric or wind power equipment, or those who run progressive employment / social policies)
 

Distribution Bonds

 
These bonds distinguish between capital (the premium you pay to purchase the bond) and income (the returns generated by the fund). These bonds pay out the accrued income of the fund as income, and the value of your investment will fall in line with the payout on each distribution date.
 
Because these bonds are geared towards providing income, they tend to be invested in a wide spread of assets, but with a big proportion in fixed interest securities to minimise risk.
 

Guaranteed / Protected Equity Bonds

 
There has been much publicity lately about 'precipice bonds' - bonds that guaranteed return of capital - but only if the market did not fall below a certain point at a certain date. And after 3 years of stock market falls between 2000 and 2003, many investments returned big losses.
 
However, the universe of Guaranteed / Protected funds is diverse, and the controversy surrounding some of these bonds does not mean that they are all 'tainted' in any sense. Bonds offered by insurance companies carry different guarantees at different times, so paying attention to the 'guarantee' or 'protection' is important.
 
Bonds can be given a blanket 'guarantee' (i.e. a fixed rate return is given at outset, similar to a National Savings Product), whilst others may link the return to an investment indice (such as the FTSE 100 or Dow Jones Index), and some bonds may quantify the guarantee if the index the bond is linked to falls below a certain point, whilst other bonds may guarantee 100% of capital irrespective of the index taking a nose-dive when the bond is due to mature.
 
If this sounds confusing, it is wise to remember that guarantees always involve costs. Generally, the better the guarantee, the lower the ultimate return compared to a non-guaranteed bond (assuming the bond was invested in equities during a time of good investment returns).
 

Onshore vs Offshore Bonds

 
Offshore Bonds are similar to on-shore Investment Bonds in that both are single premium life policies within which income and gains may be rolled-up. However, Offshore Bonds are usually based in tax havens (such as the Isle of Man, Jersey, Luxembourg) and therefore permit investment returns to be rolled-up without tax, whereas gains made and investment income received within on-shore Bonds are subject to tax. The tax treatment is also different when Bonds are encashed by UK residents, though in this case the Offshore Bond is subject a potentially higher tax charge.
 
Offshore Bonds may be suitable for investors who:
 
  • Will be non-taxpayers, or non-UK resident, when they come to encash their Bond.
  • Are UK resident but non-UK-domiciled, for tax purposes.
  • Are non-UK resident but UK domiciled for tax purposes.
  • Are higher rate taxpayers, including those who have utilised their Capital Gains Tax allowances.
  • Are investors wishing to switch investments without incurring Capital Gains Tax.
 
Some of the situations in which Offshore Bonds can be valuable are:
 
  • Retirement planning. Providing gross roll-up during the investor's working life and reduced taxation on encashment after retirement.
  • School fees planning. Investments can be made in trust on behalf of a child and encashed by the child on becoming a student.
  • Spouse to spouse. A higher rate taxpaying spouse might pass capital to the non-taxpaying spouse, who invests in an Offshore Bond which will enjoy gross roll-up and can be encashed without liability to tax.
  • Inheritance Tax planning. Unlike onshore Bonds, there is no need to for an insurable interest. Consequently Offshore Bonds can be written e.g. on the lives of children and grandchildren.
     
     
 

Tax treatment

 
Investment bonds are also known as non-qualifying policies, which give rise to no income or capital gains as such in the hands of the investor, and thus provide a means of rolling up investment returns. The insurance funds in which premiums are invested are subject to life company taxation (currently 20% on income and 22% on capital gains). The taxation of bonds differs from other investments in that since the bonds have already borne tax there is no personal liability, either to basic rate income tax or capital gains tax on any profit arising from the investment. However, a liability to higher rate tax may arise on partial withdrawals, or when the bond is ultimately realised for cash. Such liability is related to the 'chargeable gain' (see below). It is possible to withdraw from the bond 5% of the original investment each year (or cumulatively) for each of the first 20 years.
 
The allowance is treated as a return of capital and it is cumulative in that unused allowances can be carried forward for use in future years.
 
A chargeable gain is calculated as follows:
 
  • If partial withdrawals are made then the chargeable gain is determined at the end of the policy year when all withdrawals taken in the year are added together. The gain is the amount by which the withdrawals exceed the allowance available, i.e. 5% for the current year plus any unused allowance carried forward from previous years.
  • On final realisation adding the final cash value to the total of all previous withdrawals, and then deducting the initial investment and any previous chargeable gains determine the chargeable gain.
  • The resulting chargeable gain is then taxable as if it were an addition to the investor's income tax rate, but credited with basic rate income tax having already been paid.
  • Therefore only a higher rate taxpayer or a basic rate taxpayer, close to the higher rate threshold, would be liable.
  • 'Top Slicing' relief applies and can save tax when the addition of the chargeable gain to the investor's income takes the income across an income tax threshold into a higher rate tax band.
  • This gain is divided by the number of relevant years to produce an average yearly gain, which is treated as the top slice of income in the tax year in which the gain falls.
  • The tax payable (if any) on the top slice is calculated and multiplied by the relevant years to give the total income tax payable.
 

Investment bonds and trusts

 
Investment bonds are particularly suitable to the trustees of Discretionary Trusts and Accumulation and Maintenance Trusts. They permit tax and administrative savings during the life of the Trust, and enable Trustees to pass funds to the beneficiaries without suffering the consequences arising from the limited CGT holdover relief, now available to other investments.
 
If the creator of the Trust is a UK resident and alive when the trustees trigger a chargeable event, (or when death triggers the event) any gain is assessed on the creator. For this reason it would normally be appropriate for the bonds to be written on the life or lives of the beneficiaries, rather than that of the creator.
 
In circumstances where the beneficiary is subject to a lower rate of tax than the creator, it might be appropriate when eventually the beneficiary became entitled to receive the Trust capital for the trustees rather than en-cashing the bond themselves, to assign the policy to the beneficiary to en-cash.
 
Equally in order to avoid policy gains crystallising in the hands of the trustees upon the death of the settlor, it would normally be appropriate for the bond to be written on the life or lives of the beneficiaries rather than that of the settlor.
 
If the whole of the Trust Fund was invested in an Investment Bond, for the years in which there was no chargeable event, there should be no need to complete a trustees' self assessment income tax form, as the trustees would not be in receipt of any income and would not be triggering any charge to capital gains tax.
 
Where the Trust accumulates income, the trustees are generally liable to income tax at the rate of 34%, but an investment bond creates no income, as outlined above.
 
Following recent changes in dividend taxation, beneficiaries of Discretionary and Accumulation and Maintenance Trusts are penalised by the revised tax treatment of equity dividends, and effectively receive 20% less net dividend income than previously. Broadly speaking an investment bond avoids this effect.
 
 
NOTE: This document is intended to provide a brief overview of the subject. It should not be read as a recommendation to use any particular product, as it does not take into account individual circumstances and attitudes.
 
 
 

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