UK Taxation

Benjamin Franklin once said, “Our Constitution is in actual operation; everything appears to promise that it will last; but in this world nothing is certain but death and taxes”.  Whilst both death and tax are pertinent discussion points, this page will only discuss the latter!

Tax is a certainty and we pay it through many direct and indirect charges on the products we purchase and the income we earn.  We should therefore, in our opinion, pay much closer attention to those products that are more tax advantageous than others but with one caveat. Whilst it is important that the tax merits of each product should be understood, they should in no circumstance be the only factor when deciding ones investment path.  Below we highlight some of the more commonly used UK investment vehicles.

Please note that the following is intended for use only by those classified as UK resident for tax purposes.

 

Cash

Banks and building societies pay corporation tax on their profits but this does not directly affect the performance unlike the other products below.  It may, however, affect the interest rate applied to your savings.

Outside a Cash ISA, all interest is taxable unless you are a non-taxpayer, in which case, interest can be reclaimed or paid gross.   Interest is paid net of 20% tax so there is no further liability for a basic rate taxpayer.  A higher rate taxpayer must pay an additional 20%.

Pensions

Broadly speaking, pensions are the most tax efficient investment vehicle available to UK residents. Contributions are paid net with 20% added into the plan for basic rate and higher rate taxpayers and a further 20% reclaimable for higher rate taxpayers via self assessment.  In other words, a £1,000 gross contribution will cost £800 for a basic rate tax payer and just £600 for an individual on the higher rate.

The pension fund itself grows free of capital gains and income tax whilst internal switching of investments are also capital gains tax free.  The only taxes payable within a pension are the non-reclaimable 10% withholding tax on UK dividends and the varying levels of withholding taxes on foreign dividends when applicable.

When an individual comes to take an income either by way of unsecured income (formerly income drawdown) or through an annuity, any income received is taxable at the individual’s highest rate.

ISAs

Much like pensions, ISAs offer one of the most tax efficient ways for a UK resident to save but with the added advantage of vastly improved flexibility.  ISAs grow free of capital gains and income tax but, again, dividends are received net of the prevailing country's withholding tax. On non-dividend income received in an ISA, a tax reclaim is permitted where tax is deducted at source on UK Income. 

In the hands of the individual, any income from an ISA is tax-free as is any capital gain.  However, a capital loss within an ISA cannot be used to offset a gain elsewhere.

Unit Trust/OEIC

Unit trusts and OEICs do not offer any tax advantages in the same way as a pension or ISA wrapper.  However, the actual taxation of the vehicle is still very competitive when compared to other forms of investment within the UK.  Of course, many unit trusts and OEICs can be held within an ISA so the same tax applies here in that no further tax is due on UK dividends as they are received net of the 10% withholding tax and there is no internal capital gains tax when fund managers sell assets at a profit.

However, an individual selling or switching a mutual fund will crystallise their loss/gain and therefore create a chargeable event which could be subject to capital gains tax.  Each individual has his or her own capital gains tax allowance which can be used to reduce the gain.

Any income from a unit trust is also taxable.  A basic rate taxpayer will pay no further tax on dividends received from equity unit trusts nor any further tax on fixed interest income as long as the tax has been deducted at source.  Higher rate taxpayers will pay an additional 20% on the grossed-up fixed interest income and 22.5% on the grossed-up equity dividends.

 

Investment Trust

These are taxed in much the same way as a unit trust/OEIC with one key difference. A unit trust/OEIC will pay corporation tax on non-dividend income and grossed-up non-UK dividends at 20% whereas an Investment Trust will pay corporation tax of up to 30%.  UK dividends are received net of the 10% tax credit with nothing further to pay.

In the hands of the individual, any capital gains will be subject to tax if the gain exceeds the annual allowance.  Income will also be taxed with dividends attracting a maximum tax of 32.5% and interest 40% for a higher rate taxpayer.

Offshore Investment Bond

Offshore Investment Bonds are bonds that do not attract taxation at source under HMRC rules.  Likely places of deposit include the Isle of Man, the Channel Islands and Luxembourg.  The term ‘gross roll-up’ is commonly used to describe these bonds as the bond itself pays very little internal tax.  However, the common misconception is that the bond pays no tax, which is incorrect as dividends received into the bond are net of 10% on UK shares and net of the withholding tax from other foreign dividends.  Usually, however, there is neither capital gains tax on the sale of underlying assets nor any income tax on non-dividend income.

When money is remitted to the UK, tax is then applied.  There is no capital gains tax on gains made from an investment bond; it is charged under income tax instead.  Therefore, individuals are unable to use their annual capital gains tax allowance.  Basic rate taxpayers will pay 20% on any gain with those on the higher rate paying 40%. It is worth bearing in mind that internal switching of investments is free of income and capital gains tax.

Unsurprisingly, income tax is also charged on any income bought back into the UK too.  Unlimited income (return of capital) withdrawals are allowed up to the bond providers limit but these will be charged at 20% for a basic rate tax payer with a further 20% to pay for higher rate taxpayers.

Onshore Investment Bond

These are one of the least tax efficient investment products after the changes to capital gains tax in the 2008 budget.  However, they can be useful to higher rate tax payers requiring an income, those in the age-allowance trap and for inheritance tax and trust planning.

Much like all the products above, dividend income is received net of 10% from UK shares and net of the withholding tax from other foreign shares.  However, the bond manager actually pays 20% on the grossed up dividend from foreign shares with some credit given if a double taxation treaty is in place.  20% corporation tax is also payable on other income and gains on directly held assets.  Furthermore, capital gain tax is levied on the disposal of underlying assets but this can be reduced via indexation.

An individual will pay income tax on any capital gains at their marginal rate without the use of the annual allowance to reduce the gain. Those basic rate taxpayers close to the higher rate will have their gain top sliced to see whether any additional tax is payable. Any capital gain may affect the increased personal tax-free income allowance of those aged 65 and over.

Basic rate taxpayers can take an income (deemed to be return of capital) up to the bond provider’s limit with no immediate taxable liability.  This income (return of capital) does not affect the increased personal tax-free income allowance for those aged 65 and over.

Higher rate taxpayers can take an income (return of capital) of up to 5% per annum with no immediate tax liability. An income (return of capital) above this level will result in a chargeable event of 20% additional tax.

Summary

As we mentioned at the top of the page, the taxation of the investment vehicle should not be the overriding principle as to whether to invest or not.  However, it should be widely regarded as an extremely important factor when determining your investment strategy.  Careful consideration needs to be given to your overall circumstances and especially your risk profile and income-needs, to ascertain which product is best suited to you at this moment in your life cycle. 

Please contact us if you would like to discuss this further.


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