Topic 10 - Taxation Implications of Investment Products

Question 1

What are the two ways of trading derivatives and how do they differ?

Answer 1

Derivative Type - Over the Counter

Happen between dealers via phone or electonrically Private negotiations for individual trade without use of trading. Some types are swaps, forwardsand customised options. Not restricted in transaction size as is with exchange.

Derivative Type - Exchange Traded

Standardised in quality and quantity through exchange that acts as guarantor and mitigation of counterparty risk. Examples are futures and standardised optionsn.

Question 2

What are forwards?

What is the difference between forward and future contracts?

Answer 2

Future is contract for future delivery of share, commodity, currency etc.

Holders obliged to buy

Can be exchange traded for over the counter ones are called ‘forward contracts’.

Question 3

How are Futures and Forwards Taxed?

When is tax exempt?

When are they taxed differently and how?

Answer 3

Normally generate gains subject to CGT for individuals or corporation tax for companies. Also losses.

Gains on futures for Gilts or qualifying corporate bonds exempt. Losses not allowable. Also exempt is Spread Betting, a sub product of Forwards.

Following cases dealt with as income:

• Not within Part 7 CTA09 legislation for derivative contracs.
• Futures and Options in schemes that give guaranteed return
• If Futures or Options used to hedge interest rates orother risks as company would. Then can be classed as trading profits and treated as income.

Question 4

What is an option?

How are they taxed?

Are there any exemptions?

When can the tax treatment be different?

How does the share identification rules work with relation to Options?

Answer 4

Option is contract giving owner right but not obligation to buyor sell asset at strike price on or before date.

Normally subject to CGT on disposal but exempt if contract for gilt edged securities or qualifying corporate bonds.

Can sometimes be treated as trader of options and so subject to income tax.

Bed and Breakfasting Rules

Options subject to share identification rules which match recently sold options to new purchases on the same day or 30 days within selling. If after 30 days then could still be subject to Section 104 Holding which matches shares of the same type and same company.

Question 5

What are the different types of options?

If an option expires and not exercised, what is the tax position?

Answer 5

Put Option - Bearish. Gives owner option and right to sell and owner obligation to buy.

Call Option - Bullish. Gives owner option and right to buy and owner obligation to sell.

American Option - Can be exercised at anytime during term. At or before maturity date so can take advantage of price movements during term.

European Option - Only exercised at maturity.

If expired then treated as disposal for owner of option and gain of asset holder who would benefit from premium paid.

Question 6

What are warrants?

How are they taxed?

Answer 6

Can subscribe for asset at specific price. Similar to option but when exercised a new asset is created whereas a call option is for existing assets.

Exemption is for covered equity warrant - where third party hold substantial shareholding.

Again CGT applicable and treated as shares are. No income generated so not income tax.

Majority of warrants are settled in cash so no shares exchange hands and so no stamp duty to pay. If they are exchanged then stamp duty charged at 0.5%.

Question 7

What are CFDs and Swaps?

How are they taxed?

Answer 7

CFD and Swaps are agreements two exchange difference between opening and closing price of contract.

Derivative that allows trading of market without actually owning asset. Can profit from long or short positions.

Deposit for contract needed, often around 10%

Retail CFDs are futures so charged under CGT rules

If regular and main source of income then can be considered trade and treated under income tax.

If long position on shares then may be entitled to recieve amount equivalent to dividend payable on shares

Commission can be used as cost to offset tax

Question 8

What is spread betting?

How is it taxed?

Answer 8

Spread betting is not derivatives but can simply gamble on future direction of prices.

A similar deposit is needed like CFDs

As no assets purchased or disposed of no CGT or CGT losses allowable.

Question 9

How are hedge funds taxed?

Answer 9

Most hedge funds offshore so can take advantage of tax treatment and can avoid some UK regulatory requirements requirements.

UK Hedge Funds

Taxed as collective.

Notional 10% tax credit on dividends abolished in 6 April 2016. And new dividend allownace introduced.

Non equity fund - At least 60% of fund in cash, bonds and debt and pays interest not dividneds then 20% tax charged up front and higher/additional rate taxpayers pay the extra.

Gains made in the fund are chargeable to CGT for the investor on encashment.

Offshore Hedge Fund

Same tax as offshore collectives so either reporting or non reporting.

Even if in tax haven, dividends it recieves subject to witholding tax that is non-reclaimable. Normally issue if assets are higher yielding. If in fixed interest securities, income normally tax free

Question 10

What is a reporting fund?

What information has to be sent to HMRC when applying for reporting status?

What are the advantages of reporting funds?

Answer 10

Reporting Fund

Fund manager decides whether to apply for reporting status by applying to HMRC within 3 months of first day of accounting period. Must state whether:

• If fund intend to prepare accounts in line with international accounting standards. If not what practice they will adopt.
• statement of the first accounting period.
• Copy of fund prospectus
• Undertaking to comply with requirements to provide info to investors and HMRC

Most UK resident and domiciled prefer reporting funds. Advantage being dividends and interest treated same way as UK based fund and UK CGT rules so can use CGT allowance and CGT is lower rates than income.

Question 11

What is a non reporting fund?

How are they taxed?

Why are they sometimes used instead of reporting funds?

Answer 11

Non Reporting Funds: a.k.a roll-up fund

All income accumulated and no interest/dividends paid. On sale CGT allowance can’t be used.

On disposal all gains taxed as income at marginal rate.

May use this path to shelter income in knowledge that on sale their tax rate will have dropped or no longer UK resident. If not resident then gains free of UK tax

Question 12

What are Absolute Return Hedge Funds?

How are they taxed?

Answer 12

A.K.A - Non-directional fund

Designed to generate steady return regardless of bull or bear market and uses derivatives to limit volatility. More suitable for conservative investor wanting low risk.

Taxed same as other hedge funds

Question 13

What are structured products?

What are the main types of Structured Products?

Answer 13

Intruments with varying term, pay-out and risk profiles.

Track performance of underlying assets.

Each product is bespoke to issuer. No standards. But following are categories:

Structured Deposits - Fixed term deposits but return is not interest rate but linked to underlying asset such as FTSE 100. Protection from FSCS.

Structured Capital-Protected Products - Similar to deposits as designed to return original investment at maturity. Typically in loan form. Do not benefit from FSCS protection.

Structured Capital At Risk Products - Potential for returns and losses. Often take form of loan and do not benefit from FSCS protection.

Question 14

Structured Products - Auo Call / Kick Out

Answer 14

Auto Call Facility or Kick Out normally with structured products with fixed term. Can be ended early and pays out specific amounts on det dates. Owner can bank returns early but as set term it can mean it matures before the plan recovers a loss.

Question 15

How are structured products taxed?

Answer 15

• Unless held in ISA normally taxable.
• Most subject to CGT at maturity which is beneficial at CGT rates lower than Income tax rates.
• Some income plans may be taxable as income and distributed net of basic rate so further liability could apply
• Cash settled on LSE so no stamp duty tax payable

Question 16

How are With Profits - Insurance Based Funds taxed?

Answer 16

Onshore Fund

• Pays corporation tax on income and gains
• Treated as basic rate tax paid by policyholder
• Cannot be claimed back if non tax payer

Offshore Fund

• Not subject to UK Taxes
• Host country may apply withholding tax
• UK Tax Resident only taxed on chargeable event

Question 17

How are policy holders of Qualifying With Profits Insurance Policies taxed?

Answer 17

Qualifying Policies

Tax already paid in the fund. No additional tax for policyholder as long as it’s qualifying.

Policies issued after 5 April 2013 restricted to premiums of £3,600 annually and limit is for all policies owned. Also applies to beneficiaries.

Question 18

How are policyholders of Onshore Non-Qualifying With Profits Insurance Based Funds Taxed?

Answer 18

Onshore Non Qualifying

• Can withdraw 5% of original capital each year
• Unused allowance can be carried forward
• Tax as income if:
  
  • Chargeable event - Death, maturity, surrender, assignment, or excess withdrawals over 5% or 100%.
  • Chargeable gain has arisen. Tax deferred 5% withdrawals added back in to calculate if there is a gain or not.
  • The gain when added to investors other income takes them into higher tax brackets. Can use top slicing in these instances.

Worked example: Exces Withdrawals Onshore bond

Samuel invested £20,000 into a life assurance bond on 6 May 2012. Samuel made no withdrawals until 28 April 2018 when he needed to withdraw £8,000. At this time the bond was worth £24,000 and Samuel was a higher-rate taxpayer.

Without segmentation – or equally across all segments

5% annual allowance

£1,000

6 years allowance available: £1,000 x 6

£6,000

Amount of withdrawal

£8,000

Tax deferred allowance

(£6,000)

Excess over allowance

£2,000

The excess over the allowance is a chargeable event resulting in a chargeable gain so Samuel would be liable for tax of £400 being £2,000 x 20%.

After the withdrawal his bond is worth £16,000 (£24,000 − £8,000).

With segmentation

20 initial segments of

£1,000

5% annual allowance from each segment

£50

Each segment now worth

£1,200 (£24,000/20)

If Samuel fully encashes six segments he will have 6 x £1,200 = £7,200 of the £8,000 that he needs. The remaining £800 can be taken from the remaining 14 segments – six have been fully encashed and no longer exist. £800/14 = £57.14 from each segment.

On each segment, Samuel has six years of annual 5% tax-deferred allowance available: £50 x 6 = £300. As the amount he requires from each segment (£57.14) is within this amount, there is no chargeable event. So the £800 taken from the remaining 14 segments has no immediate liability for tax.

The six segments that were fully encashed are chargeable events, with the chargeable gain on each segment being the difference in the segments’ value now from the initial investment.

As each segment has grown by £200 the chargeable gain is £200 x 6 = £1,200.

Samuel is therefore liable for tax of £240 (£1,200 x 20%).

By having a segmented bond, Samuel has saved £160 in tax on his withdrawal and his bond will now continue with 14 segments. It will still be worth £16,000, but each segment will now be worth £1,142.85.

Question 19

How are policyholders of Offshore Non-Qualifying With Profits Insurance Based Funds Taxed?

Answer 19

Offshore Non Qualifying Policies

• No tax deducted in fund so benefits from grolss roll up.
• On chargeable event, full gain added to policyholders income and tax at relevent rate.
• Qualify for the personal savings allowance
• Quirk of system means withdrawing any excess can be done through encashing whole segments or partial surrender of segments or a combination fo both. Each method has very different results from a taxation point of view.

Worked example: Excess withdrawal Offshore Bond

Just under four years ago, Anita invested £200,000 in an investment bond, which is based offshore and is split into 100 segments. She is an additional-rate taxpayer.

The bond is now valued at £250,000 and she needs to withdraw £100,000, with no previous withdrawals having been made.

Two methods can be used to achieve this with differing tax treatment.

Method 1 – partial surrender across all segments

An equal amount of £1,000 is withdrawn from each of the 100 segments. Anita can make use of the 5% withdrawal facility with this. She has four years available (£200,000 x 5% x 4) for £40,000 in total. Any amount taken over this is a chargeable excess, so this would result in a chargeable gain of £600 per segment, or £60,000 in total. As this is an offshore bond, the whole excess is subject to Anita’s marginal rate of 45%, meaning a tax charge of £27,000.

Therefore, it is possible that a chargeable event could occur, resulting in a tax charge, even when a bond is showing a loss. Care should be taken to choose the most appropriate method for the client.

Method 2 – encashing whole segments

Where whole segments are encashed, there has been an overall gain on those segments. Any gain on those segments will be subject to income tax. Anita needs to cash in 40 segments to acquire the £100,000 with a gain of £500 on each of those segments, so an overall gain of £20,000, which would lead to a tax charge of £9,000. This method will reduce the amount that can be taken in future years via the 5% capital withdrawal facility because only 60 segments would remain.

If the bond had been showing a loss and whole segments were encashed, there would be no resulting tax charge, which is very different to Method 1.

Combining Both Methods

A combination of the above methods can often produce the lowest immediate income tax charge.

The lump sum payment can be made up of the encashment of a number of whole segments followed by a partial surrender across the remaining segments using the available 5% a year allowance for those segments.

The taxation for each of the stages will be as described in the relevant sections in this topic.

Using the same example of a £100,000 investment split into 100 segments, with a current value of £125,000 and withdrawing £20,000 in year three, the required amount could be made up by encashing five full segments (5 x £1,250 = £6,250) plus £13,750 by way of a partial encashment from the remaining 95 segments.

This would be within the revised 5% allowance (£95,000 x 5% x 3 = £14,250).

The total immediate chargeable gain using this method would be £250 x 5 = £1,250.

This is a brief summary of how the different methods of withdrawing a lump sum from an investment bond can produce very different results from a tax point of view.

Question 20

How are income and capital gains taxed within with profits pension funds?

What options do planholders have when taking benefis and how are they taxed?

Answer 20

Income and capital gains of most pension scheme investments in the with-profits fund will be tax exempt.

On taking benefits, the planholder can:

• Take 25% tax free PCLS and remainder as drawdown or annuity taxed as earned income
• Take whole as lump sum with 25% tax free and remainder at planholders marginal rate.
• Take lump sums with 25% of each withdrawal tax free and balance taxed as income.