What are investment wrappers? - a guide to investment tax structures in the UK
Friday 9th July, 2021
What is meant by an investment tax wrapper?
Financial advisers are often accused of using obscure industry jargon, when talking to clients. I know that I am sometimes guilty of this and I think any professional tends to unintentionally fall into the phrases that they feel most comfortable with, when trying to explain something which may be quite complex. For the adviser, this may be fine, but for the client it can be incredibly frustrating and confusing.
One of the phrases most often bandied about by financial advisers is the term “tax wrapper”. When I look at it objectively, it is a very confusing phrase. It sounds like something you should get if HMRC suddenly started their own clothing line!
However, it is a remarkably important phrase and it is crucial that investors understand it, as it goes right to the heart of how an individual makes their portfolio as tax efficient as possible.
In the article below, I will explain what a tax wrapper actually is, highlight some of the more common tax vehicles and explain some of their most important features. This can be quite a complex area, so please don’t hesitate to give us a call if you have any questions. We are always happy to help.
Tax will always impact the level of return that you get from your investments and, as our focus is to get the highest return possible, then taking advantage of tax efficient investment wrappers is crucial. These can affect both the speed of the investment growth while the funds remain invested, as well as the tax efficiency of any returns withdrawn.
This involves structuring your investment portfolio to take advantage of any tax allowances you are entitled to. To be honest, this kind of structuring is where a financial adviser can really bring value. However, there is nothing stopping you from structuring your portfolio very efficiently yourself. It just involves firstly knowing what tax efficient options are available, and then implementing them properly.
There are a number of tools that can be used to structure a portfolio and create tax efficiency. I will highlight these below and also cover off some of their basic features.
What is a tax wrapper?
Many investment articles make regular references to tax wrappers. It is very important to distinguish between investments (unit trust, shares, corporate bonds, property) and the tax wrapper in which they are held.
A tax wrapper is simply a vehicle that can be wrapped around a portfolio of assets and determines how the gains/returns generated by the assets will be treated for tax purposes.
The most common types of tax wrappers are:
- Offshore/onshore investment bonds (not to be confused with corporate/government bonds, which are an asset held within a tax wrapper, but are not a tax wrappers in their own right)
Unit trusts, shares, corporate bonds etc. held outside these wrappers are called unwrapped and are subject to the standard tax treatment for that asset class. However, if you hold a share inside an ISA, for example, the tax treatment of the returns changes completely, as they become tax free.
Similarly, you can hold a number of different asset classes and investment types (shares, unit trusts and OEICs etc) within an Offshore Investment Bond. In this case, the taxation of returns is deferred until withdrawn from the wrapper itself. At this point the gains are uniformly subject to Income Tax, regardless of the asset class that generated the returns to begin with.
Once again, holding the investments within the Offshore Investment Bond changes the way the investment returns are treated for tax purposes.
Unit Trusts/OEICs, Investment Trusts and Shares
These are the work horses of the average investment portfolio. They are able to be held within pensions, offshore bonds and ISAs, however they can also be held outside of a wrapper, where they are subject to Capital Gains Tax on gains, as well as tax on dividends and interest distributions.
Investors are often put off by the acronym OEIC. OEIC simply stands for Open Ended Investment Company. An OEIC is a mutual fund, just like a Unit Trust, but is set up with a company structure rather than a trust. Rather that units, you buys shares. Apart from that, there are few differences between a Unit Trust and OEIC.
In the UK the most common and well-known tax wrappers are probably Individual Savings Accounts (ISA), which allow the investor to hold either cash or stocks and shares without having to pay tax on any capital gains or dividends/income generated. Any income or gains withdrawn from the ISA are similarly free from tax.
At the moment the annual allowance for ISAs is £20,000 per person. This means that between a married couple, they could put £40,000 per annum into this massively tax efficient environment.
In addition to the above ISA allowance for adults, children are also entitled to a Junior ISA allowance which is currently £9,000 per year.
There are also some more niche ISA types, which allow investors to take advantage of other less common investment options, or are structured to help the investor to save for a property purchase or retirement and benefit from certain government bonus schemes.
- Innovative Finance ISA – This allows the investor to take advantage of peer-to-peer lending. By utilising a peer-to-peer lending platform, the investor is able to lend money to an individual or company in return for an agreed interest rate. The interest rate available to the investor is normally far higher than that from a cash account, but there is always the risk that the borrower will default.
- Help to buy ISA – The focus of this ISA was to help first time buyers save for a property purchase. This allowed the saver to save £3,400 in the first year and then£2,400 per year thereafter. The government will boost savings with a 25% top-up. These savings vehicles closed to new savers on 30 November 2019.
- Lifetime ISA - Once again, the focus of this ISA is either saving for a property purchase or for retirement. It can hold either cash or investments. The investor can save up to £4,000 per year into it. The government will add a bonus of 25% to the ISA contributions. Only those aged between 18-39 can open a Lifetime ISA.
I am often asked by people whether they are better off holding cash or investments within their ISA. As always, it really does depend on what you are trying to achieve with the funds being held, but as a general rule I recommend using your ISA to hold an investment portfolio that has the potential to generate sizeable returns, rather than using the ISA to protect your cash savings from tax.
One of the reasons for this is that most people are very unlikely to have to pay tax on their cash savings. This is due to the fact that most of us have a Personal Savings Allowance (PSA) of £1,000 against which to offset tax on our cash deposits (This reduces to £500 for higher rate tax payers and £0 for additional rate taxpayers). Helen Saxon from MoneySavingExpert points out (Personal Savings Allowance. Earn up to £1,000 savings interest tax-free) that at today’s terrible bank savings rates you would need over £200,000 in the top easy-access savings accounts to generate a return that exceeds your PSA and causes a tax liability.
This differs substantially from investment portfolios, where the returns can be anywhere from 1% to 40% of the portfolio value in a positive year, depending on the nature of the portfolio and the risk being taken.
Pensions allow you to build up funds in a tax efficient environment, while also allowing you to claim tax relief on contributions.
In addition to this, you are allowed to withdraw 25% of the value of the pension (capped in line with the lifetime allowance) tax free. The remaining funds will be taxed as income when withdrawn.
As if this were not enough tax efficiency, the pension funds do not form part of your estate for Inheritance Tax purposes and you can leave your pension to any person you wish. This means that you can pass any residual pension to selected beneficiaries upon your death, free from Inheritance Tax.
There are a wide variety of different pensions available. Most workers have a pension via a workplace pension scheme. These tend to be a basic pension wrapper with very low costs and a very basic investment offering. The pension funds are normally invested into a default fund, which may be life-styled to control the asset allocation depending on the member’s selected retirement age. These workplace pensions are now structured to meet the requirements of Auto Enrolment.
There are also personal pensions, which are pensions you set up yourself separate from any workplace pension and employer involvement. These can range from incredibly basic and low-cost Stakeholder pensions which have a limited investment range and retirement options, all the way through to Self-Invested Personal Pensions, which have, as a general rule, the broadest investment offering and can hold a wide range of funds, shares, corporate bonds and even commercial property. Due to their greater facility and fund offering, SIPPs naturally tend to be more expensive, however, this is not always the case. Most SIPPs charge a fixed administration charge, as opposed to a percentage of the assets under management and can therefore be considerably more cost effective, especially for larger pension funds.
There are pensions which are adviser led, which require a financial adviser in order to utilise them and then there are other pensions which are designed to be run by the pension member themselves.
As you can see, there is a pension out there to meet pretty much every investor’s goals. It is often worth chatting to somebody in order to make sure that you select the right one for you.
Offshore and Onshore Investment Bonds
Offshore Investment Bonds allow for deferral of tax on the gains. There is little or no tax paid on any gains achieved while the funds remain invested within the bond. The investor is therefore able to benefit from gross roll up, which means they get growth on money they would have otherwise paid out in taxes if the offshore bond were taxed on an arising basis.
The benefit of this tax deferred capability is that it gives the investor control over when to realise a tax liability. This means that a higher rate tax payer can effectively put off creating a taxable event on the bond until such a point as they are a basic rate or non-tax payer and thus substantially reduce their tax liability.
However, when a 'chargeable event' does occur, the whole gain being withdrawn will be taxed in that tax year. This could result in more of the gain being taxed at higher rates than if it had been taxed on an arising basis. The government has therefore made top slicing relief available to try and address this, by allowing a deduction from the amount of tax due, in certain circumstances.
Investment Bonds also allow the investor to withdraw up to 5% of their original capital per year, tax deferred, and it is treated as a return of capital. This means that the withdrawal is not subject to tax and does not have to be declared on a tax return.
Lastly, the Offshore Bond is divided into a number of segments of equal value. The investor is able to assign the whole bond or individual segments away to any person they wish, without the assignment being treated as a disposal for tax purposes. The assignee becomes the owner of the assigned segments and any gains will be taxed against the position of the assignee, as if they had owned the assigned portion from the outset. This creates all sorts of avenues for Inheritance Tax planning, as well as options for mitigating the tax on gains by assigning the bond to a spouse or partner in a less punishing tax bracket.
An Onshore Investment Bond has similar benefits, but gains are subject to UK life fund taxation within the bond, thus offering less opportunity for gross roll up. Tax is deemed to have been paid at basic rate within the bond.
Enterprise Investment Schemes (EIS)
EIS is designed to encourage private investment into new and rapidly growing British companies, by offering attractive tax reliefs. The investment is made into start up companies with a high potential for growth, but also a high possibility of failure. The investor can invest in an EIS which offers access to a diversified portfolio of EIS qualifying start-ups or they can take a higher conviction route and invest it all in one company.
The tax reliefs made available by the government for these schemes reduce the downside risk and make these investments far more attractive to investors. These can be particularly attractive to high earners, who no longer can claim significant tax relief via pensions due to the Taper Allowance. As a general rule, investment in EIS is limited to £1m per tax year.
No matter what the tax benefits on offer, it is important not to lose sight of the fact that these are very volatile and risky investments. Once the investment is made, it is not possible to simply sell out, and the investor is tied in until there is an exit (successful or otherwise) from the EIS. It is also not unusual for the value of these investments to fall suddenly to nothing, if the company invested in goes bust.
In addition to the risky nature of these investments, there are also high initial charges and often performance fees applied, which can create a drag on the investment performance.
The benefits are as follows:
- 30% income tax relief – your income tax bill can be reduced by 30% of the amount invested into EIS. This relief can be applied to the tax year in which you purchase the shares, or carried back to the previous year.
- Tax-free gains – gains on EIS investments are not subject to Capital Gains Tax (CGT).
- CGT deferral – if you owe tax on another gain, for example from the sale of a share portfolio or investment property, you can defer the payment of CGT by investing the value of the gain into EIS-qualifying companies.
- Loss Relief – if your EIS investments underperform, you can offset any losses against other income or gains.
- Inheritance Tax relief – if held for two years, and still held at the investor’s death, EIS investments may be exempt from Inheritance Tax.
Venture Capital Trusts (VCTs)
VCTs are very similar to EISs in that they offer exposure to small companies and start-ups with high levels of growth potential. In order to encourage investors to invest in these vehicles, they offer a number of tax benefits. The VCTs themselves are publicly listed on the London Stock Exchange and can, theoretically be traded. In reality, the market for VCTs is pretty illiquid and it is difficult to find buyers.
Similar to EISs, the underlying companies are small and volatile with great potential for returns, but an equally high potential for failing. The VCT tends to be more diversified than an EIS, with investments spread across far more companies.
As mentioned above, these vehicles can be traded on the open market, but there is not much liquidity. As a result, the VCT providers generally offer a share buyback scheme, where they agree to purchase the shares back from the investor at a discount to Net Asset Value. The discount is normally 5% - 10%.
As with an EIS, the set-up costs for a VCT can be pretty chunky. Before you baulk at the costs, it is important to note that this is a niche product and the companies being invested in need to meet certain requirements to qualify for the reliefs. A lot of work and research goes into choosing and maintaining the underlying investments, hence the higher initial costs.
The benefits are as follows:
- Income Tax credit - 30% Income Tax credit on investments of up to £200,000 each year when you buy shares in a new VCT share offer – but you need to have paid at least as much tax as the rebate and must hold the shares for at least five years
- Tax-free dividends - There is no Income Tax to pay on dividends from VCT shares
- No Capital Gains Tax - You won’t be liable to Capital Gains Tax when you sell your VCT shares
As you can see, there are a number of different tax wrappers available, each offering a variety of tax benefits and functionality. In order to make the most of these options, it takes careful planning to ensure that the investment vehicles chosen are suitable for what you are trying to achieve.
By using these wrappers correctly, you can save substantial amounts of tax. However, it is crucial when setting the investments up, that you don’t just consider the near term, but also consider what your exit strategy is. Without a good exit strategy, all the benefits can be lost.
It is therefore incredibly important that you consult a financial adviser who can help you put together a plan that weaves these options together in a manner that best suits your goals and ambitions.
If you would like to discuss any of these options further, please don’t hesitate to give us a call.