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Investment bonds and entrepreneurs relief on retained profits?

Investment | Life Helpful? 3

Asked by Redwinebox20499, submitted 30 May 2011.

Open Quote As part of my retirement planning my advisor has recommended that I buy onshore bonds which do not attract either income tax or CGT if I only withdraw 5% each year and the 5% can be rolled over if I do not make any withdrawal during any year.

This seems to fit very well into my plans, although at this stage he has not identified who provides these bonds. Can you provide me with any information?

Do you have any comments regarding risk etc?

I also have a substantial sum of retained profit in my limited company. He has also suggested that it would be better to pay a one off 10% tax and close the company, than start a new company to continue trading until I retire. Obviously he is looking to release the funds for investment and this seems to be a realistic way of using this money since it is difficult to find a way of achieving a decent return on company surplus cash.

Do you have any comment on this stratergy?
End Quote

Answered by Justin on 31 May 2011

Onshore investment bonds are taxed internally at basic rate on both income and gains. This means the 5% withdrawals don't avoid tax, although any additional higher/top rate liability is deferred until the bond is eventually encashed.

As a result investment bonds are rather pointless for basic rate taxpayers - there's no income tax saving and gains will be automatically taxed at basic rate, whereas investments held outside of a bond could benefit from the annual capital gains tax allowance (£10,600 for 2011/12).

Higher rate taxpayers already using more valuable tax allowances such as capital gains, ISAs, pensions (and possibly NS&I Index-Linked Certificates) might consider investment bonds, but it's not a straightforward decision.

Firstly, much better to use an offshore investment bond than onshore, as there's no tax automatically deducted on income and gains. It's not tax-free, as I'll cover in a moment, but at least the investments can 'roll-up gross', i.e. grow without tax being deducted as go along.

The potential advantage of using an offshore bond is that you can withdraw up to 5% of your initial investment a year (rolled over if you don't use) without tax being deducted. When the bond is encahsed the 5% withdrawals are added to any overall gain to work out the total amount on which tax is due. You then pay tax on this at your marginal rate at that time (via a calculation called 'top-slicing' - more info on our life investments page).

Provided income tax rates don't rise in future then at worst you'll benefit from deferring the full tax due for as long as you own the bond. But assuming you're a non or basic rate taxpayer at the time you encash the bond you might avoid paying higher/top rate tax on some or all of the withdrawals/gain at that time.

However, if you end up paying (deferred) higher/top rate tax on the withdrawals/gains there's still a downside from using a bond - capital gains tax is currently charged at 28% on conventional investments for higher/top rate taxpayers, whereas you'd pay 40%/50% on gains within a bond (as they're taxed at income tax rates). I don't think the benefit from deferral compensates for the eventual higher tax bill.

Investment bonds are offered by insurance companies and generally allow a wide range of underlying investments to be held within (especially when offshore), so risk can vary from low to high depending the underlying investments you choose to hold.

Offshore investment bonds can sometimes be worthwhile but, as outlined above, it's not a straightforward decision. I'd be concerned that your adviser has recommended an onshore bond over an offshore (suggests a lack of knowledge). And bear in mind that investment bonds tend to pay high sales commissions (sometimes over 6% upfront) - one reason that some financial advisers seem to favour them over other investments.

The one-off 10% tax your adviser refers to is 'entrepreneurs relief' - a 10% capital gains tax rate on the first £5 million of qualifying gains if you sell part or all of your business.

Closing your company might allow you to benefit from this (i.e. pay 10% tax on the distribution of retained profits, rather than the usual dividend rates), although I'd first discuss the implications with your accountant. The main potential issue is that the company's assets must be used for trading purposes to qualify for entrepreneurs relief, retained profits built up over many years probably wouldn't cut the mustard. HMRC might also take a dim view if you subsequently set up a near identical business shortly after closing your current company.


Please note this answer does not constitute a recommendation or financial advice and should not be relied upon when making specific investment or other financial decisions. You should always undertake your own research into whether a product or service is appropriate for your needs and, if necessary, use a qualified professional adviser.

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Readers' Comments (1) - To post a comment please register or login .


Comment by rafferty at 10:21am on 01 Jun 2011:

Not forgetting the potential problem for those over 65 and therefore receiving the "age allowance" for which top-slicing doesn't apply - covered in the Life Investment article.

(I mention it because when I recently accompanied an older friend to see a financial adviser who wanted to sell her bonds which he claimed were 'tax-free', the adviser also claimed to be unaware of the age allowance problem. Which was a little surprising.)