Life funds get a lot of bad press, particularly from fans of mutual funds, who tend to prefer the 'c...
Life funds get a lot of bad press, particularly from fans of mutual funds, who tend to prefer the 'cleaner' tax structure of authorised unit trusts and open-ended investment companies.
The reasons for this preference are valid but the arguments are not always straightforward. In certain cases life funds can prove very flexible and attractive from the tax point of view, particularly for long-term investors looking for retirement planning vehicles outside of their pension arrangements.
To help clarify the tax position we asked the consultant Watson Wyatt to analyse the treatment of the onshore and offshore versions of a typical UK equity life fund and unit trust. The analysis is complicated but it reveals that for most people it is better to invest in UK equities through an onshore rather than an offshore vehicle. Further, where clients do not use their full annual capital gains tax exemption (£7,200 in 2000-2001), they are usually better off using a unit trust or Oeic rather than a life fund.
However, for clients who are permanently higher rate taxpayers and who regularly use up their CGT exemption, then despite widely differing tax systems, the two routes to collective funds give surprisingly similar results. In this case it can make sense for certain taxpayers to exploit the tax anomalies still enjoyed by life funds - in particular the ability to defer CGT when switching between funds and the potential for special tax treatment of the gains at retirement.
The reasons for these differences in structure have little to do with logic and a great deal to do with history. Unit trusts, which were first launched in the 1930s, are comparatively straightforward. Here the CGT liability falls on the investor who can offset it against the annual exemption.
With a unit trust or Oeic, a potential CGT liability will arise every time the investor switches funds. This is true even where the Oeic has sub funds. The Revenue treats each sub fund as a separate company and so there is no deferment for switching between funds under the same umbrella Oeic.
Life policies are much more complicated than mutual funds largely because they date back to the late 18th century when capital gains tax was just a twinkle in the government's eye and your tax bill was based on the size of your periwig and the number of windows in your house. The proceeds of life assurance policies originally were tax free - until, that is, more recent governments realised that insurance companies were selling investment products under the guise of life cover. As life offices have proceeded to develop new products and markets, the Revenue has followed hot foot, closing loopholes in their wake. The resulting tax rules are piecemeal and confusing but can be exploited to good advantage.
Ownership of funds
The chief difference between the two structures lies in the ownership of the funds. When you invest in a life fund you are actually buying a policy of insurance. Unlike the unit trust, where the investors are the beneficial owners of the assets held in trust, the life fund is legally owned by the insurance company and it is the insurance company which is taxed in the first instance - at broadly the equivalent of the basic rate (currently 22%). The tax paid within the fund cannot be reclaimed by non-taxpayers, nor can it be offset against the CGT exemption. From the tax point of view, therefore, life funds are generally not considered suitable for non-taxpayers.
We say the tax is 'broadly' equivalent to the basic rate because in practice the rate paid by the insurance company will be influenced by the company's mix of investments, liabilities and expenses. The funds of some companies, therefore, suffer a lower rate of tax than others and this can affect the return. Unfortunately this information is not accessible to the average investor.
At the end of the investment term, higher rate taxpayers are subject to additional tax on the policy proceeds to reflect the difference between higher rate and the basic rate already paid by the fund. This is not classed as a capital gain so they cannot offset it against their CGT exemption.
However, it may be possible to reduce or avoid the higher rate bill due to the effect of 'top slicing relief'. This averages the profit over the number of years the policy has been held and adds the profit slice to the investor's income in the year the policy matures. If part or all of this falls into the higher rate bracket it would be taxed, but with careful planning many investors can avoid this liability by cashing in the policy when they become basic rate taxpayers - in retirement, for example.
There are other unique features of life funds which can be attractive to higher rate taxpayers - for example the ability under many policies to withdraw up to 5% of the original capital each year for up to 20 years. There is no tax charge at the time of withdrawal but higher rate tax is deferred until the investor cashes in the policy, where again top slicing relief may reduce or eliminate the liability. The 5% returns of capital do not have to be declared for income tax purposes in the year of withdrawal.
Life policies also offer a free or cheap switching facility between funds. These switches do not give rise to a CGT liability at the time as this is deferred until investors withdraw their funds. For the active investor this is a very attractive feature. Most life offices offer access to externally managed funds as well as their own internal range and these links often include leading unit trust funds. Skandia, for example, offers access to 250 unit trusts run by 20 different fund managers so clients can switch between their favourite managers - and defer their CGT bill until they choose to cash in the policy.
The impact of tax
Robert Hall, partner in the insurance practice at Watson Wyatt, says: "Each year, fewe
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