We look in more detail at how fixed-income products are taxed.
Following on from last week's article about the new retail bond market, we thought some more detail on the tax aspects would be well received. So here goes.
The basics
As a starting point, I thought it would be useful to define what we are talking about, certainly which specific definitions are used for tax purposes.
Bonds are often also called debentures, and in simple terms, is a way in which companies can generate debt finance (as opposed to equity finance from shares). The loan stock or debenture is a type of security, rather than a share, and is, effectively, an IOU from a company to the bond holder, which normally pays a rate of interest (the coupon) at periodic intervals.
Gilts are government-backed securities, so called because such loan stock is so secure it is almost gold edged. Ahem. The most common forms of gilts are Treasury or Exchequer Stock, and the coupon rate can be fixed, or index-linked.
QCB stands for Qualifying Corporate Bond and the HMRC definition of a QCB is "As a general rule any non-convertible security denominated in sterling and issued on normal commercial terms will be a corporate bond".
This means that most standard UK company bonds and debentures will be QCBs, unless the company takes specific action to fall outside of the QCB legislation. In general, the most common reason for a bond not being a QCB is because there is scope for that bond to be converted to shares at some future point.
Income Tax and Capital Gains Tax
As previously mentioned, gilts and QCBs are specifically exempt from Capital Gains Tax, meaning any gain (or loss) on the trading of such securities will not be liable to CGT. However, by their very nature, the scope for large gains or losses is limited.
Interest payments made on loan stock (the coupon) is taxable as interest in the same way as any other type of interest, e.g. bank or building society interest. The coupon paid on gilts is normally paid gross (i.e. without deduction of tax at source), but they are still liable to tax at your normal marginal rates. If interest is paid net, basic rate tax at 20% will have been deducted, so there is no additional liability for basic rate taxpayers.
Accrued income
There is an additional income tax consideration, however. The accrued income scheme (AIS) was introduced in 1986 to combat 'bondwashing' which involved capitalising future interest payments due in order to create a larger (exempt) capital gain. By capitalising the interest this meant that lower amounts were liable to income tax.
The AIS applies to applies to interest-bearing marketable bonds and loan stock, including gilts, local authority bonds, permanent interest-bearing shares in a building society (PIBS), or company loan stock (debentures) and works by specifically identifying an element of consideration received or paid on a sale or purchase as accrued income and dealing with it separately.
There is a de minimus exemption from the AIS scheme for holders of relevant securities which have a total nominal value (not market value) not exceeding £5,000 at any time during the tax year in which the next interest payment is due, or the previous tax year. Watch out for holdings owned by children, as a result of a parental gift, as these holding will be amalgamated with the parent's. There are also specific other exclusions from charge for certain individuals or bodies, such as registered pension schemes or non-residents.
Where the purchaser is entitled to receive the next interest payment, the sale is described as 'cum div' and where the vendor will receive the next interest payment (as there is normally a time delay between taking details of who is entitled to receive interest and its actual payment), this is called an 'ex div' sale.
Sellers will be taxed on cum dividend sales but receive relief for ex dividend sales. Buyers are taxed on ex dividend purchases and receive relief on cum dividend purchases.
An example
The easiest way to illustrate how the scheme works is by way of an example:
On 31 March 2009 you sell £5,000 nominal value of 3.5% Treasury Stock 2013, which pays interest on 15 February and 15 August. The sale price is more than £5,000 and the contract note shows that £82 accrued interest has been added to the sale price. As the next payment of interest on the gilts you have sold is on 16 August 2009 (the tax year 2009/10) you will be taxed on an additional £82 of interest in 2009/10, not in 2008/09 which is when the sale took place.
On 10 April 2009 you buy £7,500 nominal value of 5% Treasury Stock 2015 which pays interest on 10 March and 10 September. Again, the contract price is more than the nominal value and the contract note shows that £45 accrued interest has been included in the total price you paid.
The next interest payment is on 10 September 2009 (the tax year 2009/10). The gilt generates an interest payment of £187.50 on 10 September, so you will get tax relief on the accrued income suffered by reducing the interest shown on your tax return to £187.50 - £45 = £142.50.
Clear as mud!
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