A battle between the UK's Inland Revenue and companies that have sold 'high-income' equity-linked bonds over the taxation of fund income has started to affect bond-holders - although the companies have known for some time that fund income might be subject to income tax rather than just capital gains tax, it's only now that one of them, Eurolife, has for the first time applied the possible tax charge to bond-holders' capital, and has come in for criticism as a result.
These type of high-income bonds typically invest the bond-holders' capital in equity-linked funds, eg index-trackers, using derivatives to guard against major market swings, and pay out income during the life of the bond which is borrowed against the security of the holdings. Then on maturity, the accrued capital is paid back less the income already paid. The increase in bond holdings (a mixture of reinvested dividends and capital growth) was though to be subject only to capital gains tax, but because of the derivative element, the Inland Revenue now claims that it is subject to income tax.
The liability to income tax arose after the Inland Revenue issued a complicated circular in February 2000 entitled: Proposed approach to settlement of cases to which the guidance in 4.42C of the Inland Revenue Life Assurance Manual applies. In fact that refers to derivative-backed bonds, and there has been considerable uncertainty as to which bonds are affected and which not. Citibank won a case against the Revenue last year, and other companies have cases pending. Eurolife is one of them, but unlike its fellow insurers has decided to charge bond-holders 4.75% of their capital at the end of this year, to reserve against the tax liability.
The company says it will return the money if it wins against the Revenue, but that hasn't stopped bond-holders complaining. In a letter sent out to investors, Eurolife says it is offering "an alternative investment, which overcomes the complexities/uncertainty of life assurance fund taxation and completely eliminates the effect of the reduction in the cash value of your bond." Investors can decide to roll over their cash into a new Eurolife product. The bond has a three years and two months term and offers a 10 per cent annual income or 32 per cent growth. The letter also states that should investors chose to take out the bond, Eurolife Fund Managers will take over the tax risk from the existing bond and provide an investment equivalent to what the maturing bond should have paid out. But the replacement investment has a different (and worse) risk profile, and critics are saying that Eurolife should not make such an offer, which may constitute mis-selling.
David Wootton, managing director of Eurolife, said: "The Inland Revenue has always been happy with just capital gains tax. But last year it suddenly decided it wanted to levy income tax as well, without changing the law. If the Revenue feels strongly that these bonds should be taxed differently, then the law should be changed. It should not be done simply by re-interpreting rules to suit themselves."
Mr Wootton said the Revenue had lost a similar case against Citibank last year. "The Inland Revenue had a better case that time and still it was thrown out by the High Court. I'm confident the Revenue will lose this case as well." A hearing is due to take place before the Special Commissioners on June 11.
Insurance industry estimates suggest that £10bn is invested in similar high income bonds held in around 700,000 separate policies. Virtually all are owned by retired or nearly retired people. Many have several bonds. When these bonds mature over the next year or so, investors could collectively be around £500m worse off if the Inland Revenue wins.
Swiss Life has a similar bond with £100m due to mature early next year. 'We have a legal opinion that says the Inland Revenue is wrong to impose this retrospectively,' says Jerry Staffurth at Swiss Life. 'But if legal challenges fail, we shall have to decide whether to pass it on or not. That may depend on whether we have to pay the full amount. We have to weigh up the costs against our reputa tion, although the bond details say we have a right to deduct. These bonds are not guaranteed.'
Each company structures its bonds slightly differently, so it's not clear that any ruling will apply to all companies, but other companies which may be caught by an adverse ruling include Abbey National, GE Life, HSBC, Scottish Mutual and Scottish Life International.
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