UK government debt is taxed in a rather unusual way.
This year's party political conference season has kicked off with public spending cuts being the proverbial hot potato. The reason for these proposals is, of course, the spiralling level of debt currently owed by the Government.
One of the ways in which the Treasury raises funds is by issuing loan stock, for example Treasury Stock or Exchequer Stock to investors and paying an interest coupon on the amount outstanding until a specified redemption date. Fools who purchased these gilts a few years ago may not look so foolish now. Gilts are also often used by risk averse investors or funds and when 'lifestyling' funds ready for withdrawal or onward investment.
But what are the (pretty unusual) tax implications of holding gilts?
Capital Gains Tax
Quite simply, gilts (and certain other securities) are specifically exempt from capital gains tax. Although gilts are issued and redeemed by the Government, it is also possible to buy or sell gilts on the open market. Gilts are normally quoted and sold in £100 tranches of nominal value, but depending on the coupon rate and the redemption date, it is possible for £100 of gilts to be sold for £120, £150 or £90.
As gilts are exempt from capital gains tax, even if £100 stock is sold for £150, no gain will be charged to tax; on the other side of the roundabout, however, gilts sold for £90 will not generate a capital loss either.
Gilts are redeemed at their nominal value (i.e. £100) when they reach their redemption date.
The interest coupon offered on gilts is taxed as exactly that, interest received. The coupon rate is normally split in to two (or four) equal half yearly (or quarterly) payments.
Interest is normally paid gross, i.e. before deduction of tax but may be paid net of 20% tax similar to other types of interest, e.g. bank interest on request. Whether interest is paid gross or net does not affect whether it is taxable or not -- it generally is! If you pay tax at higher rates, additional tax will be due, but if you pay tax at rates lower than 20% (which, believe it or not, is possible) and have a tax credit on the income, a repayment of tax may be due, although if you are likely to be in this position it would make more sense to receive interest gross anyway.
However, there is a peculiarity for income tax purposes on gilts and certain other types of security, called the accrued income scheme.
The accrued income scheme (AIS) came about as a direct result of the fact that gilts are exempt from capital gains tax. As a result, the practice of 'bondwashing' became widespread, which involved capitalising future interest payments due in order to create a larger (exempt) capital gain, and lower interest amounts, liable to income tax.
As a result, the AIS was introduced in 1986, 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.
Note that 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.
The treatment depends on whether the sale of the securities is with or without the accrued interest, also referred to as sales 'cum-dividend' or 'ex-dividend'.
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.
Accrued income amounts should be detailed on the face of the contract note of sale or purchase. If it is not disclosed and an 'alternative arrangement' is reached between the parties, the amount of that arrangement will be used (provided it is a 'clean price', whatever that may be). Otherwise, an accrued income element will be calculated by applying the formula I x A/B, where I is the interest payable, A is the number of days in the interest period up to and including the settlement day, and B is the number of days in the period.
The payments for each kind of security, e.g. all those that relate to gilts are aggregated and if there is a net accrued income 'gain', a charge to income tax as accrued income profits arises. An accrued income loss, on the other hand, is relievable by being set against the actual interest received. Note that this relief is given when the next interest payment is received, which may delay receipt of the relief until the next tax year.
HM Revenue & Customs' guidance Manual helpfully points out that "The amount taxable as income is removed from both the sale and purchase considerations of the securities for capital gains tax purposes", which is completely irrelevant as gilts are exempt from capital gains tax but maybe makes them sound a bit more generous. Perhaps we need to make spending cuts in the HMRC spin doctoring department…
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