How Gilts Are Taxed

Published in Investing on 24 September 2009

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.

Income Tax

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.

Accrued Income

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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Iniq 25 Sep 2009 , 12:27pm

Presumably gilts held within an ISA are exempt from all tax - income tax and capital gains tax?

As a stock-and-share ISA investor in his late 60s, I intend (for the sake of stability) to move gradually out of equities and into gilts, as and when the FTSE evntually fully recovers.

What is the most convenient and economical way of holding gilts within an ISA, please? Presumably gilt funds levy a charge, and even Hargreaves-Landsdown impose a 0.5% annual fee to hold gilts directly in an ISA.

gordonbanks42 25 Sep 2009 , 1:19pm

@Iniq:

"...even HL..." : HL is very good at what they're good at, but you shouldn't assume that everyone else is more expensive than them across the board.

Other brokers, such as Interactive Investor and Alliance trust, do not levy ad valorem charges on holding gilts within an ISA. You may find that their ISAs are more cost-effective for your purposes, although you will need to weigh up other factors, such as their dealing charges and the fund supermarket facilities they offer.

Also bear in mind that the broker may have a fee cap. For example, HL caps its annual fees at £200 + VAT at present, so if you're lucky enough to be holding more than £40k of chargeable assets with them, your average charge rate will effectively be lower than 0.5%.

Iniq 25 Sep 2009 , 1:45pm

Thanks, gordonbanks42, for a prompt and helpful response.

Any comments, please, on the respective merits of holding gilts (within an ISA) directly / via gilt funds / via gilt tracker funds?

gordonbanks42 25 Sep 2009 , 3:42pm

@Iniq:

A less prompt response this time, because I had the temerity to go off for lunch. It is Friday, after all. :-)

Your choice of broker may affect the TER you would pay if you held gilts via a fund, and will probably affect any initial charge. That's the same as with any fund, of course. Most gilt funds' TERs don't seem to be as low as they "should" be, given how relatively cheap the funds are to run. I find that irritiating and I am disinclined to encourage them too much.

Holding directly provides the option to hold to maturity, which provides certainty* of capital and income return over the term of the gilt. I find this a very attractive feature. You don't get that if you hold via a fund. You will always have to exit a fund at the price ruling on the day, which can go down as well as up etc. etc.

* except for ILGs, where the index-linking means there can be no certainty.

I'm not convinced of the merits of a gilt tracker.

My view is that the market does not significantly misprice individual gilts (although it might misprice the whole market or a significant chunk of it from time to time), so there is little value to be added by an active manager at the individual stock-picking level. Once you have decided whether you want long, short or medium and you want index-linked or not, you might as well just buy something typical of that kind of gilt and hold to maturity. Saves you the cost of selling it, as well.

I guess if you just wanted some overall exposure it could be worth holding via a fund.

The fact that you're holding in an ISA means that it's all CGT-free anyway, so the CGT advantages pointed to by Sam's article don't apply in this situation.

I am not sure whether a gilt fund would be able/willing to pay distributions free of withholding tax. If it did, the income position would be the same within an ISA as without. If not, I think the tax position on income from a gilt fund within an ISA might favour a direct holding of gilts instead. I am no tax expert, esp not on the taxation of income from OEIC and AUT units held in an ISA. Perhaps Sam can elaborate on this point?

If you are very paranoid / prudent, you might want to consider that holding via a fund also introduces the risk of uncompensated loss in the event of fraud by the fund manager or its custodian - a risk which is not present when holding gilts directly. Of course if you're holding gilts or gilt fund units within an ISA, you have the same risks at the "wrapper" level (fraud by the ISA operator or its custodian) whichever option you choose.

When I say uncompensated loss, I mean that the FSCS will not compensate for losses over £50k due to fraud in a situation like this. So whether you consider that to be relevant will also depend on the size of holding you are contemplating.

Iniq 25 Sep 2009 , 5:15pm

Thanks again, gordonbanks32.

Quote:

"I am not sure whether a gilt fund would be able/willing to pay distributions free of withholding tax. If it did, the income position would be the same within an ISA as without. If not, I think the tax position on income from a gilt fund within an ISA might favour a direct holding of gilts instead. I am no tax expert, esp not on the taxation of income from OEIC and AUT units held in an ISA. Perhaps Sam can elaborate on this point?"

The issues involved are clearly a little more complex than many people (including me!) realise.

There must be many investors who wish to take full advantage of all their annual ISA allowances but who (like me, at my age) seek stability and security rather than maximum return. I would hold ALL my ISAs as cash ISAs if I could; I therefore seek a stock-and-share ISA investment which resembles cash as closely as possible, which is presumably gilts. I also understand that bonds and gilts benefit more from the tax-exemptions of an ISA than equities do - but I would like clearer information about this.

It is a shame that both the Fool and fund supermarkets like H-L spend most of their time talking about equities, and very little about other, less volatile investments (and their tax treatment) which may be more suitable for older, retired investors like me.

gordonbanks42 25 Sep 2009 , 7:41pm

@ Iniq:

The least volatile gilts are the shortest ones. The longer they have to run, the more potential volatility. There are two weapons you can use against volatility with gilts over longer periods - hold to maturity or buy short ones and replace them with other short ones from time to time. My understanding is that the former works within an ISA and the latter doesn't.

HMG doesn't like us holding cash and near-cash instruments in Stocks and Shares ISAs. (God knows why not - it effectively means that an ISA cannot be "lifestyled", which seriously nobbles its usefulness as a long-term investment vehicle). To this end, your ISA operator will probably (and by law should) not allow you to purchase short-dated gilts to put into an ISA. Short-dated means "having less than 5 years to maturity at the time of purchase". So when I said "several years" above, I meant "at least five years".

However if you buy gilts with more than 5 years to run and hang onto them, I don't know whether the ISA operator would come back to you and ask you to sell them once they have less than 5 years to maturity. They might not. I wonder whether other Fools have any experience of this situation.

If you can foresee some fixed time span of several years over which you want capital security, and you don't mind a few (minor) ups and downs in the meantime, then I think that you would do best to choose a gilt which matures around that point in the future and hold it directly.

Iniq 28 Sep 2009 , 12:39pm

Quote:

"HMG doesn't like us holding cash and near-cash instruments in Stocks and Shares ISAs. (God knows why not - it effectively means that an ISA cannot be "lifestyled", which seriously nobbles its usefulness as a long-term investment vehicle)."

Spot on! Over-65s should be able to switch their ISA from equities to cash (even if only just once) if they wish.

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