QCBs and taxes

My understanding is that no capital loss on a QCB is allowable for relief (either CGT or Income tax) and hence when you are buying a bond significantly above par (which is the case of MOST bonds these days) you end up paying a lot of income tax on the coupons you receive, losing some money in the principal and getting no allowance for that. That transforms what is a low yielding instrument in potentially a negative yielding instrument after tax.

Assume an extreme case of a bond with 1 year left to maturity and priced in the market with around 0% yield to maturity. Let's assume it pays a 8% coupon at maturity and hence its price will be around 108%. If you buy that bond you get taxed at your marginal income tax rate in the 8% coupon you get at the end and you lose capital as the price of the bond drops from 108 to 100. The end result is a loss of 40%*£8 = £3.2 (assuming a 40% income tax bracket) in the £108 investment you made, in what should have been a zero yield instrument.

The QCB regime of no CGT is great if you find bonds below par, but can be nasty in these environment where interest rates a super low compared to the coupons of the bonds that have been issued some time ago.

Please let me know if my understanding is wrong.

Comments

  • What you have said is correct. If you are a higher rate taxpayer then bonds trading well above par with high (taxable) coupons may not be the most appropriate from a purely taxation point of view. As you say bonds below par with a tax free capital gain to maturity are few and far between.

    In the example you gave which is a little extreme you would have invested 108 and got back effectively 104.8 (capital plus after tax income) so the overall loss is around 3%.

    A lot depends on the size of your holdings but one solution is to use ISAs or pensions to hold your fixed income investments and any low yielding equities with potential capital gains could be held outside of tax wrappers where you could use the annual CGT allowance if they increase in value.

    Also you get at least £500 interest tax free which will help a little and £5000 dividends. Could potentially look at VCTs which pay tax free dividends and give tax relief if bought at issue.
  • edited October 2017
    Thank you for this information. It is very useful
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