How to Achieve Minimum Tax Liability with Clustered Bonds
Clustering, or segmentation, is something that is tested within various CII exams. For example, it can feature in AF1, AF4 and perhaps even AF5, as well as at diploma level with R02 and R03. In particular, it seems R03 is a firm fan of testing a candidate’s knowledge in this area. Read on to learn how best to answer this sort of question.
THIS ARTICLE IS RELEVANT TO EXAMINABLE TAX YEAR 2018/19.
The question in the most recent CII R03 exam guide gives an example of an additional rate taxpayer who invested in an onshore investment bond with £100,000 just over 6 years ago. The bond was clustered (or segmented) into 100 policies, and the recent valuation is £160,000. The investor now wants to realise £80,000 with minimum tax liability, and the question asks how this can be achieved.
Where do you start with a question like this?
The first thing to understand with CII questions is the technicality they are testing. With this one, it’s clustering an investment as opposed to leaving it as one investment and the formulas for partial and full surrenders. As this was a £100,000 investment clustered into 100 policies, each cluster was £1,000. The recent valuation of £160,000 is also divided by 100 to give a value of £1,600 each.
Some delegates might work this out before looking at the options available; others may find the answer by going through each option first. We’re going to go through the options.
Option A
Option A says a partial withdrawal can be taken across all the segments of £800 per segment without any tax liability. Is this true? We know 5% of the original investment can be taken each year as a tax deferred withdrawal. In our example, 5% of £1,000 equals £50 and the bond has been held for ‘just over 6 years’. This seemingly innocuous piece of information is actually really important to understand in any exam question on bond taxation as ‘just over 6’ means 7 years’ worth of 5% withdrawals can be taken without any tax liability, so 7 x £50 = £350 but still not enough to take £800 without a tax liability, so the first option is incorrect.
Option B
Option B states a partial withdrawal can be taken across all the clusters/segments of £800 with a 25% tax liability on £45,000. We’ve established £350 can be taken, so by taking £800 a gain will be made on each policy of £450. Multiply this by 100 and you get £45,000 which would be liable to 25% income tax on as an additional rate taxpayer. This answer is correct.
The CII R03 exam often tests a candidate’s knowledge of clustered bonds. The example found in this article will help your revision. Click To Tweet
Options C and D
Option C states 50 segments can be surrendered resulting in a 25% tax liability on £5,000 and option D states 50 segments can be surrendered resulting in a 25% tax liability on £30,000.
The full surrender calculation is the current value minus the original investment so £1,600 – £1,000 = £600 multiplied by 50 policies, this equals a gain of £30,000 which would be chargeable to 25% income tax. This makes C another wrong answer and D another right answer, but because the tax liability in D is less than that in B this makes D the correct answer to the question. Remember it stated in the stem ‘with minimum tax needing to be paid’.
It’s a good question and one that could stump even the most prepared R03 delegate in exam conditions, if they haven’t seen a question quite like it before. It’s definitely worth practising if you’re looking at sitting this exam anytime soon. Although, you may not get a question quite like this in any of the investment exams, it’s necessary to understand the detail of why segmentation is often more beneficial to the investor than having one policy. There are certainly no disadvantages in having the investment clustered.
Grab the resources you need!
If you’re studying for your CII R03 exam, and you don’t think you’ve had enough practice yet, get our free taster to try out one of Brand Financial Training’s mock exam papers for yourself. Click the link to download the R03 mock exam taster now!
Alternatively, you can download the taster for AF1, AF4 AF5, or R02 resources if any of those exams are causing you to stress.