How to Achieve Minimum Tax Liability with Clustered Bonds
Do you know how to achieve minimum tax liability when the investment bond is clustered? This article takes a closer look at the example provided in the CII R03 exam guide and shows you how to answer it correctly – useful for those who are planning to sit any of the CII R02, R03, R06, AF1, AF5 or J10 exams.
It came to our attention that clustering is tested in the CII R03 exam, as well as featuring in the investment exams.
The question in the R03 CII exam guide gives an example of an additional rate taxpayer investing 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 she can achieve this.
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 for £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 says she can take a partial withdrawal across all the segments of £800 per segment without any tax liability. Is this true? We know she can take 5% of the original investment 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 she can take 7 years’ worth of 5% withdrawals 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.
This states she can make a partial withdrawal across all the clusters/segments of £800 with a 25% tax liability on £45,000. We’ve established she is allowed to take £350 so by taking £800 she will make a gain on each policy of £450. Multiply this by 100 and you get £45,000 which she would be liable to 25% income tax on as an additional rate taxpayer. This answer is correct.
Options C and D
Option C states she can surrender 50 segments resulting in a 25% tax liability on £5,000 and option D states she can surrender 50 segments 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 which equals a gain of £30,000 which she would have to pay 25% income tax on. 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.
It’s a good question and one that could stump 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, and as much as 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.
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Over to You…
So what do you think? Do you feel confident enough to answer a question like this if it were to appear on your CII exam?