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How bonds and bond funds are taxed

Okay, there’s no way to sugar this: I’m writing about tax on bonds [1], so I’ll keep it short, if not exactly sweet.

Bond taxation is confusing and life is fleeting and so – double-quick – here’s what you need to know to keep on the right side [2] of the taxman:

The following two tables sum up the income tax and capital gains tax treatments and differences between the main types of bond vehicle.

Further explanation lies beneath.

Tax on bonds: interest

  Bond fund
(OEIC, Unit Trust)
Bond
ETF
Individual
gilt
Individual
bond
Tax on interest Income tax rate [3]
(e.g. 20%)
Income tax rate Income tax rate Income tax rate
Interest paid gross or net of tax Gross Gross Gross Gross
ISA / SIPP shelter Exempt  Exempt Exempt Exempt

 

Note: Bond funds [4] have paid income gross since 2017 [5].

 

 

Tax on bonds: capital gains

  Bond fund
(OEIC, Unit Trust)
Bond
ETF
Individual
gilt
Individual
bond
Capital gains tax (CGT [6]) Payable Payable Exempt [7] Payable unless a qualifying corporate bond [8]
Non-reporting fund (offshore) CGT payable at
income tax rate
CGT payable at
income tax rate
n/a n/a
ISA / SIPP shelter Exempt Exempt Exempt Exempt

 

That’s the tax on bond and bond fund sitch in a nutshell.

Now let’s look at the details.

Where should you stash your bonds and bond funds?

If your fund is more than 60% invested in fixed interest and cash at any point during its accounting year then its distributions count as interest payments – not as dividends.

Distributions / excess reportable income [9] will therefore be liable for income tax at your standard rate, rather than softie dividend tax rates [10].

You can avoid income tax on bonds and bond funds by tucking them away inside your ISA / SIPP [11] – or by being a non-taxpayer.

Since 2017, bond funds registered as OEICs or Unit Trusts pay their income gross – that is, with no tax deducted. A welcome simplification.

The tax rate you’ll pay on bond income will depend on your overall income tax [3] status.

Non-reporting bond funds may pay interest gross. More on non-reporting funds below.

To hold an individual bond in your ISA or SIPP it must be listed on the stock exchange or issued by a listed company. 

Individual gilts are immune from capital gains tax [7]

Gilt funds, however, pay tax on capital gains.

Following the great bond rout [12] of 2022 – which scythed through gilt prices – the absence of CGT on individual gilt gains could make holding low-coupon gilts with high redemption yields the most tax-efficient option for you. Do your sums carefully.

Offshore bond funds

If an offshore fund / ETF does not have UK reporting status [13] then capital gains are payable at income tax rates.

That’s bad news because capital gains tax rates are much friendlier than income tax. The £6,000 tax-free capital gains allowance [6] – falling to £3,000 from 6 April 2024 – would count for nought in this instance. And higher-rate taxpayers would pay (income) tax on their capital gains at 40% instead of 20% in CGT.

Make sure your offshore bond tracker says it’s a reporting fund on its factsheet. HMRC also publish a list of reporting funds [14].

Offshore bond funds / ETFs are subject to withholding tax [15] just like equity funds.

If your bond fund is domiciled in the UK then reporting status and withholding tax isn’t an issue.

Index-linked Gilt ETF vs Index-linked Gilt Fund taxation

Some UK-based index-linked gilt funds are exempt from income tax on the inflationary component of interest payments.

In other words, if inflation shot up 5% in a year and the gilt paid 1% interest on top of that, then you’d only pay income tax on the 1% and not the other 5%.

However, offshore index-linked gilt ETFs will generally impose income tax on the whole interest payment (including the inflation-based element) because they do not enjoy the same exemption as an onshore fund.

So if you’re stocking up with an index-linked gilt fund then look for a tracker fund that’s based in the UK. (Email the provider to make sure they’re packing a tax exemption on inflation-linked interest.)

Take it steady,

The Accumulator

Note: This article on tax on bonds is an updated version of our 2015 original. Comments below may refer to old information, so double-check anything before acting. We’ve left old comments intact as there’s some good tidbits as usual.