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How bonds and bond funds are taxed

How bonds and bond funds are taxed post image

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

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

  • Bonds are not taxed the same as equities.
  • Bond funds are not taxed the same as individual bonds.
  • Offshore bond funds are not taxed the same as onshore ones. (In other words, the treatment may be different if your bond fund sits outside the UK.)
  • Exchange-Traded Funds (ETFs) are not taxed the same as bond funds.

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 treatment of interest

Bond fund
(OEIC, Unit Trust)
Tax on interest Income tax rate
(e.g. 20%)
Income tax rate Income tax rate Income tax rate
Interest paid gross or net of tax Net of 20% tax Gross Gross Gross
ISA / SIPP shelter Exempt (reclaim 20%
tax withheld)
Exempt Exempt Exempt

Source: HMRC and fund providers.

Tax treatment of capital gains

Bond fund
(OEIC, Unit Trust)
Capital gains tax (CGT) Payable Payable Exempt Payable unless a qualifying corporate bond
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

Source: HMRC and fund providers.

That’s the bond and bond fund tax 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 will therefore be liable for income tax at your standard rate, rather than softie dividend tax rates.

If your interest is paid gross then you’ll need to pay income tax on it, unless it’s tucked inside your ISA / SIPP or you’re a non taxpayer.

Bond funds registered as OEICs or Unit Trusts pay interest with 20% tax already deducted.

  • So a basic rate taxpayer has no more to pay. (Yay!)
  • A higher rate taxpayer owes another 20%.
  • A non-taxpayer is due 20% back.

If your bond fund is safely dunked inside an ISA or SIPP then you should automatically receive interest payments gross, but it’s worth a double-check email to your provider.

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. (You can now keep short-term bonds in your ISA – the old five-year lifespan rule has been scrapped.)

Individual gilts are immune from capital gains.

Gilt funds must pay capital gains.

If an offshore fund / ETF does not have UK reporting status then capital gains are payable at income tax rates. That’s bad news as capital gains tax rates are much friendlier than income tax. The £11,000 tax-free capital gains allowance would count for nought in this instance while higher rate taxpayers would pay tax on their capital gains at 40% instead of 28%.

Just make sure your offshore bond tracker says it’s a reporting fund on its factsheet. HMRC also publish a list of reporting funds.

Offshore bond funds / ETFs are subject to withholding tax 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 index-linked gilts 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

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{ 52 comments… add one }
  • 51 The Accumulator January 2, 2016, 8:14 pm

    @ Jas – Have you tried googling how to claim back tax on interest? Bond distributions are just interest and HMRC put pretty much everything online – saves them a phone call 😉

  • 52 Fremantle September 12, 2018, 11:31 am

    This would be a great page for an update, particularly after the change to personal savings allowance. The income tax treatment of income from a mixed fund like Vanguard Lifestrategy 40% would be intersting.

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