Budget could scupper guaranteed bonds: A tax loophole that allows better returns on a popular investment may be closed. Vivien Goldsmith reports

----------------------------------------------------------------- GUARANTEED STOCK MARKET INVESTMENTS ----------------------------------------------------------------- Company Term Minimum Guarantee Exposure year investment % of capital % of FT-SE Save & Prosper 5.25 5,000 130 114* General Accident 5 2,500 130 95 Midland Life 5 5,000 95 104.5 NatWest Life 5 5,000 100 100 Legal & General 5 3,000 100 96** Halifax 5 2,000 115 100 John Govett 24 hours 1,000 98 115 Hypo F&C (A) 90 days 5,000 100 26.9 Hypo F&C (B) 90 days 5,000 98 83.7 ----------------------------------------------------------------- *Maximum 175% **FT-SE tracker fund -----------------------------------------------------------------

GUARANTEED stock market investments offer the chance of substantial gains with the comfort of knowing what the worst outcome might be.

But some of the deals on offer are threatened by a possible change in the Budget to close the tax loophole that allows them to deliver better returns to investors.

The Association of British Insurers has had talks with the Inland Revenue. 'A change is clearly on the cards, but I would not expect this to be retrospective,' said Benedict McHugo, tax manager at the ABI.

This could create the traditional pre-Budget buying frenzy, which has been absent for several years.

While the terms of the stock market guarantees to investors are comparatively simple, these investments are put together with complex financial engineering.

The basic design salts away enough of the capital in a predictable market such as gilts to underpin the guarantee. The rest is used to buy options on the FT-SE 100 index so that the investment closely follows the performance of the largest shares traded on the stock market.

But one form of this investment - bonds using offshore reinsurance - is threatened by the expected change in the Budget.

The General Accident bond, for instance, is an offshore life insurance bond reinsured outside the UK in Europe.

UK taxation is based on investment gains less any expenses, but this does not take reinsurance into account. So if the bond's funds are passed through a reinsurance company offshore the returns are in effect tax-free.

David Heslop, marketing manager at General Accident, said: 'We get the best of both worlds - gross roll-up of the fund, while basic rate taxpayers have no further tax liability.'

The Budget could impose another tax charge when the funds return to the UK, destroying the economics of the deal. Companies would have to think again about how to structure stock market- based guaranteed products.

If the Revenue does close the tax loophole, General Accident is confident that it can devise another stock market tracker with some sort of guarantee. 'But it might not be such a good deal,' Mr Heslop said.

Save & Prosper also reinsures its life insurance bond offshore. Colin Rye, director for insurance business, said: 'The Inland Revenue has made no secret that it would like to stop this method of reinsurance. It is possible that it will happen in the Budget.'

Save & Prosper is looking at other ways of offering a guaranteed stock market product, but Mr Rye warned: 'Returns will not be as attractive.'

John Govett's Safeguard fund is onshore and offers daily dealing so investors are not locked in. From the begining of each quarter there is a 98 per cent guarantee on the capital value.

Since the guarantee was last put in place on 15 September the market has fallen to the protected level. So anyone investing now is guaranteed to get 100 per cent back on 15 December, minus charges.

An investor who put money into the fund in March when it was launched saw the fund drop 1.9 per cent in the first quarter when the market dropped 6.5 per cent; then in the quarter to September the fund rose 1.6 per cent while the market rose 2.2 per cent.

Returns are taxed as capital gains, which means investors with gains under the allowance of pounds 5,800 after inflation pay no tax.

This is an ideal vehicle for repaying an interest-only mortgage, and several building societies are considering offering it as an alternative to an endowment policy.

Hypo Foreign & Colonial's two Protected Capital Plus funds are open-ended funds based in Jersey so the funds roll up tax-free. But when investments are returned to the UK gains are taxed as income.

Halifax Building Society's Guaranteed Equity Bond is based onshore. It locks in gains once they reach 25, 50 and 75 per cent. Returns are taxed as income.

(Photograph omitted)