Warners Private Clients – Investment does not need to be taxing
29 January 2010
In this article Mike Wiggins from Orchard Wealth Cultivation looks at the potential forthcoming tax increases and outlines some of the simple, advanced and high risk strategies that may help to lessen the impact of those tax increases.
As the UK government begins to tackle the unprecedented levels of debt which have been generated as a means of stabilising the financial system of the UK, we can all expect to experience increasing taxation. For the savers in our society and those who have prudently amassed wealth, this is not good news. These individuals will be in the frontline when the assault begins.
Clearly there is no political will to subject the savings community to this plan before an election, however, the deferment is just that and the need to reduce the UK debt mountain using the savings of the prudent is just around the corner.
There remains therefore an opportunity to arrange financial affairs ahead of the election and the following emergency budget to minimise the impact. As is always the case, it will be important to review the strategies following the changes to legislation which must come out of that budget, however, there are already some clear areas that need to be addressed.
Income tax increases are already announced which will impact higher earners in a number of ways – higher rates of tax, loss of personal allowances and restriction of tax relief when funding pensions.
Every individual’s situation will be different and there can be no substitute for an individually designed investment strategy and review programme. However, this article looks at some of the strategies and investment vehicles which may help to reduce, eliminate or defer those tax increases.
Simple Steps
Where possible, balance income between spouses/partners so as to avoid either party exceeding the £100,000 level. As from April 6th 2010 personal allowances will be lost at a rate of £1 for every £2 of income over £100,000. With the personal allowance remaining at £6,475 per annum (for those individuals under 65) this will mean the allowance will be fully removed once income reaches £112,950. This is an effective rate of tax of 60% on income between £100,000 and £112,950!
The new 50% tax rate (42.5% for dividends) will also apply to all income over £150,000 per annum.
It is important to note that, as from 6 April 2010, the special income tax rates for trustees will become 50% for non dividend income and 42.5% for dividend income. However, whereas the rates for individual taxpayers will apply for income above £150,000, for trusts that suffer the special rates, the rates for trustees will apply whatever the income, subject only to the 20% or 10% (in the case of dividend income) standard rate band of £1,000 which is itself subject to an anti-fragmentation rule to stop an individual establishing a series of trusts each enjoying the full standard rate band.
All trusts that are subject to the special rates should be reviewed, and appropriate action taken, as a matter of priority.
For the directors of small/family businesses it may be appropriate to review how you and your employees are remunerated. Whilst dividends may not reduce the income tax liability itself, it could reduce the National Insurance costs helping offset income tax rises and remember, the small company’s corporation tax rate has been held at the current rate for a further year. When sacrificing salary in order to receive reward in an alternative way (dividends, pension contribution etc) consideration should be given to the impact on national minimum wage, state benefits, other employer scheme benefits and earnings for the purpose of personal pension contributions/mortgages.
If you are unable to divide your earned income, what about your savings/investment income?
Whilst interest rates are very low and likely to remain so, it helps to avoid the loss of 40/50% of this return in income tax.
Review holdings and consider placing these in the name of the lower tax payer. You will of course need to consider access to funds for the higher rate tax payer where such action is taken. This may involve reviewing wills and ensuring that you have Lasting Powers of Attorney (or Enduring Powers if already in place).
Where your investment risk profile allows, consider growth based investments. Whilst income produced is taxed at your highest rate of income tax, capital gains remain at 18% and only on gains in excess of £10,100 in the current tax year (£5050 for trusts).
If you are likely to fall into the 50% tax bracket post April 2010, consider pulling forward income entitlement (dividend payments, bonuses) to the current 2009/10 tax year.
For those who have significant gains built up in investment bonds it may be appropriate to realise the gains in the 09/10 tax year rather than 2010/11 (unless you anticipate being a lower rate tax payer in the future – in retirement perhaps?).
Business owners should not forget that entrepreneurial relief remains at 10% up to a ‘lifetime’ level of £1,000,000 so a strategy of ‘self investment’ can still look attractive, however, there are of course significant risks of relying on this strategy alone.
Pensions remain a tax efficient route for many to defer income and tax liabilities to a time in the future when an alternative income stream will be required. Tax liabilities may also be lower (due to a lower income bracket) thereby avoiding 50% or 40% income tax while a high earner and realising the pension income at 20%/40% rates – and, don’t forget, 25% is currently free of tax.
For individuals who wish to gain more control over their pension investments both Self Invested Personal Pensions and Small Self Administered Schemes can be advantageous. If you run a family business then the Self Administered Scheme can be particularly attractive. All members of the family can be members of the same scheme and the investment flexibility includes loans back to the company. With these schemes it is possible to reduce corporation tax liabilities by funding for the future family income and yet retain the ability to lend the funds back to the business. Any loan attracts interest but at least all interest is simply going into your own future income pot.
Care has to be taken in respect of pension contributions following the introduction of the special annual allowance charge in the 2009 Finance Act and pre budget report. Whilst this new legislation will take effect from 6th April 2011 special provisions were included in legislation (anti forestalling rules) to prevent significant funding before that date. As a result of the pre budget report, anyone with ‘relevant income’ over £130,000 per annum (in 2009/10 or the previous 2 years) will be caught by the new tax relieved contribution limits. Also, whilst continuing regular contributions (at least quarterly) are protected from the new rules any contributions with less frequency are not. Therefore, if you are a small business owner who tends to make pension contributions annually once you have considered the year end financial position of the company, then you will be restricted in respect of tax relief on any contributions over £20,000. There are some exceptions to this and it will be important to discuss the new rules and your options before committing to any course of action. We can of course help you in this respect.
For those who have accumulated wealth or simply prefer to maintain full access to savings, Individual Savings Accounts (ISAs) continue to provide a tax efficient home. Don’t forget that for those over the age of 50, higher levels of tax free savings are available. The £7,200 limit continues to apply until April 2010 to all those under 50 (£3,600 into cash ISA). For those over 50 a £10,200 limit applies with £5,100 being investable in cash.
For those with a long term investment horizon (minimum 10 years) Maximum Investment Plans (MIPs) are likely to return to vogue. MIPs provide a tax efficient savings plan especially for those who are higher rate tax payers. Technically these savings plans are insurance contracts and as such provide limited life cover, however, this is not their primary purpose. Due to the life contract treatment, the plans are taxed internally at the life company rate (typically around 18%). When the plans mature the proceeds are paid with no personal tax liability.
For those who have utilised their ISA allowances and have a positive view for the longer term growth story in Asia, for example, MIPs may provide an effective route to tax efficient profits. Today’s products offer access to a wide range of funds which include global emerging markets.
So far we have looked at ways of reducing tax liabilities simply by maximising allowances and using schemes such as pensions which reduce taxable earnings or ISAs which accumulate tax free (save for tax on dividends which cannot be reclaimed). However, alternative schemes exist which enable investors to reclaim paid taxes (tax reducers).
Advanced Steps
VCT and EIS
Both of these investment vehicles benefit from attractive tax treatment in order to encourage investors to supply the capital required for UK business. Due to the legislation which governs these investments, many will invest in early stage companies which represent both higher growth potential and higher risk of loss. However, some companies provide schemes which are structured to reduce the risks whilst still providing the tax benefits.
Venture Capital Trust (VCT)
VCTs offer 30% income tax relief up to a maximum investment of £200,000 per year. In other words, as long as you have paid tax of £60,000 you can claim the whole amount back. You may look at this as though it has cost you £140,000 to effect an investment of £200,000 or that, of your £200,000 investment, you have put at risk £140,000. The shares in the VCT must be retained for a minimum of 5 years in order to retain the tax refund. Exiting the VCT before the 5 year period would result in the tax relief being withdrawn (and, in the above example, a £60,000 tax liability).
VCTs do not only offer tax relief on the way in, but are also able to provide tax-free dividends (and will typically distribute profits in this way) and tax free gains (when shares are sold).
Enterprise Investment Schemes (EIS)
EIS offer 20% income tax relief up to a maximum investment of £500,000 per year against the income tax bill of this year (or the previous year if you choose). So, for example, you could invest £1,000,000 this year and receive 20% income tax relief on £500,000 for this year and an additional 20% income tax relief for the other £500,000 against last year’s income tax bill, resulting in a total of £200,000 tax relief (again, assuming you have liabilities to this level).
Capital gains tax deferral is a feature of an EIS and means that you can invest funds and defer gains made up to 3 years previously. Deferring previous gains enables investors to use any future capital losses to offset previous gains.
Whilst EIS do not benefit from tax free dividends all capital gains made within the EIS are tax free (for this reason profits are not normally distributed as dividends but as capital gains at the end of the investment term). In addition, investments qualify for inheritance tax relief after 2 years. Therefore, if, in this example, £1,000,000 had been invested for 2 years then this sum would benefit from Business Property Relief (100% under current legislation) and, assuming other assets had made full use of the nil rate band, save the estate inheritance tax of £400,000.
As with most tax advantaged schemes, additional investment risk is substituted for the tax savings. There are many different institutions offering variations of both the VCT and EIS arrangements, however, the levels of investment risk and ability to access funds can be very different. Ensure that you seek individual advice from a suitably qualified professional.
A suitably qualified professional will be an Independent Financial Adviser (fee based) who is qualified to an advanced level and has successfully completed an investment paper such as The Chartered Insurance Institute’s J06 (or equivalent) as part of his/her advanced qualifications.
Combining some or all of these solutions can bring greater tax savings. For example, once held for 5 years, a VCT could be used to make a pension contribution and receive further tax relief.
High Risk Steps
All of the above are strategies and schemes well known to HMRC and currently considered to be non contentious. However, there are other more ‘exotic’ or ‘interesting’ schemes available. Many involve trust arrangements and are often offshore. Whilst some of these schemes may offer significant potential tax savings it should be noted that HMRC are giving considerable focus to anti-avoidance. Therefore, consideration should be given to the possible application of anti-avoidance rules and/or HMRC challenge through the Courts. A careful ‘cost/benefit’ analysis before embarking on any tax planning journey involving ‘schemes’ is strongly recommended.
One area which has recently gained a lot of interest and activity is that of Employee Benefit Trusts (EBT) and Family Benefit Trusts (FBT) in addition to Employer Financial Retirement Benefit Schemes (EFRBS). HMRC have shown strong interest in these arrangements and have stated that for close companies there could be an inheritance tax charge on the shareholders when a contribution is made if they can benefit from the trusts arrangements. Part of the attraction of EBT and FBT is that the director who sets up the scheme can benefit from the trusts arrangements (normally through loans). Whilst no specific mention of these arrangements was made in the pre-budget report, proceed with caution!
There is often plenty of non-contentious planning that can be used to reduce the taxable footprint before the more ‘exotic’ and potentially expensive schemes are utilised.
Mike Wiggins
Certified Financial Planner, Dip PFS
