1.1.2 THE BASIC RATE OF INCOME TAX
For 2005/2006, the basic rate of income tax will be 22%. The higher rate threshold has been increased to £32,400. The basic rate will apply to income in the band £2,091 to £32,400. The basic rate of tax is relevant to:-
· Contributions to personal pensions, stakeholder pensions and FSAVC arrangements which will be made net of tax;
· Charitable covenants and Gift Aid;
· Annual payments.
1.1.3 THE HIGHER RATE THRESHOLD
The higher rate threshold has been raised to £32,400.
Whilst this appears good news, over the last 10 years or so the number of higher rate taxpayers in fact has increased because the higher rate tax threshold has not increased in line with earnings. Higher rate taxpayers will still have a need to shelter income from tax. This will be particularly relevant to income generated by investments.
CAPITAL INVESTMENT BONDS
Although gains under capital investment bonds are subject to income tax (not capital gains tax) when realised, these products can be particularly useful in income tax planning because:-
· they are non-income producing – there is no need to make an entry in the annual tax return until a chargeable event gain is made, say on full encashment or a withdrawal of more than the cumulative unused 5% allowances;
· no personal liability to basic rate tax or the equivalent arises on income and growth (although the income and gains generated by the investments underlying UK bonds are taxable in the hands of the insurance company). An insurance fund represents a particularly tax attractive environment for reinvested dividends as no further tax is payable by the life company on this “franked” income;
· tax efficient “income” can be taken in the form of partial encashments; and
· the basic rules that apply to capital investment bonds with UK life companies mean that, when an investor encashes his bond, the gain will be added to his other taxable income and, if appropriate, (after top-slicing relief), he will suffer higher rate income tax. The gain under a UK bond is treated as having suffered lower rate (20%) tax and so the maximum rate of income tax that will arise on such a gain if an encashment is made in 2005/2006 will be 20%, i.e. 40% higher rate tax less 20% lower rate tax. Two particular points need to be noted here:-
1. the gain is not grossed up to reflect the lower rate tax paid within the insurance company’s funds – it is the net gain that is chargeable; and
2. although the gain is treated as if lower rate tax has been paid, it is likely that the insurance company has in fact paid tax at a rate less than the lower rate. For example, insurance company policyholder funds would currently only suffer 20% corporation tax on income other than dividend income. Dividends received with a 10% tax credit would bear no further tax. Moreover, although a life assurance company is liable to 20% corporation tax on capital gains, in practice this liability will be at a lower effective rate reflecting loss relief and the ability to only realise assets at the best “tax time”. As indexation allowance is still available to companies, this will apply to the insurance company’s investments meaning that indirectly the policyholder benefits from this allowance.
The upshot of all this is that although because of the lower rate tax credit a policyholder’s gain will be treated as having suffered tax at 20%, it may in fact have only suffered tax at (say) 18%. This, combined with the fact that the chargeable event gain will not be grossed up for income tax purposes, will mean that the effective rate of tax on the gain may be as low as 34.4% for 2005/2006 notwithstanding that the policyholder is a 40% taxpayer. For this reason UK capital investment bonds continue to look very attractive for the higher rate taxpayer seeking capital growth in a tax-sheltered environment and especially to the extent that the growth is driven by reinvested income.
Of course, complete tax sheltering is available via an offshore bond but, on encashment, all gains will then be taxed as the taxpayer’s top slice of income without a 20% tax credit. Whether an offshore or UK bond is more appropriate in any particular case will depend on many factors including likely investment terms, returns, withholding taxes and charges.
It is also important to remember that neither taper relief nor the annual capital gains tax exemption can be used in respect of capital investment bond gains although, as mentioned above, capital gains made by a UK life fund will currently qualify for indexation allowance which will have a downward impact on the effective rate of tax that the fund suffers.
COLLECTIVE INVESTMENTS THAT DISTRIBUTE INCOME
For those with minor children/grandchildren, opportunities that existed for using their personal income tax allowance by setting up trusts for their benefit under which the trustees invest in distribution units of unit trusts, OEICs and investment trusts ceased to exist from 6 April 1999. This is because the tax credit attaching to dividends from UK companies and distributions from equity collectives can no longer be reclaimed.
In relation to trusts established for a minor unmarried child where that child has a vested right to income, if the income exceeds £100 gross in a tax year it is automatically taxed on the parental settlor irrespective of whether the income is paid to or for the child’s benefit. However, scope exists for trusts for grandchildren where consideration should be given to investing offshore to obtain the benefit of gross dividends or distributions. If it is desired to achieve tax effective accumulation of income from UK investments held in a trust under which the grandchild has an interest in possession then, subject to investment considerations, it will be necessary to invest in areas that produce income other than UK dividend income. As well as interest from cash deposits, this will include income from corporate bonds and certain collectives whose income payments are treated as interest distributions rather than dividends.
1.2 PERSONAL ALLOWANCES, RELIEFS AND CREDITS
All allowances and thresholds other than the age allowance (increased in line with earnings) have been raised in line with statutory indexation. This means:-
· the personal allowance is increased to £4,895.
· an increase in the level of age allowance from £6,830 to £7,090 (for those aged 65 – 74) and from £6,950 to £7,220 (for those aged 75 and over).
· an increase in the level of income that a person can enjoy before age allowance is cut back. This figure has risen from £18,900 to £19,500.
· the married couples allowance (MCA) for those aged between 65 and 74 (provided at least one spouse was aged 65 or over before 6 April 2000) will increase to £5,905, and for those aged 75 and over will increase to £5,975.
· the standard MCA was of course withdrawn from 6 April 2000. In calculating the reduction in age allowance when income exceeds £19,500, the increased MCA is cut back to not less than £2,280 (the “minimum amount”).
· tax relief for maintenance payments will be available only where at least one party was 65 or over at 5 April 2000. The relief is increased to £2,280.
· relief in respect of the MCA and maintenance payments continues to be given as a tax credit at the rate of 10%.
1.3 MORTGAGE INTEREST RELIEF
No changes have been announced with regard to mortgage interest relief in respect of principal residences which was generally abolished from 6 April 2000.
Interest payable on loans used to buy land or property which is used in a rental business, which would include buy-to-let property, is deductible in computing profits or losses of the rental business.
1.4 OTHER RELIEFS
The threshold for tax exempt rents under the Rent a Room scheme for tax year 2005/2006 remains at £4,250.
1.5 TAX ON SAVINGS INCOME
The starting rate of 10% will apply to the first £2,090 of taxable income. Savings income which falls within the band £2,091 to £32,400 will be taxed at 20%.
1.6 TAX RECLAIM/PAYABLE CHART (UK RESIDENT AND DOMICILED INVESTOR) 2005/2006
|Source||Tax deducted at source?||Tax reclaim by non-taxpayer?||Tax reclaim by 10% taxpayer?||Tax payable by basic rate taxpayer?||Tax payable by higher rate taxpayer?|
|BUILDING SOCIETY/BANK INTEREST||YES 20% (R85)||YES 20% (R40)||YES 10% (R40)||NO||YES (40% WITH 20% TAX CREDIT)|
|NON-UK BUILDING SOCIETY/BANK INTEREST||NO||NO (NO NEED)||NO (NO NEED)||YES 20%||YES 40%|
|UK DIVIDENDS||NO (10% TAX CREDIT)||NO||NO||NO||YES (32.5% WITH 10% TAX CREDIT)|
|GILT INTEREST||NO (IN MOST CASES)||NO (NO NEED)||NO (NO NEED)||YES 20%||YES 40%|
|TAXABLE ELEMENT OF ANNUITY||YES (R89)||YES (R40)||YES (R40)||NO||YES (40% WITH 20% TAX CREDIT)|
|UK BOND GAINS||NO (BUT UP TO 20% SUFFERED IN FUND)||NO (NOT POSSIBLE)||NO (NOT POSSIBLE)||NO||YES 20%|
|NON-UK BOND GAINS||NO||NO (NO NEED)||NO (NO NEED)||YES 20%||YES 40%|
|OFFSHORE ROLL-UP FUNDS||NO||NO (NO NEED)||NO (NO NEED)||YES 22%||YES 40%|
|OFFSHORE DISTRIBUTOR FUNDS – DIVIDENDS DERIVED TOTALLY FROM EQUITY INCOME||NO||NO (NO NEED)||NO(NO NEED)||YES 10%||YES 32.5%|
|OFFSHORE DISTRIBUTOR FUNDS – DIVIDENDS NOT DERIVED TOTALLY FROM EQUITY INCOME||NO||NO (NO NEED)||NO (NO NEED)||YES 20%||YES 40%|