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Drag net

Fiscal drag is going nowhere fast, says Brian Murphy, financial planning manager at Axa Wealth, but it is a great opportunity for advisers to bag more business by helping clients mitigate higher-rate tax liability

Fiscal drag is an expression that has become popular in the past few years. It occurs where allowances, exemptions or tax bands do not increase in line with some measure of inflation, meaning that more people end up paying more tax.

We have seen it in respect of inheritance tax, where the nil-rate band has been frozen at £325,000 since 2009/10 and will remain so up to and including the 2014/15 tax year.

It is estimated this freeze will mean that 650,000 extra families will be dragged into the IHT net, even allowing for the transferable nil-rate band on death. That is a substantial number but it means there are 650,000 more families who will need IHT advice.

For advisers, there is a chance to talk to clients about whole-of-life policies in trust, or lump-sum IHTmitigation strategies, such as loan trusts or discounted gift schemes.

Furthermore, even if the nil-rate band does eventually start to increase again in 2015/16, such rises will be in line with the consumer price index, which, historically, has been lower than the previously used retail price index.

But it is not just IHT that is affected. Income tax has also been a victim of fiscal drag. Although the personal allowance has been rising significantly, the threshold at which individuals start to pay higher-rate income tax has been reducing.

In 2009/10, the personal allowance was £6,475 and the higher-rate threshold was £43,875. For 2013/14, the personal allowance is due to be £9,205 but the higher-rate threshold will fall to £41,450.

If the higher-rate threshold had been index-linked since 2009/10 in line with the RPI, it would be about £49,600 in 2013/14.

As a result, the Institute of Fiscal Studies estimates 15 per cent of taxpayers will be higher or additional-rate taxpayers in 2013/14, compared with just 10.4 per cent in 2009/10. In 2011/12, there will be an estimated 3.8 million of us paying higher-rate tax and about 307,000 paying tax at the additional rate.

Again, this means there will be more higher-rate taxpaying individuals than ever before, who will be interested in advice over how this liability can be mitigated.

Use of pension contributions is one method. In 2012/13, someone with a total income of £42,475 will be a basic-rate taxpayer, so a gross pension contribution of £1,025 will be eligible for tax relief at only 20 per cent. In 2013/14, however, if income remains the same, then such a contribution would attract relief at 40 per cent.

Another idea might be to reduce the income tax liability by investing in enterprise investment schemes or venture capital trusts and claiming 30 per cent tax relief on the contribution.

It should be remembered that such a contribution does not reduce taxable income but does decrease the overall tax payable, so a contribution of £100,000 would reduce the overall tax liability by £30,000.

For more adventurous investors, since April 6, this year, the seed EIS has offered income tax relief at 50 per cent to individuals investing in early-stage qualifying companies up to an annual limit of £100,000.

A £100,000 contribution under a seed EIS will reduce a client’s overall tax liability by £50,000.

Furthermore, there will also be a capital gains tax exemption for gains realised on disposal of an asset in 2012/13 and invested in a seed EIS company in the same year, giving a potential overall tax saving of 78 per cent.

Remember that the annual capital gains tax exemption for 2012/13 was also frozen at its 2011/12 level of £10,600.

The level of adjusted net income at which individuals start to lose their entitlement to the personal allowance remains at £100,000 and, again, pension contributions here could ensure that the ability to enjoy the personal allowance is retained.

The level of income at which the 50 per cent additional rate starts remains at £150,000, although this rate will reduce to 45 per cent in 2013/14.

Advice on how to avoid the 50 per cent tax rate in the last year of its existence will be needed and pension contributions could play a vital role. The ability to carry forward contributions and judicious managing of pension input periods could be important here, plus advice on deferring bonuses or the taking of dividends until 2013/14, together with the postponing of the surrender of insurance bonds until after April 5, 2013.

It seems that fiscal drag is here to stay but more people paying more tax means more people who need advice and, in a strange way, it could be said that fiscal drag is the adviser’s friend.

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