Technical Connection details tax-saving strategies which are hugely important this year with tax rates set to soar
February and March are key months in which to consider tax planning to maximise the use of an individual’s allowances, reliefs and exemptions for the current tax year. Some of these will be lost if not used before the tax year end. As well as last-minute tax planning for 2009/10, now is also a good time to put in place strat egies to minimise tax in 2010/11.
This year, effective planning will be even more important for those on higher incomes because we know that, for them, tax rates are set to increase, either directly or indirectly, with effect from April 6, 2010.
This means that prior action is needed for a person to optimise their income tax position and, for this reason, in this article we primarily focus on income tax.
In this article, all references to spouses and married couples include registered civil partners. The comments put forward are intended for tax planning purposes and due consideration must always be given to the commercial issues involved in making a particular investment.
1: INCOME TAX
Four key changes will take place from April 6, 2010:
i: The standard personal allowance will be frozen at the 2009/10 rate of £6,475
ii: The threshold for the start of higher-rate tax will be frozen at £37,400
iii: A 50 per cent tax charge will apply to taxable income that exceeds £150,000
iv: People with income of more than £100,000 may find that they will lose some or all of their standard personal allowance.
The impact of (i) and (ii) will mean that even more people will fall into charge to higher-rate tax – some purely down to a standard pay increase.
The impact of (iii) and (iv) will mean that people with income of more than £150,000 and £100,000 respectively will pay even more tax.
There are four main ways in which tax increases can be combated:
- Independent taxation planning
- Utilising tax exemptions and allowances
- Using tax-efficient investments
- Dealing with the loss of the personal allowance
Independent taxation planning
Independent taxation planning has become much more important following the proposed increase in the top rate of income tax to 50 per cent for those with taxable income of more than £150,000 and the introduction of an effective rate of 60 per cent on income between £100,000 and
£112,950 caused by the withdrawal of the personal allowance.
For people with income over the rates detailed above and who are married or have a registered civil partner, the tax savings available by diverting income into the lower-income partner’s name will be even more substantial.
Most of these strategies need a full tax year to deliver maximum effect so these suggestions may serve more as a reminder for planning for the coming tax year than as a means of saving tax this tax year. The appropriate type of tax planning to adopt will depend on the type of income a person enjoys, that is, earned/business income or investment income.
i: Employment income
a: Employers could pay bonuses and dividends before April 6, 2010.
b: Employers could consider paying, say, three years worth of salary and bonus this tax year to top employees, who then lend the money back to their employer in return for an agreed rate of interest.
c: Employers could consider paying salaries in the form of interest-free loans, which may then be written off if and when the top rate of tax
reduces. This will involve a benefit in kind charge on the interest not paid – albeit at a fairly low current rate.
ii: Owner/directors of a private limited company
a: Where married couples run their business through a company, it will be sensible for salary payments or divi – dends to be shared as evenly as possible. Following the Arctic Systems’ case which confirmed the legitimacy of such an arrangement, the Government’s income-shifting
proposals have been put on hold for the time being.
b: In the run-up to this year’s tax increases, owner/ directors should consider maximising the salary and dividends taken out of the business before April 6, 2010, thereby paying tax at 40 per cent and 32.5 per cent rather than at 50 per cent on income and 42.5 per cent on dividends over £150,000 after April 5, 2010. Any such “advanced” payments can be lent back to the business if a cash flow challenge exists.
c: Tax relief on pension contributions is to be restricted for those with high incomes – see later.
Where a higher-rate taxpaying spouse owns investments, income from these may suffer tax at a rate of up to 40 per cent or 32.5 per cent (if dividends) rising to 50 per cent and 42.5 per cent respectively from April 6, 2010.
Therefore, subject to practical considerations, the transfer of investments to a lower or non-taxpaying spouse can save tax and increase overall net of tax investment returns. To be effective, such transfers must be outright and unconditional.
i: Utilising tax exemptions and allowances
- Everybody should make maximum use of all personal allowances available to them and their family. A husband and wife each have their own personal allowance.
This is particularly relevant where one spouse pays tax at a lower rate than the other. A non-working spouse with no investment income will be able to receive income of £6,475 for tax year 2010/11 before he or she pays any tax.
- Older married couples benefit from an increased age-related personal allowance. It may be advisable to transfer incomeproducing assets between couples where one would otherwise exceed the age allowance threshold of £22,900 (2009/10 and 2010/11).
ii: Using tax-efficient investments
With the rates of tax effectively increasing, it is more important than ever that people invest in the most tax-efficient way possible.
Investors aged over 50 in this tax year can invest up to £10,200 into an Isa, £5,100 of which can be in a cash Isa.
For somebody over 50 who has not yet used all of their increased Isa allowance of £10,200, now could be the time to do this. From April 6, 2010, the increased Isa investment allowance app – lies to all qualifying individ – uals, irrespective of age.
b: Enterprise investment schemes
For tax year 2009/10, an investment of up to £500,000 can be made to secure income tax relief at up to 20 per cent, with relief being restricted to the amount of income tax otherwise payable.
Unlimited capital gains tax deferral relief is also available on an investment in an EIS, provided some of the EIS investment potentially qualifies for income tax relief.
c: Venture capital trusts
VCTs offer income tax relief for tax year 2009/10 at up to 30 per cent for an investment of up to £200,000 in new shares, with relief being
restricted to the amount of income tax otherwise payable. Dividends and capital gains generated on amounts invested within the annual subscription limit are tax-free.
d: Growth-orientated unit trusts/Oeics
Given the relatively high rates of income tax as compared with the current rate of capital gains tax, it makes tax sense to invest for capital growth as opposed to income. Based on the current rules, growth-orientated unit trusts/Oeics and zero dividend preference shares look tax-attractive for the higher-rate taxpayer.
Although income (dividends and interest) on collectives is taxable – even if accumulated – if this can be limited, then so can any tax charge on the investment.
Instead, if emphasis is put on investing for capital growth, not only will there be no tax on gains accrued or realised by the fund managers, it should also be possible to make use of the investor’s annual CGT exemption (currently £10,100) on later encash ment with excess gains only suffering tax at 18 per cent currently.
For couples, it makes sense for them both to invest to be able to use both annual CGT exemptions when investments are encashed.
e: Single-premium investment bonds
Because single-premium investment bonds are non-income-producing, no taxable income arises for the investor during the “accumulation period”.
Not only that but any divi – dend income acc umulates without corp oration tax within a UK insurance company’s internal investment funds. However, UK bonds are not so tax-efficient from a CGT standpoint, with capital gains (after indexation allowance) realised by the UK life fund suffering corpor ation tax of up to 20 per cent.
The investor policyholder will receive a basic-rate tax credit for deemed taxation in the fund, meaning that, on eventual encashment, a tax charge will only arise if the investor (after top-slicing relief) is then a higher-rate or additional-rate taxpayer.
Ways in which this taxcharge may be mitigated involve the following:
i: Deferring encashment of the bond until a year in which the investor is a basic-rate taxpayer – say, after retirement. In the meantime, if cash is required, use the 5 per cent taxdeferred withdrawal facility
ii: Assigning the bond to an adult basic-rate or nontaxpaying relative (say, spouse or children) pre-encashment, the assignment will not trigger
a tax charge and tax should be avoided on subsequent encashment.
More tax efficiency at fund level can be achieved via an offshore bond because there is no internal tax charge on investment growth.
However, there is then no tax credit for a UK-resident investor. Whether a UK or offshore bond is best for any particular investor will depend on the facts.
Dealing with the loss of the personal allowance
From April 6, 2010, where an individual’s “adjusted net income” is above the income limit of £100,000, the amount of the standard personal allowance will be reduced by £1 for every £2 above the income limit.
For example, based on the personal allowance of £6,475 for 2010/11, an adjusted net income of £112,950 or above would mean that no personal allowance is available.
A number of people may have adjusted net income of just over £100,000 which will cause them to lose part or all of their personal allowance.
How can they plan for this forthcoming tax change? Well, much will depend on the type of income that causes the cutback.
- Earned income can be reduced by either:
- Paying a pension contribution or arranging for a salary sacrifice. This could achieve an effectivetax saving at 60 per cent (or 61 per cent if employee’s NICs are saved). Investment income Depending on an individual’s circumstances, the following may be appropriate strategies:
- Redistribution of investment capital to a spouse with a lower income so that the income generated is taxed on him/her instead.
- Reinvestment in tax-free investments, such as an Isa, so that taxable income is replaced with tax-free income.
- Reinvestment in taxefficient investments that generate no income and so will not impact on the loss of the personal allowance. Such investments would include:
- Certain National Savings products.
- Unit trusts/Oeics geared to producing capital growth.
- Single-premium investment bonds from which a 5 per cent taxdeferred withdrawal may be taken each year, for 20 years, without affecting
the personal allowance calculation.
Any year-end pension tax planning will need to be made against the backdrop of the restrictions that are being made to the availability of higher-rate tax relief on pension contributions for some people.
The Government will be introducing a “high income excess relief” tax charge, which is designed to restrict the relief available on pension contributions/ accrual in respect of highearners, with effect from April 6, 2011. A change was also implemented, with effect from December 9,
2009, to bring in antiforestalling provisions designed to stop those individuals likely to be affected by the new rules in April 2011 from maximising their contributions in the meantime.
Advisers will need to be familiar with the main aspects of these changes, both in terms of the proposed rules to apply from April 2011 and the action that should be taken now by high-income individuals looking to maximise their pension provision.
In particular, the following points should be considered:
- Anyone with “relevant income” of below £130,000 in tax years 2009/10 and 2010/11 should seek to maximise their pension contributions while there is no restriction on their available tax relief. This is particularly important for anyone who is likely to fall foul of the income limits applicable from April 6, 2011.
- Anyone with “relevant income” of £130,000 or more but less than £150,000 should be made aware that they are now potentially subject to the special annual allowance and full advantage should be taken of their special annual allowance (that is, normally £20,000 but potentially up to £30,000 where sufficient “infrequent money-purchase contributions” have been paid in tax years 2006/07 to 2008/09 inclusive) in both tax years 2009/10 and 2010/11.
- Anyone with “relevant income” of £150,000 or over should take full advantage of their special annual allowance (that is, normally £20,000 but potentially up to £30,000 where sufficient “infrequent money-purchase contributions” have been paid in tax years 2006/07 to 2008/09 inclusive) in both tax years 2009/10 and 2010/11.
3: NATIONAL INSURANCE CONTRIBUTIONS
An increase in NICs of 0.5 per cent for employees and employers was to take effect from April 6, 2011. Following the 2009 pre-Budget report,
these NIC rates are now each scheduled to go up by 1 per cent (instead of 0.5 per cent) to 12 per cent (employee) and 13.8 per cent (employer).
Employees will also pay a 2 per cent surcharge on earnings above the upper earnings’ limit. For those employees who will be affected by this
increased National Insurance burden (and are not caught by the new “high income excess relief” tax charge) salary-sacrifice pension arrangements remain attractive. These enable the employee to sacrifice salary (and so save NICs) and, in return, the employer will make a pension contribution of the sacrificed salary plus some or all of the saved NICs.
4: CAPITAL GAINS TAX
The main planning points to remember in connection with the annual CGT exemption are:
- The annual exemption for individuals is £10,100 for 2009/10 (and £5,050 for most trustees). The annual exemption cannot be carried forward.
If an individual has investments with inherent gains, he/she should consider making disposals to realise any gains within the annual exemption.
To ensure gains are properly realised, the disposer must not personally reacquire the same shares within 30 days of disposal.
- The annual exemption is available to each of a married couple and so, between them, capital gains of up to £20,200 in tax year 2009/10 can be realised without any CGT liability. Transfers between spouses living together are on a no-gain/no-loss basis so, provided any transfer is outright and unconditional, a prior transfer to a spouse could effectively double the potential use of the annual exemption.
- A transfer of an asset showing a loss to a spouse with assets showing a gain can be considered but care should be taken over the CGT antiavoidance rules that apply.
5: INHERITANCE TAX
Given the state of the economy, it is no surprise that the inheritance tax nilrate band will be frozen at £325,000 for 2010/11.
The freezing of the nil-rate band is clearly bad news for some wealthier clients who have a potential inheritance tax liability on their death but cannot afford to gift capital.
For them, insurance-based trust solutions in the shape of discretionary trusts, loan trusts and discounted gift trusts may well be suitable.
All those who are concerned about inheritance tax should seek to use their available £3,000 annual exemption(s) before the end of the tax year.