February and March are key months to consider tax planning to maximise the use of allowances, relief, exemp-tions, etc, for the tax year. Some of these will be lost if not used before the year-end.
Tax planning is an impor-tant part of financial plann-ing but it is not the only part. It is essential that any tax planning strategy being considered also makes commercial sense.
As well as last-minute tax planning for 2006/07, the year-end is also a good time to put in place strategies that can minimise tax over the coming year.
1: INCOME TAX PLANNING 1.1 PENSIONS
The new pension rules introduced in April 2006 have made pension saving a lot easier for almost everyone.
There are now two key limits when you are making pension savings – an annual limit on how much can be input to all your pensions during the year – the annual allowance – and a limit on the total amount that can be accumulated within all your pensions – the lifetime allowance.
The annual allowance starts at £215,000 in the 2006/07 tax year and is the limit on how much extra can be accumulated within all of your pension schemes during the tax year. For this purpose, the benefits and aggregate contributions will be valued for those scheme years ending within the 2006/07 tax year. This annual limit increases each year and will be £255,000 for 2010/11.
The lifetime allowance starts at £1.5m in the 2006/07 tax year and is the maximum amount you can accumulate in all of your pension funds and still get favourable tax treatment when you take benefits. This limit increases each year and will be £1.8m in the 2010/11 tax year.
There have also been very significant changes in assessing the maximum personal contribution that you can make. To be eligible for tax relief, you can pay the higher of £3,600 or your total UK earnings.
Contributions are normally paid net of basic-rate tax and if you are a higher-rate taxpayer, further tax relief can be obtained through your self-assessment tax return. An employer can also pay contributions – see later.
There is now no ability to carry forward unused pension allowances to future years or carry back pension contributions to earlier years for tax relief purposes.
Another very significant change is that you can now belong and contribute to as many pension arrangements as you like. This is of particular interest to people who are members of their employer’s pension scheme as, up until April 6, 2006, there were only limited opportunities to make additional savings to pensions and still get tax relief on contributions.
Now, if you are a member of your employer’s company scheme, you can also take out the pension policy of your choice to run alongside. You only need to check that you remain within the generous limits of not making personal contributions exceeding your UK income and the total input to your pensions not exceeding £215,000 in the tax year.
Your pension savings can be in addition to any AVCs or FSAVCs that you may also be making.
1.2: INDEPENDENT TAXATION
The tax-saving opportunities available for married couples continue and are now also available to same-sex couples who have registered as civil partners. Accordingly, references to spouses and married couples include same-sex partners who are registered civil partners.
The following are the main tips for saving tax through independent taxation. Most of these need a full tax year to operate to give 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 year.
Where a higher-rate taxpaying working spouse owns investments, income from these may suffer income tax at a rate of up to 40 per cent or 32.5 per cent (if dividends).
Subject to practical considerations, the transfer of investments to a non-working spouse can save tax and increase overall investment returns. Such transfers must be outright and unconditional.
Where possible, a couple should try to ensure that pension plans are made for each of them so that at least there will be some income stream in retirement that will be available to use that individual’s personal allowance (see also below).
You should try to make maximum use of all personal allowances available to you and your family.
A husband and wife each have their own personal allowance. This is particularly relevant where one spouse is a non-taxpayer or 10 per cent/basic-rate taxpayer and the other is a higher-rate taxpayer.
A non-working spouse can receive income of £5,035 for tax year 2006/07 before he or she pays any tax and the next £2,150 is taxed at only 10 per cent.
Older married couples benefit from an increased age-related personal allowance , frequently called age allowance. This is cut back if the total income of a particular spouse exceeds £20,100 for tax year 2006/07.
This limit applies separately to each of a married couple. Careful planning by transferring investment capital to rearrange income between spouses can improve tax efficiency.
If you are engaged in a business, it can sometimes be worth considering the payment of a salary to a lower or non-taxpaying spouse, provided, he or she performs work for the business that justifies the payment.
This could be at such a level to ensure it is free of income tax and National Insurance – currently up to £97 a week, increasing to £100 a week for tax year 2007/08, assuming this is the taxpayer’s sole source of income. A pension payment can then be made in respect of this salary, meaning more tax savings are secured into retirement.
Individual Savings Accounts
The Isa is still the main method of investing with freedom from income tax and capital gains tax.
The Government recently proposed the Isa will run as an open-ended product beyond 2010, with the overall annual contribution limit being at least £7,000. It is also planned to remove the maxi/mini distinction and a facility introduced to switch from a cash Isa to a stocks and shares Isa, but not vice versa).
Up to £7,000 a year can be contributed by each of a couple, regardless of the source of the funds. This means a couple could save £14,000 a year in to these tax-efficient funds.
If the £7,000 allowance is not used in a tax year it will be lost. The Isa season is well and truly upon us.
Enterprise investment schemes
The EIS offers tax relief on an investment in new shares of an unquoted trading company which satisfies certain conditions.
Certain companies listed on the Alternative Investment Market qualify as EIS companies. For 2006/07, an investment up to £400,000 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 into an EIS, provided that some of the EIS investment potentially qualifies for income tax relief.
If you have disposed of any assets and this has resulted in a taxable gain arising which will incur a capital gains tax liability, payment of tax on such a gain can be deferred if you reinvest an amount equal to the untapered gain in an EIS within three years of the disposal.
Venture capital trusts
VCTs offer income tax relief for tax year 2006/07 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 tax otherwise payable.
There is no ability to defer capital gains tax, as with an EIS investment, but dividends and capital gains generated on amounts invested within the annual subscription limit are tax-free.
For both the EIS and the VCT, it is essential that would-be investors are aware of the likely greater investment risk and lower liquidity that will have to be accepted in return for the attractive tax relief.
1.4: GIFTS FOR CHILDREN/ GRANDCHILDREN
Again, most of the opportunities for tax saving take a full year to work so the end of the tax year is a great time to think about laying the foundations for minimising tax in the next tax year.
Bare trusts for children and grandchildren
It is possible to make use of children’s and grandchildren’s income tax personal allowances by establishing suitable trusts to hold investments. In particular, provided that the donor is happy that the child/grandchild will be absolutely entitled, a bare trust could be considered.
Remember, however, that where a parent creates a trust for a minor unmarried child not in a civil partnership, under which that child is entitled to the income (for example under a bare trust), and the income exceeds £100 gross in a tax year, it will be assessed on the parent regardless of whether it is distributed or accumulated.
The capital gains tax upside of a bare trust is the ability to offset the child’s annual capital gains tax exemption against capital gains – see later.
Finally, on bare trusts, it must be kept in mind that currently HMRC seems to have the view that these trusts for minors should be treated as being discretion-ary for inheritance tax purposes. The relevance of this in practice would substantially depend on the value of the trust property.
Discretionary trusts for grandchildren
A bare trust could be suitable where the donor is a grandparent but a discretionary trust may give more control over the assets gifted and secure an income tax benefit.
Provided income is not taxed on the settlor, that is, where neither the settlor nor the settlor’s spouse can benefit, income will be taxed on the trustees.
The first £1,000 of gross income per discretionary trust in a tax year falls within the standard rate tax band which means the normal trustee rate of 40 per cent or 32.5 per cent will not apply to the first £1,000 of grossed-up income in a tax year.
2: CAPITAL GAINS TAX PLANNING
The following are the key planning opportunities that should be considered as the tax year-end approaches.
2.1: ANNUAL EXEMPTION
The annual capital gains tax exemption for individuals is £8,800 for 2006/07 and £4,400 for most trustees.
The annual exemption cannot be carried forward. If you have investments with inherent gains, you should consider making disposals to realise any gains within the annual exemption.
If you want to sell and repurchase stocks or shares, this must take place over a period of more than 30 days or with somebody else, say your spouse or your Isa manager, buying back the stocks or shares.
The annual exemption is available to both a husband and wife and so, between them, capital gains of up to £17,600 in tax year 2006/07 can be realised without any capital gains tax liability.
Transfers between spouses living together are on a “no gain/no loss” basis so, as long as any transfer is outright and unconditional, a prior transfer to a spouse could effectively double the potential use of the annual exemption.
Capital losses could also be crystallised for tax purposes if gains in excess of the annual exemption have arisen in the same tax year. Remember, losses cannot be used if generated solely by virtue of the indexation allowance which is frozen at April 1998.
If you are contemplating making a disposal in the near future which will trigger a capital gain in excess of £8,800, it may be worthwhile, if legally and practically possible, to spread the disposal across two tax years.
Alternatively, if the disposal cannot be spread or is very substantial, you could delay the disposal until after April 5, 2007 to defer the payment of capital gains tax until January 31, 2009.
If you have realised a capital gain within the last three years, consider taking advantage of the deferral relief available on investments into an enterprise investment scheme (see 1.3 above).
Gains under a bare trust (even for a minor unmarried child) will be treated as having been made by the beneficiary regardless of who the settlor is.
Thus, that beneficiary’s annual exemption will be available on gains made on trust assets. This may make the bare trust described in 1.4 above even more attractive.
2.2: USING LOSSES
Consider realising losses on investments to offset against capital gains. Do not cause net capital gains to fall below £8,800 or part of the annual exemption will be wasted. Carried-forward losses can be offset to the extent that they reduce current year capital gains to £8,800.
3: ESTATE PLANNING
Inheritance tax has assumed greater importance over the last couple of years. It is certainly one of the most emotive taxes, with taxpayers and the popular press expressing a strong sense of injustice, especially over the impact of the tax on residential property.
If your estate is likely to be subject to IHT on your death, planning action should be considered now while effective planning opportunities are still available.
One of the simplest methods of inheritance tax planning is to make full use of this year’s annual exemption (£3,000) and any unused exemption from the previous year. It is important to remember that it is necessary to use the current year’s exemption before using any of the previous year’s available exemption.
The exemption is available to both a husband and wife and is now more important, as an exempt transfer can reduce a chargeable lifetime transfer.
The normal expenditure out of income exemption can also be useful. To use this exemption, gifts must be:
– Made out of income, and
– Of such a size as not to affect your normal standard of living.
An appropriate life insurance policy held in trust may be a good way of using this exemption (see later).
Where it is not possible to make an outright gift because of the need for continued income, the use of an insurance-based trust arrangement, such as a loan trust or discounted gift trust, may provide you with IHT planning combined with future access to regular capital payments which can be used to supp- lement income.
There are a number of plans available, generally on a bare trust or non-bare trust basis as appropriate, each appropriate to people in different circumstances with varying objectives.
HM Revenue and Customs has confirmed that the more popular forms of lump sum insurance-based inheritance tax plans will not be subject to the pre-owned assets income tax rules.
Care needs to be exercised over the application (or otherwise) of the relevant property (discretionary trust) regime, especially given the current uncertainty over bare trusts for minors, and the resulting potential for entry, periodic and exit charges. Advice is absolutely essential.
Premium payments to a life insurance policy (on a basis of joint lives, last survivor for a married couple) under trust will often be a simple, economic and acceptable way of providing cash on death that is free of IHT and using the annual and normal expenditure out of income exemptions. In some cases, it may even be appropriate for the beneficiaries to contribute towards the premium payments.
Don’t forget that if your client is a director of a private company with a March 31 financial year-end, there may well be opportunities for the corporate tax position to be improved through action taken before the year-end.
The tax-saving qualities of deductible contributions to registered pension arrangements and the potential to minimise outflow to the authorities through careful dividend/ salary/pension planning should very much be on the year-end planning agenda for these clients.