Given that there was so little fundamental change in the Budget, I thought it might be opportune to revisit the area of income tax. Changes to allowances and thresholds may be seen as so mundane that the planning opportunities are likely to be overlooked.
The starting rate of 10 per cent for 2001/02 applies on the first £163.1,880 of taxable income, that is, after allowances and reliefs. It should be noted that the starting rate does not apply to trusts. However, it does apply to any capital gains that, when sat on top of income, would fall within this band. Admittedly, this is unlikely but it is worth remembering. Remember, also, that capital gains falling within the basic-rate band will be subject to capital gains tax at 20 not 22 per cent.
For 2001/02, the basic rate of income tax will be 22 per cent and will apply to income in the band £163.1,881 to £163.29,400.
By allocating income and possibly gains between spouses, particularly where the income is currently concentrated in the hands of one spouse and especially where one spouse pays income tax at a higher rate than the other, it is possible to save tax. This reallocation can be achieved by transferring assets, including capital investment bonds to be encashed, unconditionally from one spouse to the other. No capital gains tax or inheritance tax liability will arise on such transfers.
The increase in the higher-rate threshold is likely to mean fewer people will be higher-rate taxpayers. However, over the last 10 years, the number of higher-rate taxpayers has grown because the 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. Consideration should be given to:
Reducing taxable income by offsetting pension contributions against earned income.
Capital growth-orientated unit trusts.
Investments which secure tax relief such as the enterprise investment scheme, venture capital trust and enterprise zone property.
Higher-rate taxpayers might also consider the tax-deferring merits of capital investment bonds because:
They are non-income-producing so there is no need to make an insertion in the tax return until a chargeable gain is made, say, on full encashment or a withdrawal of more than the cumulative unused 5 per cent allowances.
No personal liability to basic-rate tax arises on income and growth although income and gains generated by the underlying investments are taxable.
Tax-efficient “income” can be taken in the form of partial encashments.
The basic rules that apply to capital investment bonds with UK life companies mean, 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 basic-rate tax so the maximum rate of income tax that will arise on such a gain if an encashment is made in 2001/02 will be 18 per cent.
Two particular points need to be noted here:
The gain is not grossed up to reflect the basic-rate tax paid within the insurance company's funds, it is the net gain that is chargeable.
Although the gain is treated as if basic-rate tax has been paid, it is likely the insurance company has paid tax at less than the basic rate. For example, insurance company policyholder funds would currently incur 20 per cent corporation tax on savings income while dividends received with a 10 per cent tax credit would bear no further tax.
Moreover, although a life insurance company is liable to 22 per cent corporation tax on capital gains, in practice, this liability will be at a lower effective rate reflecting loss relief and the ability to realise assets at the best time for tax purposes. As indexation relief is still available to companies, this will apply to the insurance company's investments, meaning the policyholder benefits from this relief.
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 and be subject to tax at his marginal rate of income tax. 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 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 currently qualify for indexation relief, which will have a downward impact on the effective rate of tax suffered by the fund.