March is a key month in which to consider tax planning to maximise the use of an individual’s allowances, reliefs, exemptions etc 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 strategies 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 6 April 2010. This means that prior action is needed for a person to optimise their tax position.  As a result financial advisers have an excellent reason to talk to clients who will be affected by the increases.

Of course, tax planning is an important part of financial planning, but it is not the only part.  It is essential, therefore, that any tax planning strategy being considered also makes commercial sense.

In this bulletin all references to married couples include registered civil partners.

1.     INCOME TAX PLANNING

Income tax rates are currently 10% (on certain investment income), 20% and 40%.  Four key changes will take place from 6 April 2010:-

(i)        the standard personal allowance will be frozen at the 2009/10 rate (£6,475)

(ii)      the threshold for the start of higher rate tax will be frozen at £37,400

(iii)     a 50% 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 a number of ways in which tax increases can be combated:-

(i)            Maximising use of a couple’s allowances, reliefs and exemptions

(ii)          Utilising tax exemptions and allowances

(iii)         Using tax efficient investments

We deal with all of these in more detail below.

1.1       Maximising use of a couple’s allowances, reliefs and exemptions

Planning to maximise the use of a couple’s allowances, reliefs and exemptions has become much more important following the Chancellor’s announcement that the top rate of income tax will increase to 50% for those with taxable income of more than £150,000; and the introduction of an effective rate of 60% on income between £100,000 and £112,950 caused by the withdrawal of the personal allowance.  For such people, 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.  But don’t forget the tax savings are still attractive for the increased number of people who will be 40% taxpayers and, for them, income tax saving opportunities still exist for married couples who carry out appropriate planning. 

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 year. The appropriate type of tax planning to adopt will depend on the type of income a person enjoys ie. earned/business income or investment income.

(A)       EARNED INCOME

(i)         Employment income

(a)       Employers could pay bonuses and dividends before 6 April 2010 – except to certain bankers of course!

(b)       Employers could consider paying, say, three years’ worth of salary and bonus this tax year to top employees, who then loan the money back to their employer in return for an agreed rate of interest over the three-year period.

(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.

(d)       There are a number of ways to reward employees through share option schemes on which capital gains tax at (currently) 18% is paid as opposed to up to 50% tax on income.

 

(ii)        Owner/directors of a private limited company

Points to consider for 2010/11 for these people are:

(i)         Where married couples run their business through a company, it will be sensible for salary payments or dividends to be shared as evenly as possible.  Following the taxpayer’s success in the case of Jones v Garnett (2007) – the so-called “Arctic Systems” case – the Government’s income-shifting proposals have been put on hold for the time being.

(ii)        In the run up to next year’s tax increases, owner/directors will no doubt consider maximising the salary and dividends taken out of the business before 6 April 2010, thereby paying tax at 40% and 32.5%, rather than at 50% on income and 42.5% on dividends over £150,000 after 5 April 2010. Any such “advanced” payments can be lent back to the business if a cash flow challenge exists.

 

(iii)       Tax relief on pension contributions is to be restricted for those with high incomes.

(B)       INVESTMENT INCOME

Where a higher rate taxpaying spouse owns investments, income from these may suffer tax at a rate of up to 40% or 32.5% (if dividends).  These rates could be as high as 50% and 42.5% respectively from 6 April 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.

1.2    Utilising tax exemptions and allowances

• Where possible, a couple should try to ensure that they both have pension plans to provide an income stream in retirement that will also use their personal allowances.

 

• Clients 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 income-producing assets between couples where one would otherwise exceed the age allowance limit of £22,900 (2009/10 and 2010/11).

 

1.3    Using tax efficient investments

With the rates of tax effectively increasing, it is most important that people invest in the most tax efficient way possible.

(a)       ISAs

The ISA is still the main method of investing savings with freedom from income tax and capital gains tax.  There are still two types of ISA – a cash ISA and a stocks and shares ISA.  The overall annual contribution limit is £7,200 of which no more than £3,600 can go into cash.  The balance can be invested in a stocks and shares ISA.  This means a couple could invest £14,400 between them.  Those investors aged over 50 in this tax year can currently invest up to £10,200 into an ISA – £5,100 of which can be in a cash ISA.  For somebody over age 50 who has not yet used all of their increased ISA allowance of £10,200, now could be the time to do this.  From 6 April 2010, the increased ISA investment limit applies to all qualifying individuals irrespective of age.

(b)         Other tax efficient investments

 

•       Growth-orientated unit trusts/OEICs

 

Given the relatively high rates of income tax as compared to the current rate of capital gains tax (CGT), it makes tax sense to invest for capital growth as opposed to income.  Whilst we mustn’t forget that CGT rates may well increase in the future – especially after the forthcoming General Election – 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 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 encashment  with excess gains only suffering tax at 18% currently.  For couples, it makes sense for them both to invest in order to be able to use both annual CGT exemptions when investments are encashed.

• 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, any dividend income accumulates without corporation tax within a UK insurance company’s internal investment funds.  However, bonds are not so tax efficient from a CGT standpoint with  capital gains  (after indexation allowance) realised by the UK  life fund suffering corporation tax of up to 20% .  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 tax charge may be mitigated involve the following strategies:-

(i)            defer 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% tax-deferred withdrawal facility

(ii)          assign the bond to an adult basic rate or non-taxpaying relative (say spouse or children) pre encashment; the assignment will not trigger a tax charge and tax should be avoided on subsequent encashment.

Of course, 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. Advice is essential.

(c)       Enterprise Investment Scheme (EIS)

The EIS offers tax relief on an investment in new shares of an unquoted trading company which satisfies certain conditions.  For tax year 2009/10 an investment of up to £500,000 can be made to secure income tax relief at up to 20% 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.

(d)       Venture Capital Trust (VCT)

The VCT offers income tax relief for tax year 2009/10 at up to 30% for an investment of up to £200,000 in new shares, with relief being restricted to the amount of income 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 reliefs.

2.     DEALING WITH THE LOSS OF THE PERSONAL ALLOWANCE

From 6 April 2010, the standard personal allowance will be subject to a single income limit of £100,000.  Where an individual’s “adjusted net income” is below or equal to the £100,000 limit, they will continue to be entitled to the full amount of the standard personal allowance.

Where an individual’s adjusted net income is above the income limit of £100,000, the amount of allowance will be reduced by £1 for every £2 above the income limit.  The personal allowance can be reduced to nil from this 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 their personal allowance.  How can they plan for this forthcoming tax change?  Well, much will depend on the type of income that causes the cut back.

 

Earned income

Where it is earned income that takes the individual into the £100,000-£112,950 income bracket they should seek to reduce this by either

-               paying a pension contribution or

-               arranging for a salary sacrifice

This could achieve an effective tax saving at 60%.

Investment income

Where it is investment income that causes an individual’s adjusted net income to fall into the £100,000-£112,950 band then, depending on their circumstances, any of 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 tax efficient 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% tax-deferred withdrawal may be taken each year, for 20 years, without affecting the personal allowance calculation.

3.     PENSIONS

Any year-end pensions 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 certain 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 high earners, with effect from 6 April 2011. A change was also implemented, with effect from 9 December 2009, to the anti-forestalling provisions designed to stop those individuals likely to be affected by the new rules from April 2011 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 earners 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 6 April 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 (ie. normally £20,000 but potentially up to £30,000 where “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 (ie. normally £20,000 but potentially up to £30,000 where “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.

 

4.     NATIONAL INSURANCE CONTRIBUTIONS (NICs)

This is becoming a real “stealth” tax.  In the March 2009 Budget the Government announced an increase in NICs of 0.5% for employees and employers and in the surcharge  with effect from 6 April 2011.  It was announced in the 2009 Pre-Budget Report that these NIC rates are now each scheduled to go up by 1% (instead of 0.5%) to 12% (employee) and 13.8%  (employer).  Employees will also pay a 2%  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.

It is important that the arrangement is established correctly in order to get the desired fiscal consequences.  Also it is important to note that the reduction in salary can have other consequences – for example, the individual’s salary is reduced for other purposes including pension benefit entitlement and calculating the maximum mortgage available.  Given the Government’s drive to produce more revenue, salary sacrifice arrangements are likely to have a limited shelf life so people should make the most of them while they can. 

5.     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. Since a flat rate of tax of 18% has been introduced the only advantage of such transfers is to use the annual CGT exemption of the transferee spouse.

 

• In all CGT planning careful thought needs to be given to the possibility of a future increase in the rate of CGT payable.

 

6.     INHERITANCE TAX

Given the changes in the economy, it was no surprise that the inheritance tax nil rate band was frozen at £325,000 in the Pre-Budget Report.  The freezing of the nil rate band is clearly bad news for some wealthier clients who have a potential IHT 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.  Call us for more information. 

All clients who are concerned about inheritance tax should seek to use their available £3,000 annual exemption(s) before the end of the tax year.

The announcement by the Government in the 2009 Budget that the annual Individual Savings Account (ISA) subscription limit was to increase to £10,200  (from £7,200) for those aged at least 50 in tax year 2009/10 may not have seemed much of a concession – especially given the current low dividend and interest yields.  However, in a climate where people need to take more personal control over their retirement provision, this can be a useful long-term concession.  For example, for somebody aged 45 now who plans to retire in 20 years’ time, this will mean that an extra £60,000 can be salted away into an ISA over that 20 year period.  And as this will be accumulating in a highly tax efficient environment, this will provide an opportunity for better investment returns, particularly for the higher rate taxpayer who will not then pay higher rate tax on dividend income or interest.

For the 50 year olds who can now invest £10,200 in an ISA, up to £5,100 of this can be invested in a cash ISA.  From 6 April 2010, these limits will apply to everyone who is eligible, irrespective of age.

Here is a recap of the main tax benefits of ISAs:-

• Taxpayers who pay CGT can save £1,800 for every £10,000 of capital gain

 

On gains that exceed the annual exemption of £10,100 (2009/10), CGT is now only 18%.  Whilst this tax rate is low it needs to be remembered that neither taper relief nor indexation allowance have been available to private investors since April 2008 and so taxable gains will be correspondingly higher.

“Bed and breakfasting” (selling a holding then buying it back to rebase the base cost with the aim of using the annual CGT exemption and saving future CGT) is not permitted within a 30 day period.  However, an investor can “bed and ISA”.  This means that funds or shares to the value of £7,200 (£10,200 for the over 50s) can be sold and repurchased in an ISA – at the same day’s prices.  Because future growth and income within the ISA are free of tax, this is an ideal way to shelter existing investments from tax.  The sale into the ISA creates a charge to CGT, but the capital gain is usually covered by the CGT annual exemption.

In April 2010, a couple who are over 50 could transfer £40,800 of existing shares or funds into ISAs (by investing in two instalments so as to use their two tax years’ ISA allowances).  Care would have to be taken that the capital gain arising on the shares or funds sold did not exceed their annual CGT exemptions.

• Employees in Save As Your Earn (SAYE) option schemes and Share Incentive Plans (SIPs) can, on maturity, transfer shares to the value of the ISA contribution limit and so avoid future CGT on the growth 

 

Employees have 90 days to transfer maturing shares from SAYE schemes/SIPs into an ISA.  The value of the shares transferred counts as the ISA contribution. Once inside the ISA there is no CGT (or income tax on future dividends) to pay.

• Basic rate taxpayers can save as much as £2,000 on £10,000 of income within the ISA

 

Basic rate taxpayers save 20% income tax on interest generated from a cash or fixed-interest ISA.  No income tax saving arises on shares in an ISA investing in equities because the notional 10% tax credit on dividends meets their basic rate liability outside the ISA and the tax credit is not recoverable inside the ISA.

• Higher rate taxpayers can save as much as £4,000 on £10,000 of income within the ISA

 

Higher rate taxpayers pay 40% income tax on interest from cash and fixed-interest funds and 22.5% additional income tax on grossed-up dividend income from equity funds.  No higher rate tax is paid by the investor on income arising on investments within an ISA.

From April 2010, investors whose taxable income exceeds £150,000 a year will pay 50% tax on income above the £150,000 limit.  These investors can therefore save 50% income tax on interest from cash and fixed-interest funds and 32.5% income tax on dividend income from equity funds.  For example, a £90 net dividend represents a £100 gross dividend and, if held direct, these investors would pay an additional £32.50 in tax.  If the investment is held in an ISA, this is not paid.

• Persons aged over 65, with income of £22,900 or more, can save up to £603 in income tax

For those investors aged 65 to 74, the personal allowance increases from £6,475 to £9,490.  However, for every £2 of income over £22,900 the additional age-related allowance is reduced by £1 and is completely extinguished when income reaches £28,930.  This represents an effective tax rate of 30%, and for those with income of £28,930 will attract an additional £603 in income tax.  As ISA income does not count towards this age allowance test, by holding investments in an ISA this can save up to £603 a year.

• Those with income of £100,000 and over can save up to as £2,590 by avoiding the loss of the basic personal allowance (2010/11)

 

The Government has introduced a new personal allowance “stealth” tax for those with an annual income of £100,000 or more.  From 2010/11 the basic personal allowance of such people is gradually reduced.  For every £2 of income over £100,000, the basic personal allowance reduces by £1 and is completely extinguished by the time that income reaches £112,950 (assuming the basic personal allowance remains the same in 2010/11).  This is an effective tax rate of 60% on income in this band and for those with income of £112,950, will attract an extra £2,590 in tax. 

For some people in this position it may be possible to reduce their income below £100,000 by reallocating investments between spouses and by investing in other tax-free or tax efficient investments.  One such investment is an ISA because ISA income does not count towards this personal allowance test.  In the right circumstances, if a person can fully reinstate their personal allowance, they can save up to £2,590 a year in tax.

This newsletter is provided strictly for general consideration only.  No action must be taken or refrained from based on its contents alone.  Accordingly no responsibility can be assumed for any loss occasioned in connection with the content hereof and any such action or inaction.  Professional advice is necessary for every case. 

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