Essay: Tax Planning Through Your Investments

NB: This post is a student essay, not personal / professional tax advice.
Whilst everyone’s circumstances are unique, there is a common objective for most people who have a high net worth to want to maximise investment return whilst minimising tax liability.
Would you not agree? Well you can tailor your investment strategy to meet your objectives through; utilising Allowances and Exemptions, using Tax Efficient Investment Wrappers to ensure that your investments work hard for you whilst mitigating Capital Gains and Inheritance Taxes to protect more of your estate for the benefit of your loved ones.
Pensions
We all know and understand that pensions have the benefit of providing for us in retirement however, what about using your pension contributions as a valuable tax planning tool?
Pension contributions as part of tax planning can be used to mitigate personal allowance tax traps as well as Bond and Capital Gains Tax. Please be aware that any calculations shown are on a UK basis.
Maximising Tax Relief:
You receive tax relief on private pension contributions worth up to 100% of your relevant annual earnings. Relevant earnings are broadly earnt income and do not include pension or dividend income.
Tax relief is given automatically if you are a basic rate tax payer or you are paying into a workplace pension and the contribution is taken before deducting income tax. You will have to claim tax relief if you pay income tax above 20% through your self-assessment tax return for 20% if you are a 40% tax rate payer and 25% if you pay tax at 45% if your pension scheme automatically only collects 20%.
Reclaiming Tax Relief:
For anyone earning over £100,000 for every £2 above you will lose £1 personal allowance (tax year 2018/19) and this continues until all your personal allowance is gone. With an income of over £123,700 (tax year 2018/19) all the personal allowance is lost.
Case Study
Mr Smith has an income of £110,000 and so has lost some of his personal allowance. By making a pension contribution of £8,000 net, £10,000 gross he has increased the amount of tax free income through the reclaimed allowance and has also pushed out the basic rate band. As a result, he has saved £4,000 in tax and received relief in the pension of £2,000 this is an effective rate of tax relief of 60% and giving him a pension pot of £10,000 as illustrated below.
Reflection on income distribution
Reflection on Income and tax bands
Mitigating Bond Taxation
Whenever a chargeable gain arises on an investment bond it is assessed for income tax purposes. Putting it simply any gain is divided by the amount of full years that the bond has been held to determine what is known as the ‘slice’. The slice is then added to your income to determine if there is any tax liability.
If the bond is an onshore bond and you remain in the basic rate band then there will be no tax liability as the bond is assumed to have paid basic rate tax within the fund. However, should you fall fully into the higher rate band then a further 20% tax is due and within the additional rate band this would be 25% due.
In principal, with planning, by calculating the amount needed to move some or all the slice into a lower tax band and then make a pension contribution in the same tax year that the bond gain is taxed you have now moved the slice and income into the basic rate tax band. By doing so you have now reduced the tax payable thus increased bank balance and created an increased pension fund. Confirming that a pension contribution can be a very effective method of negating higher rate tax on the encashment of investment bonds.
These principals work similarly for pension contributions for net pay arrangements and for offshore bonds.
Mitigating Capital Gains Tax
Capital Gains Tax (CGT) is the tax charged on the capital gain, profit, that is made on the disposal of an asset. The profit is considered to be taxable income.
CGT rates changed on the 6th April 2016 reducing from 18% to 10% for non and basic rate tax payers and 28% to 20% for higher and additional rate tax payers (Except in relation to gains accruing on the sale of residential property that do not qualify for private residence relief). When the gain is calculated it is added to the top of your income and will include any slice on bond gains.
As described earlier your basic rate band is increased by any grossed up personal pension contribution. So again, by calculating the amount needed to move some or all the gain into a lower tax band and then make a pension contribution in the same tax year that the capital gain is taxed your pension contribution will now have pulled all the income at higher rates of tax into a lower rate tax band. By doing so you have now reduced your tax liability and created an increased pension fund. With careful planning the relief would be greater than the tax payable on the gain.
These principals work similarly for pension contributions paid gross as they reduce the taxable income.
(www.pruadviser.co.uk)
Investment Bonds
Investment bonds can be highly tax efficient investments. They are life insurance policies that allow you to invest in a variety of available funds to meet your attitude to risk.
Investment bonds are not deemed to be income producing assets which means that investors and/or trustees do not need to complete self-assessment tax returns. Funds within a bond can be switched without giving rise to CGT and reinvested income does not give rise to income tax. Bonds can also be assigned unlike ISA and Pensions.
You can take 5% withdrawals of the original capital and they will be regarded as return of capital rather than income. Top slice relief can be used on chargeable gains move you to a higher tax bracket, as described earlier.
Bonds can be taken out on multiple lives unlike ISA and pension investments and can be placed in trust and removed from trust without an Income Tax charge or CGT.
With both onshore and offshore bonds available choosing the right bond for you is very important. The table below shows a comparison of the Tax treatment for each.
ONSHORE OFFSHORE
Tax on Income No further tax payable on a chargeable event above 5% unless you are a higher or additional rate tax payer After 5% cumulative withdrawals the highest marginal rate of tax is payable on a chargeable event.
Tax on Capital Gains Nil Nil
Investment bonds are often used for inheritance tax planning in conjunction with the following types of Trusts, many of which can be set up on either an absolute or discretionary basis. A brief description of trust types is listed below:
• Discounted Gift
Takes part of the investment bond out of the Estate immediately. You have to take an income and the rest of the investment becomes exempt to inheritance tax after 7 years.
• Gift and loan (or loan-only)
The investment bond falls out of the Estate as the loan is repaid, typically at 5% per annum. More suitable for those with a life expectancy of at least 20 years.
• Interest in Possession
Suitable for beneficiaries who require an income with the capital paid, often to another beneficiary, at the end of the term or a predetermined age.
• Retained interest
A portion of the investment bond is gifted to named beneficiaries and the other part is held for the benefit of the Settlor.
• Excluded Property
Suitable for UK resident non domiciled individuals who can exclude an offshore investment bond from being liable to UK Inheritance Tax.
• Will Trusts
A wide variety of trusts can be written in a will with gifts into trust to take place after the death of the Settlor. These can be codified in a will or written posthumously using a Deed of Variation. If no will is in place trusts can be defined by the laws of Intestacy and a bond must be written in a statutory trust.
• Lifestyle Trusts
Lifestyle Trusts are a form of Discretionary Trust where distributions can be made to beneficiaries at future dates for predefined amounts. The Settlor can continue to access capital and the bond would fall outside of the estate after 7 years. After 7 years the trust would continue to be subject to the standard charges for a discretionary trust.
Deciding on which trust to use for an investment bond depends on a variety of factors, such as wanting to be able to change the future beneficiaries, access to capital and/ or income and the domicility of the bond owner.
(www.investment-bond-shop.co.uk/trusts-inheritance-tax-planning)
Individual Savings Account (ISA)
ISA wrappers are extremely tax efficient savings vehicles as they are not subject to income tax or capital gains tax. The current ISA allowance is £20,000 per annum. The junior ISA allowance is £4,128 and is available to children under the age of 18.
You can have any number of different types of ISA however, you can only pay into one of each type each tax year and by investing across your ISA savings you have to ensure that you do not go above the annual allowance.
For example, if you have a cash ISA, a Stocks and Shares ISA and an Innovative Finance ISA and you put £3,000 into your cash ISA, £4,000 into your Innovative Shares ISA you would have £13,000 left of your annual allowance to invest.
The ISA has evolved over the years and there are now several different types available to invest in. Here is a quick overview with pro’s and Con’s.
1. Cash ISA
Pro’s -Low risk way to save tax efficiently. Withdraw cash when you need to and both fixed and variable rates available.
Con’s- low interest rates mean low savings growth.
2. Stocks and Shares ISA
Pro’s – No UK income or capital gains tax. Freedom to invest in line with your attitude to risk. Withdraw money when you need to. Potential to grow money over the longer term.
Con’s – Risk of losing money as you are investing in the stock market. Withdrawing money may not be immediate.
3. Innovative finance ISA
Pro’s – No UK income or capital gains tax. Withdraw money when you need to. Potential to grow money over the longer term.
Con’s – Not covered by the Financial Services Compensation Scheme (FSCS). Risk of losing money as you are investing in the stock market. Withdrawing money may not be immediate.
4. Lifetime ISA
Pro’s – Save towards a first home or retirement (must be opened between age 18-39, although payments can continue until age 50). Receive up to £1,000 free per annum from the government.
Con’s – Restricted eligibility age. Strict rules on what you can withdraw money for and when without paying a penalty.
Flexible ISA Rules
New rules for a flexible ISA were published in 2016. These rules came into place to allow investors to withdraw funds and replace them without having an impact on annual subscription limits. This gives you added flexibility without losing out on your annual allowance. It should be duly noted however, that offering flexibility is optional for ISA Managers and is not available in the Junior or Lifetime ISA.
Estate Planning
Should an owner of an ISA die on or after 6th April 2018 then the ISA will retain its tax-advantaged status during the estate administration period. Ensuring spouse and civil partners will also be entitled to subscribe additional amounts to their ISA, equal to the amount of the deceased’s ISA at the point that it is closed. This is only available up to three years until the date of death.
Investments
ISA contributions can be invested into various assets. These include life insurance policies, gilts, authorised unit trusts and shares in open ended investment company (OEIC’s). You can also invest your ISA into company shares that are eligible for enterprise investment schemes (EIS), venture capital trusts (VCT) and business property relief (BPR). An overview of these latter asset classes is covered below.
In addition to this if you have stocks and shares outside of your ISA wrapper then you can cash them in and make use of your capital gains tax limit and then ‘bed and ISA’ them. It should be noted that the anti-avoidance rules do not apply if you buy back the same stocks and shares through your ISA wrapper.
As you can see it is well worth, due to their tax efficiency, taking advantage of the generous limits available each tax year.
Alternative Investment Market (AIM)
Formed in June 1995 as a sub-market of the London Stock Exchange. It allows shares in smaller companies to float shares more flexibly than the main market and helps fledgling companies to grow and develop to the main market. It is often overlooked or dismissed by mainstream investors. Although not for the fainthearted there are many benefits to investing in an AIM listed company.
Here is a summary of the main benefits available:
• Business Property Relief (BPR) – 100% Inheritance Tax Relief for those who qualify although, the investment must be held for 2 years.
• Enterprise Investment Scheme (EIS) – Listed companies provide 30% initial income tax relief on investment, exemption from CGT on disposal and loss relief. There is also a CGT deferral by reinvestment limited to income tax relief for the year.
• Venture Capital Trust (VCT) –For listed investments there is an exemption from tax on dividends and CGT and there is a 30% Income Tax relief on the amount invested.
• ISA – In August 2013 AIM listed companies were allowed to be included in Individual Savings Accounts. Encouraging longer term investment by providing shelter from IHT, CGT and Income Tax.
• Relief for losses – If an investment fails or disposed at a loss, based on the tax payers tax rate, losses can be relieved against the gains in the year or subsequent year or against income in the year or prior year.
• 0% Stamp Duty – Certain companies that fall under the growth market are exempt from Stamp Duty and Stamp Duty Reserve Tax.
• Entrepreneurs relief – Investors owning at least 5% of a company for over a year may be eligible to reduce their CGT to 10%.
Business Property Relief (BPR)
Business property relief can be extremely valuable, especially if you want to pass down your wealth to your loved ones. BPR came into legislation in 1976, it is an inheritance tax relief provided by the government to encourage you to invest in certain types of companies. These types of investments do tend to be riskier however, the tax relief is designed to offset some of this risk and motivate you to invest into companies that might not be as attractive as mainstream investment options.
If you own shares in qualifying BPR companies on your death these shares are passed on to your beneficiaries free of IHT, if you have held the shares for at least two years. Holding investments in BPR is just like investing in any other type of shares, which means, unlike other forms of estate planning you retain ownership of your investment for your lifetime. It is an investment held in your name and should you need access to it at any time you can sell the shares. However, you do need to be mindful that it may not be as quick and easy to sell as other investments.
A BPR investment is likely to be higher risk and more volatile. The benefit of this tax relief will depend on your own personal circumstances and should be part of a wider strategy. BPR has been part of the UK tax legislation for over 40 years however, like any legislation it could change in the future. HMRC will assess every claim individually including whether the underlying companies that you invest into qualify for BPR when you die. Because of this it is not possible to guarantee that an investment that you make will qualify for relief in the future.
Enterprise Investment Scheme (EIS)
Enterprise Investment Scheme (EIS) was launched in 1994 to encourage private investment into early stage unquoted companies. Its success has been credited with the introduction of the Seed Enterprise Investment Scheme (SEIS), which specifically targets companies in their first two years looking to raise their first £150,000 in funding.
Following the introduction of EIS, Michael Portillo, then Chief Secretary to the Treasury said:- “The purpose of Enterprise Investment Schemes is to recognise that unquoted trading companies can often face considerable difficulties in realising relatively small amounts of share capital. The new scheme is intended to provide a well-targeted means for some of those problems to be overcome.”
(www.enterpriseinvestmentscheme.co.uk)
Again, investing in these types of scheme tends to be riskier however, for the investor it is a tax efficient way to invest in small companies with the ability to utilise a ‘carry back’ facility where investments can be applied to the proceeding tax year.
With an EIS 30% tax relief can be claimed on investments up to 1 million in one tax year if you have enough Income Tax liability to cover it. You can also invest up to £100,000 into SEIS. The shares must be held for at least 3 years from the date of issue or the tax relief will be withdrawn.
An attractive feature is that any gain is CGT free if the shares have been held for at least 3 years and the Income Tax relief was claimed on them. If you hold these types of shares they are normally held for longer time frames which then enables you to accrue your CGT exemption over a longer period.
If the shares are disposed of at a loss you can elect that the amount of losses, less Income Tax relief given can be set against income of the year in which they were disposed or income of the previous year instead of being set against any capital gains.
Payment of CGT can be differed when the gain is invested in shares of an EIS qualifying company. The gain can be made from the disposal of any kind of asset however, the investment must be made one year before or three years after the gain arose.
If as an investor you are connected to the company, you are not eligible for Income Tax relief. Connections are defined through financial interest or employment to the company.
It should also be noted that tax relief will be withdrawn if the company loses its qualifying status.
Case study examples of scenarios
Mr Smith, who is a 45% Tax payer, has invested £10,000 in an EIS company and has held the shares for over 3 years.
The company has done well and doubled its value.
Investment = £20,000
Income Tax Relief = £6,000, as a reduction in Mr Smith’s income tax bill.
Capital Gains Tax = £0
Mr Smith’s gain = £16,000 (profit + income tax relief)
The company value remains the same.
Investment = £20,000
Income Tax Relief = £6,000, as a reduction in Mr Smith’s income tax bill.
Sale of Shares = £20,000
Mr Smith’s gain = £6,000 (from income tax relief)
The company close and the shares are worthless.
Investment = £20,000
Income Tax Relief = £6,000, as a reduction in Mr Smith’s income tax bill.
At risk capital = £14,000
Loss relief on capital at risk @ 45% = £6,300
Mr Smith’s actual loss = £7,700 (£20,000 – [£6,000 + £6,300])
The availability of tax relief on EIS and SEIS investments is dependent on individual circumstances and the company concerned. It is important that you recognise that these can change in the future.
Venture Capital Trust (VCT)
Venture Capital Trust were launched in 1995. VCTs are companies that are listed on the London Stock Exchange that invest in other companies that are not themselves listed. They are classed as a closed-end collective investment scheme designed to provide capital for smaller expanding companies as well as income and/or capital gains for investors.