FINANCIAL PLANNING TIPS
Although the dust is still settling on the recent Budget announcements and we await the supporting legislation, we’ve come up with some planning ideas that have been inspired by the Budget as well as a reminder of a couple of established but less-well-known ideas.
Use capital losses and the annual exemption wisely
The Budget announced a rise in the capital gains tax (CGT) rate from 18% to 28% from 23rd June for most trusts and those individuals whose income and net gains (i.e. after current year losses) exceed the threshold at which higher-rate income tax is charged (£37,400 for 2010/11) after deducting the annual CGT exemption (£10,100 for 2010/11). As a consequence, for the 2010/11 tax year only, taxpayers will be able to deduct losses and the annual exemption in a way which minimises the tax due.
For example, consider Shirley, who has a taxable income of £27,400 in 2010/11 after all allowable deductions and her personal allowance. Shirley sold a non-business asset in May 2010 and as a result realised a chargeable gain of £20,000. In August 2010, Shirley sells another non-business asset, realising a chargeable gain of £25,100. Shirley has no losses to set against these gains.
What Shirley should do is to set her annual exemption of £10,100 against the gain arising in August, because that part of the gain is liable to tax at the higher CGT rate, leaving her with £15,000 of that gain taxable. The first £10,000 of that remaining £15,000 August gain is taxed at 18% because it falls within Shirley’s remaining unused basic-rate income tax band. The remaining £5,000 is taxed at 28%. The £20,000 chargeable gain realised in May, before the change in the CGT rate, will be taxed at the old 18% rate and has no impact on the post-22nd June gains computation.
If you realise a loss in the same tax year as a gain, the loss will be offset against the gain, even if the gain is within your annual exemption. As a result, you could end up wasting the loss, which is now more valuable as a result of the increase in the rate of CGT. However, any carried-forward capital losses from earlier tax years may be allocated against post-22nd June 2010 gains which are subject to 28% tax, rather than gains arising between 6th April and 22nd June 2010, which are subject to the old 18% rate. Some investors may prefer to pay 28% tax and preserve carried-forward losses if they anticipate CGT rising further in future years.
Use pension contributions to minimise other taxes
The Budget confirmed that the current anti-forestalling rules would remain. These restrict higher-rate tax relief on pension contributions of between £20,000 and £30,000 for those earning more than £130,000 relevant earnings in 2010/11 (or in either of the two previous tax years). However, the Budget also confirmed that the government will abolish the (complex) legislation that was to have come into effect from 6th April 2011 restricting higher-rate tax relief and instead will aim to achieve the same fiscal result by lowering the pension annual allowance from £255,000 to somewhere between £30,000 and £45,000.
The implication for those who are not caught by the current anti-forestalling rules, and particularly those with income subject to higher-rate tax, is that they should consider making the maximum pension contribution now, before the annual allowance falls to about a fifth of its current amount. An employer, including one’s own business, may make a pension contribution of up to the annual allowance of £255,000 on behalf of an employee, and this will be tax-deductible, providing that it passes the ‘wholly and exclusively for business purposes’ test. The contribution could also be funded by salary ‘exchange’ and this will generate National Insurance savings that could be added to the contribution.
An individual may make a personal contribution to a pension of the higher of 100% of relevant earnings (up to £255,000) or £3,600 each tax year. Making a personal contribution to a pension expands the basic rate band and as a result can reduce or avoid other taxes, to the extent that such taxes are determined by reference to the available basic rate income tax band.
Personal contributions to a pension are deductible from earnings to determine ‘adjusted net income’ for the purposes of the £100,000 income limit, above which the personal allowance is reduced. If ‘adjusted net income’ remains below £100,000 then the personal income tax allowance will be preserved, amounting to an effective tax relief of 60%.
Chargeable gains on life insurance investment bonds are calculated by reference to whether one has any basic rate income tax band available and it may well apply to the new CGT tax rules, more of which later.
Take the example of Malcolm, who has an onshore investment bond worth £250,000, against an original investment of £150,000. He has owned the bond for 10 years and has never made a withdrawal. Malcolm has taxable income from various sources that, after deducting his personal allowance, amounts to £37,400. If Malcolm encashes the bond (assuming his spouse is not a basic-rate taxpayer to whom he can assign it beforehand), the entire gain on the bond will be taxed at 20%, as the life company will have accounted for tax at the basic rate within the fund but all the bond gains exceed Malcolm’s higher-rate tax threshold. Thus, Malcolm’s tax charge would amount to £20,000 (£100,000 × 20%).
If, however, Malcolm made a personal pension contribution of £10,000 (which actually costs him £8,000 because he pays it net of basic rate tax), he could avoid that tax charge and secure effective tax relief of 275%! This is because the pension contribution extends the basic rate band by £10,000 and as such Malcolm now has some basic rate income tax band available. The bond gain of £100,000 is divided by the number of complete policy years (known as top slicing), which in this case is ten years, thus resulting in a ‘sliced’ gain of £10,000. This sliced gain is added to Malcolm’s other income and, as it falls below the higher-rate income tax threshold, no further tax is payable.
The effective tax relief of 275% is derived by adding the tax saved on the bond to the tax relief given at source on the pension contribution and dividing that amount by the net cost of the pension contribution:
£20,000 + £2,000 × 100 = 275%
£8,000
I mentioned earlier the new CGT rules and the fact that the tax charge of 18 or 28% is determined by the total level of taxable income and whether the capital gains fall within the higher-rate threshold of £37,400. If higher-rate income tax relief on pension contributions continues to be given by the extension of the basic rate band by the amount of the gross contribution, and this is effective for the purposes of determining whether the 28 or 18% rate of CGT is applicable, then the payment of an allowable pension contribution would represent an effective way of obtaining an indirect CGT benefit. This is because it would result in an equivalent amount of capital gains being taxed at 18% rather than at 28%. As soon as we see the Finance Act legislation we’ll update readers on whether this planning is effective or not.
Employ your children
The basic principle is that an employer can pay salary of up to £15,480 per annum for any employee while they are in full-time education and that salary is free of income tax and NI when it is paid while the employee is in term time. There is, therefore, no reason why you couldn’t employ your own child, grandchild, niece or nephew in your business, as long as you give them a contract of employment and abide with the minimum wage legislation etc. Your business would then be able to continue to pay them a salary of up to £15,480 per annum when they go to university or collage.
The salary paid will be tax-deductible by your business for tax purposes so it is a very tax-efficient method of funding their education. MPs have been using this ‘loophole’ for years by employing their children as ‘researchers’ prior to their going to university but the public never seem to have heard about it. The detailed conditions were last updated in 2007 and are helpfully set out on a website (http://www.hmrc.gov.uk/manuals/eimanual/eim06237.htm).
Transfer your UK FURBS overseas
When pension simplification was introduced in April 2006, pension plans were categorised as either registered (the tax-relieved type with annual and lifetime limits etc.) or unregistered. Funded unapproved retirement benefit schemes (FURBS) were re-classified as unregistered pensions. In the absence of any election to make the unregistered plan a registered plan, a FURBS could be retained and the value does not count towards one’s lifetime allowance for registered pension plans (currently £1.8m if a higher protected amount does not apply).
A FURBS continues to enjoy freedom from inheritance tax (IHT). A UK FURBS, however, is subject to tax on income and gains arising on the underlying investments it holds at the penal ‘rate applicable to trusts’ (RAT). This means that interest is taxed at 50% and dividends at 42.5%, while gains are taxed at 28%. An overseas FURBS in a stable jurisdiction like Guernsey would not be subject to taxation on income and capital gains. Because it is not possible to reclaim any withholding tax that is levied on UK-based funds, it is best to use non-UK-sited funds and investments, such as those based in Dublin.
An additional feature of a well-drafted offshore FURBS is that it may invest in a wide range of investments, including residential property and other ‘exotica’. Loans are permitted if required, and these have the benefit of forming a debt on the FURBS member’s estate for IHT purposes. Incredibly, in many cases, the overseas FURBS is actually cheaper than the UK FURBS.
Jason Butler is a Chartered Financial Planner and Investment Manager at City-based Bloomsbury Financial Planning. He has twenty years’ experience in advising successful individuals and their families on wealth-management strategies. Jason can be contacted by email: jasonbutler@bloomsburyfp.co.uk or telephone: 020 7194 7830.