FYI Profesional – End of year Tax Planning
The run up to the tax year end is a good time to consider tax planning to maximise the use of an individual’s allowances, reliefs and exemptions for the current tax year. Some of these will be lost if not used before the tax year end. For those people who currently pay higher rate (40%) income tax and 45% additional rate income tax, tax planning at the end of this year is absolutely vital as a means of minimising tax payable and so maximising net income, capital gains and wealth. This is particularly the case with pension planning because allowances are being reduced from 6 April 2014.
As well as last-minute tax planning for 2013/14, now is also a good time to put in place strategies to minimise tax throughout 2014/15.
In this bulletin we will cover the main planning opportunities open to UK resident individuals for tax year 2013/14, which ends on 5 April 2014, and look at the strategies and disciplines to put in place to minimise tax in 2014/15.
While tax planning is an important part of financial planning, it is not the only part. It is essential, therefore, that any tax planning strategy that is being considered also makes commercial sense and sits well inside your other personal objectives.
In this bulletin all references to married couples include registered civil partners.
1. INCOME TAX PLANNING
There are four main income tax factors that are relevant for 2013/14:-
(i) the basic personal allowance of £9,440. (This is due to substantially increase to £10,000 in 2014/15). Whilst there will, in certain circumstances, be an ability for a non-taxpaying spouse to transfer a part of their personal allowance to a spouse paying basic rate tax, this will not be effective until 6 April 2015
(ii) the threshold for the start of higher rate tax is £32,010 (which reduces to £31,865 in 2014/15 but this is counterbalanced by the increase in the personal allowance)
(iii) a 45% tax rate applies to taxable income that exceeds £150,000
(iv) people with income of more than £100,000 lose some or all of their basic personal allowance
There is no doubt that the number of higher rate taxpayers is increasing. The impact of (iii) and (iv) will also mean that people with income of more than £150,000 and £100,000 respectively will continue to pay marginal rates of income tax of up to 60% on some of that income.
Tax increases can be combated in a number of ways including:-
(i) Maximising the use of all of a couple’s allowances, reliefs and exemptions
(ii) Using tax-efficient investments
We will now deal with these in more detail.
1.1 MAXIMISING USE OF ALL OF A MARRIED COUPLE’S ALLOWANCES, RELIEFS AND EXEMPTIONS
Planning to maximise the use of a married couple’s allowances, reliefs and exemptions has become even more important for those whose top rate of income tax is 45% because they have taxable income of more than £150,000. For such people who are married, the tax savings available by diverting income into the lower income earner’s name will be even more substantial. The tax savings that can arise from such planning can be just as important for the higher rate (40%) taxpayer who is married to a lower rate or non-taxpaying spouse. And don’t forget that because of the Government’s change in the tax rules, the number of higher rate taxpayers is increasing.
Similar planning may be appropriate for couples where one has income between £100,000 and £118,880. Where an individual’s adjusted net income is above the income limit of £100,000, the basic personal 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 basic personal allowance of £9,440 for 2013/14, an adjusted net income of £118,880 or above would mean that no personal allowance is available and non-dividend income in that £18,880 band is being effectively taxed at 60%.
Most of these strategies need a full tax year to deliver maximum effect so these suggestions may serve more as a reminder to plan ahead for the coming tax year than as a “last minute” 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.
(i) Earned income
Where it is earned income that takes the individual into the £100,000-£118,880 bracket they could consider reducing this by adopting one or more of the following strategies:
– paying a pension contribution or
– arranging for a salary sacrifice
With the marginal rate of tax in the £100,000-£118,880 band of earned income being 60% it may thus be possible to obtain 60% tax relief on some pension contributions.
(ii) Investment income
Where it is investment income that causes the individual’s adjusted net income to fall into the £100,000-£118,880 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 them instead. No CGT or income tax liability will arise on transfers between married couples (or for those in a civil partnership) or where the asset to be assigned is an insurance-based investment bond.
- Reallocation of dividend income for couples who run their business through a company. Where they are planning to transfer shares to achieve this, it is important that any share transfers are made by way of an unconditional gift of shares with full voting, capital and income rights – the transfer will not incur CGT where the couple are living together and either married or in a civil partnership.
- Reinvestment in tax-free investments, such as an ISA, so that taxable income is replaced with tax-free income – see section 1.2 below.
- 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:-
(i) Unit trusts/OEICs geared to producing capital growth.
(ii) 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.
It is important to note that neither an EIS, an SEIS nor a VCT investment will help to reinstate the personal allowance by reducing an individual’s income. This is because tax relief on investment in an EIS, SEIS and VCT is given by a reduction in the tax bill and not by a reduction in total income.
- Where possible, a couple should try to ensure that they both have pension plans that will provide an income stream in retirement that will enable them to both use their personal allowance.
- Clients should make maximum use of all the 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 £9,440 for tax year 2013/14 before they pay any tax. This is scheduled to increase to £10,000 in tax year 2014/15.
- 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 current age allowance income limit of £26,100. For 2014/15 the age allowance income limit is scheduled to increase to £27,000.
1.2 USING TAX-EFFICIENT INVESTMENTS
Especially for those paying the higher or additional rate of income tax it is most important that people invest in the most tax-efficient way possible.
The ISA is still the main method of investing savings with freedom from income tax and capital gains tax (CGT) without giving up the flexibility of access to the investments.
For this tax year the overall annual contribution limit is £11,520 of which no more than £5,760 can go into cash. The balance can be invested in a stocks and shares ISA. This means a couple could, between them, invest £23,040. For tax year 2014/15 the overall annual contribution limit per individual rises to £11,880. A child aged 16 or over can invest £5,760 in a cash ISA in this tax year and £5,940 in 2014/15.
Of course, no tax relief applies on an investment to an ISA but income and capital gains are free of tax. The credit on a dividend is not recoverable and so, for the basic rate taxpayer, an ISA invested in equities gives no income tax advantage. However, for a 40% taxpayer, tax freedom means the net dividend income yield improves by 33.3% and for a 45% taxpayer by 38.9%. Investors who are 45% taxpayers are more likely to be utilising their annual CGT exemption on a regular basis and so, for them, an investment in an ISA is almost essential.
(b) Junior ISAs
The replacement for the Child Trust Fund (CTF), the Junior ISA (JISA), commenced life on 1 November 2011. Broadly speaking, JISAs are available to any UK resident child, under age 18, who does not have a CTF. The key points about JISAs are:
- There is no government contribution, but any individual may contribute.
- The maximum overall contribution is £3,720 this year and £3,840 in the next tax year.
- The JISA has two investment components – cash and stocks and shares – but unlike the ISA there are no restrictions on how a contribution has to be split between the two.
- Withdrawals before age 18 are only allowed in very restricted circumstances eg terminal illness.
- The tax benefits are the same as for ISAs.
16 and 17 year olds are able to put cash into an ISA and have a JISA – this means a maximum total subscription of £9,480 for 2013/14. It must be remembered, though, that where a parent provides the capital for a cash ISA for a 16-17 year old child, the “£100 rule” on parental settlements will apply. The “£100 rule” does not, however, apply to JISAs.
Because JISAs work on a tax year basis, unlike CTFs which are based on a one year basis linked to the child’s date of birth, if there is a desire to maximise contributions to a JISA this means investing before 6 April 2014.
Children with a CTF do not qualify for a JISA but, given its tax free status, consideration should still be given to paying further contributions to that CTF. The Government has also announced that, from 6 April 2015, it will introduce provisions to permit the transfer of a CTF to a JISA.
For those who are unhappy that the JISA will be transferred into the outright ownership of the child at age 18 then alternative, still tax-efficient, methods of investing, eg through an offshore bond or through collectives held in an appropriate trust maybe, with advice, worth considering.
(c) Growth-oriented unit trusts/OEICs
Given the relatively high rates of income tax as compared to the current rates of CGT, it can make tax sense to invest for capital growth as opposed to income.
Income (dividends and interest) on collectives is taxable – even if accumulated – so 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 £10,900) on later encashment (or both annual CGT exemptions for couples).
Of course, as for all financial planning, a careful balance needs to be struck between investment appropriateness and tax effectiveness. While performance through capital growth is obviously tax attractive, reliance on growth at the expense of income can introduce (possibly unacceptable) risk.
(d) Single premium investment bonds
Single premium investment bonds can deliver valuable tax deferment for a higher/additional rate taxpayer, especially so when the underlying investments are income-producing. This is because no taxable income arises for the investor during the “accumulation period”. In particular, it should be borne in mind that any UK dividend income accumulates without corporation tax within a UK insurance company’s internal investment funds. Capital gains (after indexation allowance) realised by the UK life fund suffer corporation tax at 20% as opposed to the 28% top rate of CGT that applies to individuals. The investor will receive a basic rate tax credit for deemed taxation in a UK bond 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) Deferring the encashment of the bond until a tax year in which the investor is a basic rate taxpayer – say after retirement. In the meantime, if cash is required, the investor can use the annual 5% tax-deferred withdrawal facility.
(ii) Assigning the bond to an adult basic rate or non-taxpaying relative (say spouse or child) pre encashment; the assignment will not trigger a tax charge and tax should be avoided on subsequent encashment.
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 an investor. Whether a UK or offshore bond is best for any particular investor will depend on all the circumstances of the investment; and advisers should be sure to adequately document the reasons for their product wrapper selection for each client.
(e) 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 2013/14 an investment of up to £1 million can be made to secure income tax relief at 30%, with relief being restricted to the amount of income tax otherwise payable. Unlimited CGT tax deferral relief is also available on an investment in an EIS provided some of the EIS investment potentially qualifies for income tax relief.
(f) Venture Capital Trust (VCT)
The VCT offers income tax relief for tax year 2013/14 at 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 CGT as with an EIS investment but dividends and capital gains generated on amounts invested within the annual subscription limit are tax free.
For 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. CAPITAL GAINS TAX
Five very effective forms of CGT planning are:
– use of the CGT annual exemption (which cannot be carried forward and so otherwise will be lost);
– use of independent taxation planning strategies by married couples;
– for those approaching or paying higher rate income tax to take action so as to reduce the tax rate that applies to a gain. This can be achieved by the payment of a pension contribution;
– use of loss relief strategies; and
– CGT deferral
(1) Using the CGT annual exemption
Taxable capital gains are added to the investor’s other taxable income to determine the rate of CGT they pay. To the extent they fall within their basic rate tax band they are taxed at 18%. To the extent they exceed it, they are taxed at 28%.
The annual exemption is deducted before determining taxable capital gains. For individuals the annual exemption is £10,900 for 2013/14 and £5,450 for most trustees; the Government has stated that it intends to increase it to £11,000 in 2014/15. For higher and additional rate taxpayers, who will otherwise pay CGT at 28%, use of the annual exemption in 2013/14 has potentially become more valuable and can now save up to £3,052 in tax. For a basic rate taxpayer the tax saving is worth up to £1,962.
As far as possible it is important to use the annual exemption each tax year because, if unused, it cannot be carried forward. If the annual exemption is not systematically used an individual is more likely to reach a point where some of their gains are subject to the tax. In using the annual CGT exemption, unfortunately a gain cannot simply be crystallised by selling and then repurchasing an investment – the so-called bed-and-breakfast planning – as the disposer must not personally reacquire the same investment within 30 days of disposal. However, there are other ways of achieving similar results:
– Bed-and-ISA. An investment can be sold, eg. shares in an open-ended investment company, and bought back immediately within a tax free ISA. For 2013/14 the maximum ISA investment is £11,520. This increases to £11,880 in 2014/15.
– Bed-and-SIPP. Here the cash realised on sale of the investment is used to make a contribution to a self-invested personal pension (SIPP) which then reinvests in the original investment. This approach has the added benefit of income tax relief on the contribution and may also offer a higher reinvestment ceiling than an ISA, depending on a person’s earned income and other pension contributions.
– Bed-and-spouse. One spouse can sell an investment and the other spouse can buy the same investment without falling foul of the rules against bed-and-breakfasting. However, the sale of the investment cannot be to the other spouse – the two transactions must be separate.
– Bed-and-something similar. Many funds have similar investment objectives or, in the case of tracker funds, identical objectives. So, for example, if somebody sells the ABC UK Tracker fund and buys the XYZ UK Index fund, the nature of the investment and the underlying shareholdings may not change at all, but because the fund providers are different the transactions will not be caught by the rules against bed-and-breakfasting.
(2) Independent taxation planning
Before 23 June 2010, CGT was charged at a fixed rate of 18% regardless of the tax rate of the individual realising the gain. Now the value of the annual CGT exemption depends on whether the individual is a higher/additional rate taxpayer or not. Because the rate of CGT is 28% for a higher/additional rate taxpayer, the maximum value of the annual CGT exemption is currently £3,052.
It therefore makes even more tax sense for an individual, who is a higher/additional rate taxpayer, to transfer assets into their spouse’s name to utilise that spouse’s annual exemption on subsequent disposal. This will mean that, between them, the spouses can release capital gains of £21,800 each year with no CGT. This can be achieved by an outright and unconditional lifetime transfer from one spouse to the other. This should not give rise to any inheritance tax consequences or CGT implications (provided the spouses are living together).
Indeed, it may even be worthwhile transferring an asset showing a gain of more than £10,900 if the asset is to be sold as the result would be for the surplus capital gain to be taxed at 18% rather than 28%.
In transactions which involve the transfer of an asset showing a loss to a spouse who owns other assets showing a gain, care should be taken over the CGT anti-avoidance rules that apply (if any money/assets return to the original owner of the asset showing the loss).
(3) Pension contribution to reduce the tax on the capital gain
Some people who are realising a taxable gain may have an amount of taxable income equal to around the basic rate limit. This means that a significant part of any taxable capital gains is likely to suffer CGT at a rate of 28%. By taking action to increase the basic rate limit, it is possible for such a person to save CGT. One method of achieving this is to pay a contribution to a registered pension scheme.
(4) Loss strategies
In calculating taxable capital gains for a tax year, the taxpayer will first deduct losses of that tax year, then the CGT annual exemption and this will leave the gains for the tax year that are subject to tax. Loss relief can therefore be important, particularly for individuals who are higher/additional rate taxpayers and so pay CGT at 28%.
In this respect the rules for losses depend on whether the individual has a carried forward loss (arising from excess losses in previous tax years) or a loss from the same tax year as that in which the gain arises.
(a) Carried forward losses
Where the loss is a carried forward loss it is only necessary to reduce the taxable gain by an amount that leaves the CGT annual exemption intact.
(b) Same year losses
Losses that arise in the same tax year as capital gains are fully netted off against those capital gains to bring them down to zero. Excess losses will then become carried forward losses. In circumstances where the individual is realising losses in the same tax year as gains, they therefore need to be careful not to cause a part or all of their annual CGT exemption to be lost in the year in question.
(5) CGT deferral
If a person is contemplating making a disposal in the near future which will trigger a capital gain in excess of £10,900 it may be worthwhile, if possible, spreading the disposal across two tax years to enable use of two annual exemptions to be made. Alternatively, if the disposal cannot be spread or the gain is very substantial, the disposal could be deferred until after 5 April 2014 to defer the payment of CGT until 31 January 2016.
Some businesses have year ends either on 31 March (corporates) or aligned with the end of the tax year (unincorporated businesses). In view of this, the lead up to the tax year end is traditionally the busiest for pension contributions. The end of the current tax year is likely to be especially busy as a result of some of the pension changes that we know will happen on 6 April 2014. These are:-
- The standard lifetime allowance will be reduced from £1.5 million to £1.25 million from 2014/15.
A new form of Fixed Protection (known as Fixed Protection 2014) is now available enabling benefits to be taken up to the greater of the standard lifetime allowance and £1.5 million without any lifetime allowance charge.
Features of this change are:-
– The individual must elect by 5 April 2014
– Protection will be lost where further accrual/contributions occur on or after 6 April 2014
An option to elect for Individual Protection will also be introduced. This will:-
– provide a Protected Lifetime allowance of the value of benefits at 5 April 2014 up to £1.5 million provided benefits are then valued at at least £1.25 million
– enable contributions/pensions accrual to continue
- The annual allowance will be reduced from £50,000 to £40,000 from tax year 2014/15. However, the carry forward allowances for tax years 2011/12 to 2013/14 will remain at £50,000.
(1) Lifetime allowance
The changes to the lifetime allowance will mean that anyone likely to be affected by the reduction, and looking to retire in the near future, will need to consider all means to reduce/avoid any lifetime allowance charge. This could include:
- Electing for Fixed Protection and/or, if appropriate, Individual Protection. This should include individuals aged under 75 in receipt of drawdown pension, if they feel a future benefit crystallisation test at age 75 may result in them exceeding the reduced £1.25 million lifetime allowance.
- Considering drawing some or all of their benefits before 6 April 2014 when these will be set against the current £1.5 million lifetime allowance. For example, if an individual crystallised benefits with a value of £500,000 in February 2014 this would only use up 33.33% of their lifetime allowance whereas if they left this until 2014/15 it would use up 40% of their allowance.
- Considering how the benefits are taken. For example, an individual with money purchase benefits may well find that using their fund to purchase a scheme pension rather than a lifetime annuity may reduce the percentage of the lifetime allowance they have used up. Similarly, a member of a defined benefit scheme should consider the difference in the lifetime allowance used where they draw their benefits solely as a pension or as a tax free cash sum with a reduced pension.
(2) Annual allowance and carry forward
The reduction in the annual allowance from £50,000 to £40,000 from 2014/15 is somewhat softened by the ability to carry forward unused annual allowances based on a maximum of £50,000 for each of tax years 2011/12 to 2013/14. However, once introduced, the new limit is likely to be particularly onerous on members of defined benefit schemes with long past service. For example, it will only need a real increase in pension entitlement of more than £2,500 to trigger an annual allowance charge (assuming the member had no carry forward entitlement).
People affected should act now to maximise the ability to pay contributions to registered pension schemes. Utilisation of the carry forward rules is likely to be particularly attractive to those clients whose contributions were restricted in tax year 2010/11 as a result of the special annual allowance, especially if they are now 45% taxpayers.
4. INHERITANCE TAX
The inheritance tax (IHT) nil rate band has been frozen at £325,000 for 2013/14 and will remain at this level, at least until 2017/18. Because of increasing house prices and investment values; and the freezing of the nil rate band, once again the amount of inheritance tax collected by HMRC is increasing. People whose estates may be affected should therefore take early action.
In advance of the year end, individuals who wish to transfer wealth on to the next generation should consider making full use of their £3,000 annual exemption. If this was not fully used in the last tax year (2012/13), that unused relief can be utilised now provided the donor first fully uses their annual exemption for this tax year (2013/14). So for somebody who has made no gifts, they can make gifts of £6,000 within their annual exemptions now.
For those who have income that is surplus to their needs, it may also be appropriate to establish arrangements whereby regular gifts can be made out of income in order to utilise the normal expenditure out of income exemption. An ideal way of achieving this is to pay premiums into a whole of life policy in trust to provide for the IHT liability.
The year end is also a good time to generally consider your IHT position with a view to making larger gifts. Where ongoing control of the assets gifted is required, a discretionary trust will be useful but care needs to be exercised so as not to exceed the available nil rate band. If the investor needs access and IHT efficiency, a loan trust or discounted gift trust should be considered.
5. BUSINESS TAXATION
The small profits (former small companies’) corporation tax rate remains at 20%. The main corporation rate fell by 1% to 23% in this financial year and for the next financial year (1 April 2014 to 31 March 2015) it falls to 21%. For these companies, it will therefore be beneficial to, where possible, push profits into the next financial year.
Given the relatively low rates of corporation tax of around 20% as compared to the higher rates of income tax (possibly 45%), if personal cash is not needed it makes sense for shareholder/directors of private limited companies to keep profits inside the company at the moment rather than distribute them as dividends or remuneration. Such a distribution could then be made as and when income tax rates have reduced. Given the National Insurance contribution advantages, when it is desired to pay cash out of the company it is likely that a dividend will be the most attractive method of distribution.
On the other hand, if the intention is to retain the profits in the company indefinitely, care should be taken that these retained amounts do no prejudice entitlement to CGT entrepreneurs’ relief on a later sale of the shares in the company. This can usually be achieved by appropriate advance planning and, especially, by avoiding the investment of these funds. Reinvestment in the business should, however, not cause a problem in relation to entrepreneurs’ relief. Specialist advice so as not to put this potentially valuable relief at risk is essential.
Please contact us for clarification on any matters arising from this bulletin or to assist you with your financial strategy.
This document is for general consideration only and consequently we cannot accept any responsibility for any loss as a result of any action taken or refrained from as a result of the information contained in it.
The Financial Conduct Authority does not regulate general taxation or trust advice.