While Venture Capital Trusts and Enterprise Investment Schemes, to name but two tax-efficient wrappers, are very popular, it is important to focus on tax ‘reducers’ as opposed to strategies that reduce taxable income.
VCTs and EISs are tax reducers because the tax relief is available at a set rate, irrespective of the client’s marginal rate of income tax. By way of an example, a basic rate taxpayer can, paradoxically, receive tax relief at 30% on a VCT investment.
The distinction between reducers and allowable deductions is particularly relevant because there are a number of pivotal levels of taxable income that affect the availablility of relief and allowances. For example:
• Age Allowance Income Limit: £22,900
• Personal Allowance Income Limit: £100,000
• Pension Anti-forestalling Limit: £130,000
• 50% Additional Rate Band: £150,000
These allowances and bands are dependent on the level of ‘adjusted net income’, that is income after the deduction of allowable items as opposed to tax reducers. Examples of allowable items are:
• Pension contributions
• Trading losses
• Charitable donations.
It is therefore beneficial to minimise ‘adjusted net income’ so as to preserve allowances or minimise the income liable to tax at a higher rate.
For example, if income falls within the band of £100,000 to £112,950, a combination of the tax at 40% and the loss of the personal allowance, costing 40%, leads to an effective marginal income tax rate of 60% – a tax rate not seen since the early 70s.
Therefore, within this band every reduction in income of £1,000 leads to a tax saving of £600. A high effective marginal tax rate also arises in relation to the other ‘trigger points.
In order to reduce adjusted net income the following can be considered:
• Pension contributions (unless affected by the anti-forestalling limits)
• Losses – could be a trading loss for a sole trader or partner, a furnished holiday letting loss (2010/11) or indeed a loss on the disposal of an unquoted stock or where the latter has become of negligible value
It is important to crystallise the loss prior to 6 April to ensure that it arises in the current tax year. There may be situations where a ‘paper’ loss exists but needs to be crystallised. A trading loss will also need to be recognised in the business accounts for the period concerned and be capable of justification to HM Revenue & Customs.
Charitable donations can be one-off gifts to charity under the Gift Aid scheme and there is no upper limit. These payments are made net of tax at the basic rate but the gross amount reduces taxable income.
In addition to the potential savings in Income Tax, where income can be reduced below the higher rate tax band (currently £37,400), there may also be a reduction in the Capital Gains Tax where a capital gain arises.
Similarly, and in the same vein, it might also be appropriate to realise any capital losses in order to set these against gains. This can be important as capital losses cannot be carried back, and a cashflow disparity could therefore arise, particularly if the losses cannot be utilised for many years. And there is of course no Capital Gains Tax payable on death.
The CBI has called on the Government to reduce the 50p tax rate and restore personal allowances for those affected. As it is unlikely that the Government will accede to this request immediately it would be safer to assume that for now, as ever, reducing income liable to tax is desirable.
For those whose income derives from investments it may be beneficial to consider investments that do not produce taxable income on an annual basis, by holding assets in an Offshore Investment Bond perhaps. In this way income can still be delivered by taking up to 5% tax deferred withdrawals of capital (up to 20 years), but there is control over the timing of a tax charge.
Effectively income can also be replaced by a plan consisting of the disposal of investments liable to CGT where, if there is a gain, the highest rate of tax at 28% is still considerably less than the income tax rates that may apply on other investment income of 40% or 50% (32.5% and 42.5% on dividend income).
As ever therefore it is important to determine what the client should be trying to achieve before looking at the options available. Where one partner in a marriage or civil partnership has considerable earned income then opportunities maybe restricted, but not if the other partner has little income.
