With tax avoidance being a hot topic in the news and the end of the tax year on the 5th April approaching this is an apposite blog post. The confusion between tax avoidance which is legal and tax evasion which is illegal is not helped by a loose interchange between the two terms, for example the oft banded phrase “aggressive tax avoidance.” For my part the onus is on the government to tighten the tax code and close loopholes not attack legal avoidance as immoral.
More importantly what is often forgotten in the debate is that the government actively encourages and incentivises selected tax avoidance schemes for sound economic reasons. Investment in cash ISAs encourages savings and provides capital for banks to lend to businesses and homebuyers. Investment in Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs) attracts very generous income tax relief in order to provide much needed capital investment into very small and fledgling companies. The potential for these to grow, employ more people and generate high levels of tax for the Treasury in the future means the tax incentives are a logical investment on its part.
This blog briefly covers investment opportunities for tax avoidance. Yes they are all legal and Mr Osborne approves! No Swiss bank accounts are required.
Individual Savings Accounts (ISAs)
The allowance was raised to £15,000 last July and it can be allocated to cash or stocks and shares in any proportion. Interest rates on cash remain miniscule with the date for expected interest rate rises increasingly being pushed out by falling inflation.
Whilst ISAs are tax efficient for all investors, the use of qualifying fixed interest or corporate bond funds is particularly tax efficient within a stocks and shares ISA as the plan manager can reclaim the 20% tax deducted from interest, unlike the 10% tax credit from dividends. For those requiring a high tax free income corporate bond ISAs are excellent investments with rates of 5% or 6% p.a. from high yielding corporate bond funds (Source: FE Trustnet). It is important to note yields are variable and capital values are not guaranteed unlike cash.
Personal Pensions for the Retired
Those without earnings can still invest £3,600 into a personal pension and still get tax relief at their highest rate. Even a non-taxpayer can receive 20% tax relief! The rationale for a pension investment for the retired is to benefit from an immediately vesting annuity (IVA) and receipt of a high guaranteed lifetime income. This is leveraged by the tax relief. Here is how it works:
Net Pension Contribution: £2,880 Cheque from applicant’s bank account
Tax Relief Added: £720 Government gift
Gross Pension: £3,600 Received by the pension provider
Tax Free Cash: £900 Paid immediately to the investor by the pension provider
Amount Invested in Annuity: £2,700 The balance of the £3,600 after tax free cash is paid out
Net Cost to Investor: £1,980 This is £2,880 paid minus the £900 tax free cash received.
So what could you get in terms of annual annuity payments? It will depend on your age and annuity rates but as an example a client of mine in her late 60s last March bought an IVA and receives a level annuity of £127.40 p.a. gross. This equates to a gross yield of 6.43% p.a. (£127.40/£1,980), pretty good for a guaranteed lifetime income. Please note annuities payments are subject to tax, on death there is no capital return and the annuity is not medically underwritten. Those with certain medical conditions could get a higher rate elsewhere. For those with earnings including from self-employment larger sums can be invested into an IVA.
Venture Capital Trusts
These are especially attractive for income investors looking for high tax free yields and those seeking to reduce their income tax bill in 2014/15.
VCTs are collective investments similar to investment trusts. As with unit trusts a VCT holds a range of different qualifying smaller company stocks to provide investment diversity and risk reduction. The tax benefits are quite remarkable. Investors receive 30% income tax relief on investment up to £200,000 p.a. even if they are basic rate taxpayers, provided the VCT meets HMRC qualifying rules, the investor holds the shares in the VCT for five years and the investor has paid enough income tax in the relevant tax year. For example consider an investor who pays £5,000 income tax each year and buys new shares in a VCT for £10,000 in 2014/15. He or she will receive a tax rebate of £3,000 at the end of the tax year through their tax assessment. Please note substantial Gift Aid payments will affect the tax relief payable.
In addition VCTs pay tax free dividends and there is no capital gains tax to pay on shares when they are sold. These are similar to the tax benefits of ISAs although it must be stressed that shares in VCTs may be difficult to sell after five years. This is because there is no market for second hand VCT shares as investors do not receive tax relief on buying these. To mitigate against this many VCT providers offer a buy back facility, typically at a discount of 5-10% of the net asset value of the shares.
VCTs which buy very small companies naturally carry significant investment risk, notably volatility, default and illiquidity. However as noted the pooled structure reduces risks whilst the range of qualifying smaller companies varies from fledgling unquoted stocks to established companies like Majestic Wines, online retailer ASOS and Prezzo, all listed on the London Stock Exchange’s Alternative Investment Market (AIM). These more established companies are naturally less risky than unquoted companies not listed on stock exchanges.
In terms of suitability, VCTs are most suitable for adventurous risk and experienced investors. The FCA typically state this means high net worth and sophisticated investors. However some VCTs are managed cautiously with an emphasis on capital preservation. Moreover I consider an cautious risk investor can reasonably buy small holdings in adventurous risk investments provided the balance of their portfolio is weighted to cautious risk holdings and cash. A uniform portfolio will be undiversified and this carries significant investment risk.
And Finally – Good News for Couples
A little known transferrable personal allowance for married couples and civil partner is being introduced by HMRC next tax year starting on 6/4/15. The standard personal allowance rises to £10,600 but many people will have taxable earnings below this threshold. Low paid part time workers and pensioners with a small state pension are examples. Providing your spouse is not a higher rate taxpayer you can elect to transfer up to £1,060 of your unused personal allowance to your partner. This effectively increases their personal allowance to £11,660. The maximum tax saving in 2015/16 will be £212 p.a. (20% x £1,060). OK it is not a great deal of money but it is still worth the investment in time to make a claim. However I am not sure how the application process which opened at end of last week works.
The government is fully supportive of the use of legal tax breaks that it has created. Of course they expect knock on benefits for the economy and that tax generated in the future will recoup and even exceed the upfront tax relief. For example money lent from ISA investors will result in new house buyers paying stamp duty and VAT on DIY.
The old maxim “use it or lose it,” applies to annual allowances and tax reliefs. From a moral perspective use of them to reduce personal taxation indirectly benefits the economy. I also think that people are better judges on how to spend the tax relief than governments. However that is another issue.
This blog is intended as a general guide to investment and tax reliefs available for UK residents only. It is not an invitation to invest in the areas highlighted as these may not be suitable for you and your personal tax position. You should seek individual advice before making investment and tax planning decisions.