Wealth Management: Income Tax
Wealth: How to manage it
With a 50 per cent tax rate on high earnings scheduled for April, Neal Underwood reviews the different strategies the wealthy can use to make sure they hang on to their wealth
April 2010 will see the introduction of the 50 per cent income tax rate on earnings over £150,000. Since its announcement in Chancellor Alistair Darling’s Budget in April 2009 there has been a flurry of activity as high earners seek ways of reducing their tax burden. Colin Jelley, head of tax and financial planning at Skandia, says that while there was some appetite for mitigating tax at 40 per cent, the psychology of people paying half their income in tax has made them sit up and take action. Meanwhile Nick Fletcher, chief executive of Saunderson House, makes the point that it is not all about saving tax - it is important to think about things in the context of risk and reward.
Strategies that can be used, says Fletcher, include transferring assets into the name of a spouse or civil partner to fully utilise income tax allowances and lower rate tax bands, in cases where the person is earning less than £150,000 a year, as well as an individual’s annual capital gains tax allowance.
“You should also check your tax code,” he says. “You can use National Savings Certificates and Isa allowances - while the Isa allowance may seem small, an individual could have invested a total of £177,000 into Peps, Isas and Tessas since they were originally introduced in 1987, and a couple up to £354,000. But there’s nothing significant that you can do to turn PAYE
income into capital gain unless you go into long-term share arrangements, which have different risk and liquidity profiles.”
He also notes that it is possible to get into some very aggressive and complex tax situations trying to convert income into capital gains, but that these are often more trouble than they are worth in terms of professional fees and future uncertainty.
Fletcher also points out that, while the Government has attacked higher rate tax relief on pension contributions, it has not yet been abolished and high earners could receive 50 per cent tax relief on contributions up to £20,000 in the 2010-11 tax year. Though certain individuals can receive full tax relief on contributions over this limit, he notes very few will be able to receive higher rate tax relief on contributions over £30,000.
At the safer end of the risk spectrum, Fletcher points to index-linked and conventional gilts, where none of the capital gains are subject to tax. “If it’s appropriate to be in these things, it often makes sense to be in them outside your pension or Isa where possible,” he says.
Fletcher adds that if speculators are correct that capital gains tax will be raised from the current 18 per cent, it may be worth crystallising gains and paying tax at the lower rate if the authorities do put rates up. However, he says, it would be galling to do that if the Government then came to its senses and put capital gains tax rates down to 10 per cent, which is where he believes they should be.
There are some more sophisticated options, notes Fletcher, such as encashing insurance bonds in order to crystallise gains in the tax year prior to the introduction of the 50 per cent tax rate, or closing interest-earning bank accounts prior to the 5 April deadline and opening up new ones after that date. Again, though, he says it is important to weigh up the risk and return implications with the convenience of taking such approaches.
Finally, says Fletcher, investments such as venture capital trusts (VCTs) and enterprise initiative schemes (EISs) can provide tax relief, but they are high risk investments that potentially should only form a small part of an overall portfolio.
moving the goalposts
Arabella Saker, partner at Maurice Turnor Gardner, highlights some strategies that can be adopted specifically by law firm partners. “Law firms are generally tax-transparent partnerships or limited liability partnerships, so profits can’t usually be rolled up, but some firms are changing their accounting date to allow this year’s profits to be taxed earlier at 40 per cent, rather than later but at 50 per cent. That’s only helpful for 2009-10, however.”
Where a partner is a company for accounting purposes, Saker adds, it can roll up its share of partnership profits. “There are regulatory and other pitfalls, but with careful planning, this might be useful for some individual partners, or for performance-related benefits.”
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Andrew Goldstone, head of personal tax and estate planning at Mishcon de Reya, believes it is unlikely that many firms will choose to adjust their year-end, not least due to the administrative overhead it would cause for what would be a one-off tax saving, but also because of the cash requirements.
“For individuals, there are a few things you can do up until 5 April,” says Goldstone. “You can bring forward income early where you can, for example closing a savings account and getting taxed on the interest then reopening an account on 6 April. Where you’ve got non-domiciled solicitors, they may need to bring income into the UK. It’s probably better to bring it in now.”
Sophie Dworetzsky, Withers partner, says there are two categories into which solutions tend to fit. “There are some ideas that are very robust, and there are some which try to magic away income and are almost too good to be true,” she says. “The important point is the Revenue has made it very clear they’re taking a very proactive and aggressive stance. We talk to our clients about what we think are robust and sensible ideas.” With regard to employment income, these include paying tax for next year prior to the 5 April deadline.
The right strategy
For investment income, offshore insurance bonds can be very useful if the investment is one where the investor does not control the investments. “You’re not liable for growth within the policy where you don’t access the growth,” says Dworetzsky. “But anything you get out is subject to income tax.”
Dworetzsky continues: “The sexiest angle, if anything can be sexy in tax, is turning income into capital. There’s a big differential, but the Revenue has come out very strongly and said it’s fool’s gold. It depends what you’re doing. With investment income, some types of investment are subject to capital gains tax (CGT), such as futures or options. As ever the devil is in the detail. It does work, but you need to be very careful you get it right.”
Like Fletcher, Dworetzsky notes that investments such as VCTs and EISs are higher up the risk scale, but also that the tax treatment of pension contributions is leading many to look at these as an alternative to pensions.
In the view of Carl Melvin, managing director of Affluent Financial Planning, the obvious initial avenue where that is possible is pension contributions. “Those earning between £100,000 and £130,000 are caught in this marginal threshold. Increasing pension contributions is a way of making a deduction on taxable income, subject to not falling foul of the Pre-Budget Report [PBR] restrictions,” he says.
“Brown and Darling have kind of locked all the doors,” continues Melvin. “It’s problematic because the Treasury has tried to engineer a situation where we can’t use conventional planning. Anything that smacks of tax avoidance they’ll come down on like a ton of bricks. What this illustrates is that those high earners who we’ve been telling to increase pension contributions need to do it because the door can be closed.”
Patrick Power, associate director, Financial Planning in the specialist tax group at HSBC Private Bank, is also an advocate of using pensions in tax planning. “Because the choice of investments that can be held within pensions is so broad, any attitude to risk can be covered,” he says. “There’s no compromise on risk appetite. Some of the other tax-efficient vehicles out there such as EISs and VCTs have nowhere near as much diversification. You should be very wary about taking that level of risk. The attitude to risk and investment objective have to be primary, while the tax considerations should be secondary, but you do have to be very tax savvy. For the average ’moderate risk’ client they’re probably not appropriate or should only be considered in an appropriate proportion relative to their other assets.”
Another option Power suggests is some form of tax deferral vehicle such as an insurance bond. “You can defer tax until a chargeable event occurs,” he says. “You do have to have an exit strategy so that you can plan properly, for example, to take profits when rates are lower or to assign profits to a non-tax paying spouse or family member.”
Qualifying life policies also have some attractions, according to Power. “They’ve been seen as a bit of an anachronism, but in a 50 per cent world you could top-up pension contributions with a qualifying life policy. We’re now developing Mips [maximum investment plan], which are more transparent and have a lower charging structure. There are certain restrictions - you hold it for at least three quarters of the 10-year term and need to commit to regular payments over the term, but there’s liability only to basic rate tax on growth, and there’s the added advantage of the whole fund being available as a tax-free lump sum at maturity. These products are making a come-back. Because contributions are more or less fixed, they’re suitable for clients who were previously committed to the discipline of making regular pension contributions, but who’ll now be caught by the special annual allowance rules.”
A further strategy to reduce taxable income, says Goldstone, is giving to charity. “The 50 per cent tax rate will be a spur to people giving to charity,” he says. “If people are thinking about it in the next couple of months they should delay and get some extra tax relief.”
Jelley is particularly focused on investment, rather than income. “There are all sorts of things people are thinking about, including moving assets from income to capital gains,” he says. “We’re seeing an increasing use of low yielding collective investments, where most of the return is capital gains.
“In the wider piece, there’s lots of disposing of shares in companies to realise capital gains. While National Insurance is much more difficult to avoid, what’s quite interesting is that even in a 50p world for some people pensions are still a good thing to do. There will be lots of people caught by the £150,000 threshold who’ll only just be caught. For these people pensions will be a good vehicle.”
Jelley believes the Treasury’s estimate of what it would raise from the introduction of the 50 per cent rate was always optimistic, and this has significantly reduced due to behavioural change as increasing numbers of high earners look for strategies to reduce their tax burden.
“There’ll be a plethora of high stakes aggressive tax planning products,” says Goldstone. “I wouldn’t rule these out altogether, but they should come with a pretty big health warning. Will they work? Anyone going in will be turned over by the Revenue, but it’s a business decision like any other. The obvious thing, for investment income, is converting income to gains.”
Power stresses that there is no one solution that applies to everyone: “There’s a lot you can do on the planning side to ride out the 50 per cent storm. The need for planning is now greater than it’s ever been. Darling has said the creation of the 50 per cent rate is not an ideological move, implying that it’s temporary, but what’s temporary? These things tend to be cyclical. We went through very high rates of tax on the wealthy in the 1970s - as a result, there was a huge brain drain. We may well get to a period again where we’re losing a lot of talent and things might change.”
In the meantime, says Power, the focus needs to be on diversifying not only physical assets but also the structures used to offset losses and use allowances. “It’s about getting the right mix for your circumstances. Everyone needs to get advice,” he says.