Topic 3 - Impact of Taxation on Investment Strategies Flashcards
Treasury gilts
Three elements of gilts
How they are taxed
Types of gilts
- Gilt-edged securities (debt securities) issued by BoE. More commonly known now as ‘Treasury gilts’.
- Most UK gilts held by insurance or pension funds. Since 2009 large quanities of gilfts created and repurchsed by BoE under QE
- No CGT payable on gilts. Income is taxable but paid gross. Can be sold on secondary gilt market. Prices move inversly to interest rates.
Three elements of gilts:
Par (Face) Value - Price government will repay at end of the Gilt term. Expressed in multiples of £100. C
Redemption Date - Date (or range of dates) when the government will repay the par value.
Coupon - Rate of interest payable on the gilt, based on the par value, and payable every six months. If market interest rates are lower than the gilt coupon, the gilt is likely to sell for more than its par value in the secondary market, and if the coupon is below the market rate, the gilt price is likely to be lower than the par value.
Types of gilt:
Conventional gilts - Coupon fixed for term of gilt and par value repaid on maturity. No allowance made for effect of inflation.
Index-Linked gilts - Coupon and par value are adjusted in line with RPI. Each coupon payment comprises original coupon with an adjustment to account for increase in RPI since issue.
National Savings & Investments (NS&I)
Types of NS&I products and what they do
How they are taxed
NS&I is an executive agency of the Chancellor of the Exchequer so NS&I customers are lending to governement which pays interest, stock market linked returns or prizes with a capital guarantee. Not covered by FSCS as underwritten by government.
NS&I Premium Bonds - Opportunity of winning two £1m tax-free prizes every month or over a million other prizes. Do not pay interest and inflation may erode capital.
Guaranteed Income Bonds - 1 or 3 year fixed terms with a fixed rate of interest payable monthly . Interest is paid gross but taxable. 2 or 5 year versions are available with maturing bonds..
Guaranteed Growth Bonds - 1 or 3 year fixed terms with interest added each anniversary on a compound basis. Lump sum on maturity paid gross but taxable (income tax). 2 or 5 year versions are available with maturing bonds.
Income Bonds - Variable rate of interest paid monthly. Interest paid gross but taxable with no minimum term.
Direct ISA – NS&I’s cash ISA.
NS&I Index-linked Savings Certificates - Tax-free lump sum investments that guarantee that the spending power of the investment will grow each year, whatever happens to the cost of living, because the value of the savings is guaranteed to grow ahead of RPI.
Issued in tranches or issues with a limit of £15,000. As of Jan 2019 there were none for sale. Special maturing only certificates allow existing investors to roll over existing investments.
NS&I Fixed Interest Savings Certificates - Lump sum investments with guaranteed interest rates over set terms. Tax free. None on same as of Jan 2019. Can also roll over.
Individual Savings Accounts (ISAs)
Types of ISA
Taxation of ISAs
Annual contribution limit of £20,000. Can be combination of cash, stocks and shares and Innovative Finance ISAs.
Free of Income Tax and CGT but may be taxed within the investments themselves
No overall limit on how much a person can have invested in ISA accounts.
Help to Buy and Lifetime ISAs also available.
Types of investments to reduce tax liability:
- Gilts
- NS&I
- ISAs
- Pension Contributions
- Pension Income
- Deferral of State Pension
- Pension Drawdown
- Venture Capital Trusts
- Enterprise Investment Schemes
- Seed Enterprise Investment Schemes
- Insurance Investment Bonds
Pension Contributions
Limits and general rules
When could contribution limits be reduced?
How can tax relief be applied?
One of the most tax efficient ways of saving for retirement. No income tax or CGT on growth, only taxable once drawndown or completely tax free to beneficiaries if death before age 75.
Also receive employer contributions which are considered business expense so not taxed as a ‘Benefit in Kind’ on employee.
Fall outside of estate for IHT
Recieve full tax relief on contributions up to age 75. No maximum contribution for relief but tax charge will apply on contributions over the greater of £3,600 or their earned income. Contributions in excess of this will be added to their income and taxed accordingly. Can carry forward unused contributions for three years and get relief.
Money Purchase Annual Allowance
Taking income using flexi-access drawdown or using Uncrystallised Funds Pension Lump Sum option will reduce annual allowance to £4,000. Does not apply to those who just take tax free cash lump sum or buy an annuity.
Tapered Annual Allowance
Annual allowance of £40,000 reduced by £1 for every £2 of income that exceeds £150,000 to a minimum allowance of £10,000.
How to recieve relief
NET Pay - For occupational pension schemes (not group schemes). Contribution is gross and deducted from employee’s income by PAYE before any allownaces are applied. Reduces taxable pay and recieve full tax relief up front.
At Source - Personal and Stakeholder pensions get tax relief at source as contributions are apdi net of basic rate (20%) income tax. Tax relief is achieved by increasing basic-rate tax band.
Via Self-Assessment -
Additional Tax relief of 20% or 25% at source for higher and additional tax rate payers must be claimed via Self-Assessment.
Retirement Annuity Contracts (former personal pensions) can still be contibuted to by gross payments meaning all tax relief must be claimed by self-assessment.
Deferral of State Pension
State Pension both old and new (pre and post 6 April 2016) can be delayed for tax planning.
Increases by 1% for every 9 weeks it is deferred (just under 5.8% per annum). Those at state penson age before 6 April 2016 get a higher rate of 1% every 5 weeks (10.4% per annum).
Can revieve deferral as a taxable lump sum or increased pension.
Pension Drawdown
Use flexi-access drawdown to take tax free cash and decide if, when and how.
Phased drawdown allows income and tax free cash in stages.
Since 6 April 2015, it has also been possible to take lump sums from uncrystallised pension funds, although again only 25% will generally be tax free.
The normal minimum age for drawing non-state pension benefits is currently 55, although this will rise to 57 in 2028.
Venture Capital Trusts
What are they?
What are the qualifying rules?
What are the benefits/drawbacks?
Started 6 April 1995.
Encourage investment in range of small, higher-risk trading companies not listed on recognised stock exchange.
Companies themselves not listed but since 2011 VCTs are companies admitted to trade on a regulated market. Prior to to this they were listed on LSE.
Similar to investment trust and run by fund managers. Must be approved by HMRC to recieve tax benefits.
Company must be trading less than 12 years to qualify for VCT investment. Some exceptions.
VCT tax benefits
- Tax relief at 30% on primary market share purchases up to £200,000
- Tax relief cannot be greater than the tax liability
- Shares held for 5 years or relief clawed back
- Tax-free dividends – all shares
- Gains exempt from CGT
Enterprise Investment Schemes
What are they?
What are the qualifying rules?
What are the benefits/drawbacks?
1981 - Business Start-Up Scheme was launched - evolved in 1983 to Business Expansion Scheme. Phased out in 1993 replaced by Enterprise Investment Scheme in 1994 by Michael Portill, then Chief Secretary to the Treasury. “
“The purpose of Enterprise Investment Schemes is to recognise that unquoted trading companies can often face considerable difficulties in realising relatively small amounts of share capital. The new scheme is intended to provide a well-targeted means for some of those problems to be overcome.”
(Cotton, 2018)
Encourage private individuals to invest in small unquoted companies during times of economic uncertainty for at least 5 years.
Key issue for tx efficient growth is risk. Only suitble for sophisticted investors with right capacity for loss and ATR.
EIS tax benefits:
- Tax relief at 30% on investment up to £1m per tax year in Primary Shares. Increased to £2m if in ‘knowledge intensive’ companies.
- Tax relief capped at the tax year’s liability.
- The full limit is available to each of the joint shareholders.
- Carry back of unused relief in previous year
- Clawback of relief if disposal within 3 years (not including to spouse)
- Gains CGT exempt
- Losses can be set against other income tax or CGT liabilities.
- CGT deferral relief - Gains made on other investments can be deferred if reinvested into EIS
- EIS shares generally qualify for business property relief (IHT) if held for two years
Small Enterprise Investment Scheme
What is it?
What are the qualifying rules?
What are the benefits/drawbacks?
6 April 2012 to encourage investment into smaller companies - those with gross assets of less than £200,000.
SEIS tax benefits
- The same applies for EIS with these differences:
- Tax Relief at 50% up to £100,000 per investor
- Carry back avaialble for previous year up to £100k.
- 50% CGT exemption on other gains invested into an SEIS
Investment Bonds
What types of investment bond are there?
How do they differ?
How are they both taxed?
.
Potentially tax efficient income through deferral. 5% of original investment for each year without immediate tax liability up to maximum 100%.
Onshore
Income and gains taxed under life insurance scheme. Fund manager pays equivalent of 20%. Treated as paying 20% basic rate but not recliamable by investors.
Chargeable events – (gains are treated as income in the investor’s hands):
- full surrender of the policy or individual segments;
- assignment for money, or money’s worth;
- exceeding the 5% cumulative annual allowance;
- death of a life assured leading to payment of a death benefit;
- policy maturity.
CGT does not apply to gains made by the investor.
Up to cumulative 5% of the original capital can be withdrawn each year with no immediate tax liability
Withdrawals in excess of a cumulative 5% (or 100% of the original capital) are treated as gains and potentially taxable at the time.
On partial or total encashment, the gain is the value plus all withdrawals, minus the original investment plus all excess withdrawals. Added to investors income in year of encashment and tax at marginal rate.
Top slicing is applied to allow for the fact that the gain was built up over some years. That may prevent the investor moving into a higher tax bracket.
The 20% fund tax is credited, so:
- non-taxpayers and basic-rate taxpayers have no further liability;
- higher-rate taxpayers pay an additional 20%;
- additional-rate taxpayers pay an additional 25%.
Can be held in trust – gains are free from IHT, but income tax may be payable on a chargeable event:
- bare trust – liability for the beneficiary;
- interest-in-possession or discretionary trusts – liability for the settlor if they are still alive and UK resident in the year of the event; if not, the trustees are liable at the trust rate of 45% (less 20% fund deduction). If none of the trustees are UK resident at the time of the event, the gain is assessed on any UK beneficiary receiving benefits.
Offshore
Same rules apply as for onshore bonds
- no tax is deducted in the fund;
- gains/excess withdrawals are taxed at 20%/40% or 45% – no 20% tax ‘credit’;
- gains from offshore bonds count as interest for the Personal Savings Allowance – this does not apply to onshore bonds.
With the exception of financial products, give four other examples of tax mitigation strategies?
Keeping adjusted net income levels below £100,000
Structuring an individual’s adjusted net income to remain below £100,000 to keep their full personal allowance and reduce the amount of tax payable. Or reduce net income to keep them from becoming higher or additional rate tax payer:
- making pension contributions to reduce gross pay;
- restructing investment portfolio to use spouse’s allowance
- Using CGT allowances to withdraw regular capital in place of income
Using spouse/civil partner’s allowance
Transfer ownership of funds, assets and products to spouses and civil partners without incurring any tax charges. Praticularly if on different tax bands.
Care should be taken to ensure that both partners are comfortable with this and sure of no unintended consequences. If not married might have iHT consequences.
Marriage Allowance
Can transfer 10% of personal allowance if transferring partner is non taxpayer and recipient is basic rate taxpayer.
Using CGT Allowances
Invest in growth not income products. When require income can make regular capital withdrawals to utilise CGT allowance £12,000 2019/20. Can transfer part/all of an asset to utilise spouse’s exemption too. Especially if on different tax rates.
CGT losses can also be carried forward.
Charitable Giving
How can charitable giving reduce a tax bill?
What are the three ways to recieve tax relief on Charitable giving?
Donations can reduce tax payable as will be eligble for tax relief. Can also used to reduce to lower tax rate band or preserve personal allownace by reducing net income below £100k.
Gift of Assets - Claimed via self assessment
Gift Aid - Increase value of donation by claiming basic rate tax relief on it. Donor must declare pay tax at least equal to tax deducted - not available to non-taxpayers.
Can claim further relief via self assessment if applicable. Increases tax rate bands by amount of gross donation.
Payroll Giving - Employer deduct payments from salary before calculator tax.
Outline the steps for Income Tax Calculations?
Points to remember:
You will gain marks for correct process and elements even if calculations are wrong.
DB contributions deducted before anything else.
Personal pension contributions added to basic rate band to get correct level of tax relief.
If applying allowance/exemption - be clear what it is and provide short explanation note.
Show where figures come from.
Step 1 - Work out the personal allowance. If different from standard explain.
Step 2 - Deal with personal pension contributions & gift aid. These extend tax bands by gross amount. Show the new tax band.
Step 3 - Calculate tax with HMRC priority of income:
- Earnings - deduct occupational pension contributions on this figure.
- Savings
- Dividends
- Capital Gains
Deduct Personal Allowance from earned/pension income to establish taxable income not forgetting to extend their rate bands by gross personal pension/gift aid contributions.
Establish which tax rates to apply
1) Total income, including savings and dividends below £12,500* = No Tax.
2) Earned/pension income below £17,500*:
- No tax on income or interest below £12,500*;
- the £5,000 starting-rate of 0% will apply to savings income;
- earned/pension income above £12,500* is taxed at 20%;
- savings income (interest) taking earned/pension income up to £17,500* is taxed at 0% (starting rate);
- Personal Savings Allowance (PSA) applies to the next £1,000 interest;
- balance of any interest taxed at 20%;
- first £2,000 of dividends tax free, dividends above £2,000 taxed at 7.5%;
- any taxable interest or dividends falling into the higher-rate band are taxed at 40%/32.5%.
Taxable earned/pension income less than £37,500:
- Taxable earned /pension income at 20%.
- Add savings income and dividends to the taxable earned income – if the result is £37,500 or less then the individual will receive the full £1,000 PSA – if the result is more than £37,500 the individual will qualify for £500 PSA. No PSA for income above £150,000; dividend allowance of £2,000 available regardless of income.
- Add together taxable earned/pension income and all savings and dividend income (including that covered by the PSA and dividend allowance). Calculate how much (if any) of the basic-rate band is left. The amount remaining up to the basic-rate threshold is available for savings interest above the PSA and/or dividends above the dividend allowance at the basic rate.
- The first part of taxable savings interest that takes total income up to £37,500* is taxed at 20%. If the savings interest does not take total income to £37,500* (or there is no savings interest), taxable dividend income sufficient to fill the gap is taxed at 7.5%.
- Any savings interest or dividends above £37,500* taxed at 40% or 32.5% –remember to deal with savings income first, before dividend income.
- In the unlikely event that savings/dividend income takes income above £150,000*, 45% or 38.1% will be due on that income.
Example:
- taxable earned income £36,500;
- interest £1,200; dividends £3,000 – total income £40,700, total income above the basic-rate threshold, so £500 PSA;
- £36,500 earned income at 20%;
- first £500 interest at 0% (PSA but included in basic-rate tax band); £500 interest at 20%, basic-rate tax band used up;
- £200 interest at 40% (higher-rate tax band);
- £2,000 dividends within the dividend allowance, so no tax, £1,000 dividends at 32.5% (higher-rate tax band).
Balance of earned/pension income above £37,500:
- personal allowance reduced by £1 for every £2 above adjusted income of £100,000;
- tax the balance up to £37,500* at 20%;
- tax the amount above £37,500* at 40%;
- tax the balance above £150,000* at 45%;
- savings income above £500 PSA taxed at 40% (no PSA if income is above £150,000, so all taxed at 45%);
- dividends above £2,000 taxed at 32.5% (38.1% if income is above £150,000).
*These figures will be higher if there are personal pension or Gift-Aid contributions
