With the Chancellor expected to begin recouping coronavirus relief spending in his forthcoming Budget, John Woolley explains why it is even more important than usual to consider planning for the end of this tax year
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. Planning now can also mean it is easier to use them in the next tax year. Planning is particularly important for those people who currently pay higher rate (40%) or additional rate (45%) income tax.
This year, early year-end tax planning is even more important. This is because it is widely expected that the Chancellor will bring in measures to increase tax receipts to HM Treasury in his Budget on 3 March. Some of the current available tax reliefs may be removed or eroded. Where appropriate, we reference likely relevant changes.
In this article, all references to spouses include civil partners and all references to married couples include registered civil partners. All tax figures quoted are UK excluding Scotland.
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.
1. INCOME TAX
(a) Maximising allowances, reliefs and exemptions
Each individual, regardless of age, is entitled to a personal allowance, starting-rate band, basic-rate band, personal savings allowance (PSA) and dividend allowance. It goes without saying that maximum advantage should be taken of each of these opportunities.
Suggested planning strategies would include the following:
- Reduce taxable income below £150,000 to avoid 45% tax. Pension contributions are one of the few ways to reduce taxable income and, following last year’s changes to the thresholds on taper relief, more people may be able to take advantage of this.
- The personal allowance (currently £12,500) is gradually withdrawn for individuals with income greater than £100,000 by £1 of allowance for every £2 of excess income.
At £125,000 (in 2020/2021), the personal allowance is lost completely. Earned income that causes the loss of the personal allowance is effectively taxed at 60%. If a person’s income is between £100,000 and £125,000, then pension contributions that are paid before 6 April 2021 can reduce income and restore all or part of the personal allowance, which would otherwise be lost. This means that the pension contribution effectively benefits from tax relief at up to 60%.
- Consider reinvesting in tax-free investments, such as ISAs, to replace taxable income and gains with tax-free income and gains, or investment bonds that can deliver valuable tax deferment.
- Note that if an investment bond chargeable event gain is triggered (for example, on full encashment) the full gain is included in an individual’s income without top-slicing when assessing entitlement to the personal allowance for the purposes of calculating tax on total income. However, following last year’s Budget changes, only the top-sliced gain is included when calculating the personal allowance for top-slicing relief.
With couples there is more scope to take advantage of tax breaks because both partners have their own allowances. Maximum tax-saving benefit can be secured where income/capital can be transferred from a higher- or additional-rate taxpaying spouse to a non- or basic-rate taxpaying spouse, with generally no tax implications on the transfer.
The following points should be noted:
- Couples should generally plan to each maximise the use of their personal allowance. A non-working spouse will be able to receive earned income, including pension income, of £12,500 (in 2020/2021) plus savings income of £6,000 (£5,000 zero starting-rate band plus £1,000 personal savings allowance) and dividend income of £2,000. This means income of £20,500 can be received in the tax year before they pay any tax. Of course, where any earned income exceeds £9,500 (2020/2021), there will be a National Insurance liability.
- Investment capital can be redistributed between spouses/civil partners to potentially reduce the rate of tax suffered on income and gains. No income tax or capital gains tax (CGT) liability will arise on transfers between married couples or civil partners living together, or where the asset to be transferred is an investment bond.
Any transfer must be made on a ‘no strings attached’ basis to ensure that the correct tax treatment applies. This means investments must be fully transferred, with no entitlement retained by the transferor.
- 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 each use their personal allowance.
(b) Investment allowances
(i) Personal savings allowance
Savings income that falls within the personal savings allowance (PSA) is taxed at nil rate and so is effectively tax-free. For basic-rate taxpayers, the PSA is £1,000 a year, for higher-rate taxpayers it is £500 a year, but no allowance is available for additional-rate taxpayers. ‘Savings income’ in this instance is primarily interest, but it also includes chargeable event gains made on single premium bonds.
(ii) Dividend allowance
The rate of tax paid on dividends is 7.5% for basic-rate taxpayers, 32.5% for higher-rate taxpayers and 38.1% for additional-rate taxpayers.
However, all individuals are entitled to a dividend allowance of £2,000 irrespective of the rate of tax they pay. All investors should seek to use their dividend allowance to maximise tax-free income. Like the PSA, the dividend allowance is in reality a nil-rate band, so all dividends count towards adjusted net income, even though they are taxed at 0%.
The dividend allowance means that, regardless of their tax rates, a married couple can receive, in total, up to £4,000 of dividend income with no tax liability, provided that they share their dividends equally.
2. CAPITAL GAINS TAX
Following a review of CGT by the Office of Tax Simplification, there is intense speculation that the government may make reforms – in particular by increasing rates of CGT so they are more closely aligned to income tax rates and by reducing the annual exemption. Whether this happens or not remains to be seen. But for those investors who are concerned about a hike in the tax rates, the following CGT planning should be high on their agenda this year:
(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 that gains fall within the investor’s basic-rate tax band they are taxed at 10% (18% for residential property); and 20% if over the higher rate threshold (28% if gains from residential property).
The annual exempt amount (AEA) is deducted before determining taxable capital gains. For individuals, the AEA is £12,300 for 2020/2021 and £6,150 for most trustees. For higher- and additional-rate taxpayers, who will otherwise generally pay CGT at 20%, use of the annual exemption in 2020/2021 can save up to £2,460 in tax. For a basic-rate taxpayer, the tax saving is worth up to £1,230. It is important to use the annual exemption each tax year because, if unused, it cannot be carried forward.
Unfortunately, in using the CGT annual exemption 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, such as shares in an OEIC, and bought back immediately within an ISA.
- Bed-and-SIPP. Here the cash realised on sale of the investment is used to make a tax-relieved contribution to a self-invested personal pension (SIPP), which then reinvests in the original investment.
- Bed-and-spouse. One spouse can sell an investment and the other spouse can separately buy the same investment without falling foul of the rules against bed-and-breakfasting.
- Bed-and-something similar. This involves the sale of shares in one fund with a purchase in a similar fund with a different provider.
(2) Independent taxation planning
A higher- or additional-rate taxpayer can make an unconditional transfer of assets into their spouse’s name to make use of that spouse’s annual exemption on subsequent disposal. This will mean that, between them, the spouses can realise capital gains of £24,600 in 2020/2021 with no CGT. This should not generally give rise to any inheritance tax (IHT) consequences or CGT implications.
Indeed, it may even be worthwhile to transfer an asset showing a gain of more than £12,300 if the asset is to be sold, as it would mean the surplus capital gain is taxed at 10% rather than 20%.
In transactions that 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 contributions to reduce the tax on a capital gain
Some people who are realising a taxable capital gain may have taxable income of about the basic-rate limit of £37,500. This means that a significant part of any taxable capital gains is likely to suffer CGT at a rate of 20%. By taking action to increase the basic rate limit, it is possible to save CGT. One method of achieving this is to pay a contribution to a registered pension scheme, whereby the basic-rate tax band is increased by the gross pension contribution, thus reducing CGT on the capital gain.
(4) Loss-relief strategies
In calculating taxable capital gains for a tax year, the taxpayer must first deduct losses of that same tax year, then deduct the CGT annual exempt amount. Loss relief can therefore be important, particularly for individuals who are higher- or additional-rate taxpayers and so pay CGT at 20% (or 28%).
Where the loss is a carried-forward loss, the taxpayer need only use so much of the loss that reduces the taxable gain by an amount that leaves the CGT annual exempt amount intact. Any balance losses can be carried forward.
Same tax-year losses are fully netted off against capital gains in that tax year 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 to restrict disposals so that resulting losses do not cause a part or all of their annual CGT exemption to be lost in the tax year in question.
(5) CGT deferral
If a person is contemplating making a disposal in the near future that will trigger a capital gain in excess of £12,300 (2020/2021), it may be worthwhile, if possible, to spread the disposal across two tax years to enable use of two annual exemptions. Alternatively, if the disposal cannot be spread or the gain is very substantial, the disposal could be deferred until after 5 April 2020 to defer the payment of CGT until 31 January 2023.
3. USING TAX-EFFICIENT INVESTMENTS
The annual contribution limit is £20,000. This means a couple could, between them, invest £40,000. A child aged 16 or 17 can invest £20,000 in a cash ISA in 2020/2021. No tax relief applies on a contribution to an ISA but income and capital gains are free of tax. For those whose dividend income could exceed their dividend allowance of £2,000, tax freedom on dividend income within the ISA will save tax at 7.5%, 32.5% and/or 38.1% as appropriate.
Where a spouse has died during 2020/2021 owning an ISA, a check should be made to determine whether an additional ISA allowance is available.
(b) Junior ISAs (JISAs)
Broadly speaking, JISAs are available to any UK-resident child, aged less than 18, who does not have a Child Trust Fund account. Any individual may contribute into a JISA on behalf of a child and the maximum contribution is £9,000 this tax year. Children aged 16 or 17 can also invest £20,000 pa in an ISA – see (a) above.
(c) Growth-oriented unit trusts/OEICs
Given the relatively high rates of income tax as compared to the current rates of CGT, it can currently make sense, from a tax perspective, for a higher- or additional-rate taxpayer, to invest in collectives geared towards capital growth as opposed to income. The investor can then make use of their annual CGT exemption on later encashment (or both annual CGT exemptions for a couple).
(d) Single premium investment bonds
As non-income-producing investments, single premium investment bonds (particularly offshore bonds) can deliver valuable tax deferment for a higher- or additional-rate taxpayer.
Any UK dividend income accumulates without corporation tax within a UK life fund and realised capital gains suffer corporation tax at 20%, with the investor in a UK bond receiving a basic-rate tax credit for deemed taxation in the fund.
(e) Enterprise Investment Scheme (EIS)
For tax-year 2020/2021, an investment of up to £1m (up to £2m if investment is made in knowledge-intensive companies) can be made to secure income tax relief at 30%, with tax relief being restricted to the amount of income tax otherwise payable by the investor in that tax year. The relief can be carried back to the previous tax year.
Unlimited CGT deferral relief is available, provided some of the EIS investment potentially qualifies for income tax relief, but investors considering deferral should remember that CGT rates may increase in the future.
(f) Venture Capital Trust (VCT)
The VCT offers income tax relief for tax year 2020/21 at 30% for an investment of up to £200,000 in new shares, with relief restricted to the amount of tax otherwise payable by the investor in that year. There is no ability to defer CGT but dividends and capital gains generated on amounts invested within the annual subscription limit are tax free.
4. INHERITANCE TAX
IHT receipts steadily increased to £5.4bn in 2018/2019 but reduced to £5.2bn in 2019/2020 – probably as a result of the increasing size of the residence nil rate band. However, with the increase in house prices in 2020, combined with a frozen nil rate band at £325,000 and the number of people dying without planning due to Covid-19, we can expect receipts from IHT to increase. The Office for Budget Responsibility expects that the number of estates subject to IHT will have increased by 20% in 2020/2021. This tax has also been subject to a ‘simplification’ review by the Office of Tax Simplification, so significant future changes cannot be
(i) Residence nil rate band (RNRB)
In 2020/2021, the RNRB reached its maximum of £175,000. Future increases will be inflation-linked. Planning in connection with the RNRB should be centred on reducing the value of an estate to less than £2m to qualify for the full RNRB. It is also important to make sure that gifts on death qualify for the RNRB if that is what is intended – for example, gifts to discretionary trusts do not. As part of this process, a review of wills is essential.
(ii) IHT yearly exemptions
For those potentially in the IHT net, it makes sense to make use of the yearly IHT exemptions:
- The £3,000 annual exemption. Any unused part of this can be carried forward one tax year, but it must then be used after the £3,000 exemption for that year.
- The normal expenditure exemption. Here, any gift is exempt from IHT if:
- It forms part of the donor’s normal expenditure.
- Taking one year with another, it is made out of income.
- It leaves the donor with sufficient income to maintain their usual standard of living.
For both exemptions, there is no requirement to survive seven years.
(iii) Lifetime gifts
For people who can afford to do so and who have been giving serious thought to it, now could be a good time to bring forward the making of lifetime gifts. We do not know what any future IHT regime may involve but the current rules on lifetime gifts are very favourable – potentially exempt transfers (PETs) can be made with no immediate IHT and, if the donor survives the gift by seven years, it drops out of account, with all investment growth on the gift accruing outside the taxable estate for IHT purposes from day one.
For those who want ongoing control over who will benefit and when, a trust can be used – and for those who need some ‘income’ from a lifetime gift, a loan trust or discounted gift trust can be important.
Pensions are thought by many to be “in scope” for government changes on tax relief in the forthcoming Budget. The £35bn or so of tax relief given on contributions has been considered as ripe for attack in the last few years, although no action has yet been taken. Given the financial pressures that have arisen out of the pandemic, there would be more justification for government action this year. For this reason, people should seriously consider maximising their pension provision now – especially if they are higher-rate taxpayers who have money available for investment. Here are some areas to consider:
- The carry-forward rules allow unused annual allowances to be carried forward for a maximum of three tax years. Thus, 5 April 2021 is the last opportunity to use any unused allowance of up to £40,000 from 2017/2018. The annual allowance for the current year must be used first and carry-forward relief can then be absorbed, using the earliest year first.
The threshold income level and the adjusted income level for the tapered annual allowance increased in 2020/2021 to £200,000 and £240,000 respectively. For persons with adjusted income of £312,000 or more, the maximum contribution they can pay in 2020/2021 is £4,000. However, in calculating the amount of unused annual allowance available for carry forward from tax years prior to 2020/2021, the rules that applied in those years will be relevant.
- If somebody has sufficient carry forward and their threshold income is only just in excess of £200,000, by making additional pension contributions they could reinstate their whole annual allowance for tax year 2020/2021, meaning more pension savings may be possible.
- For those who have adjusted net income in excess of £100,000 and are in the ‘personal allowance trap’, a pension contribution could give an effective 60% tax saving.
- Pension contributions can also help families recover their child benefit, which is progressively cut back if one parent or partner in the household has income of more than £50,000. Benefit is totally lost when income reaches £60,000 (£60,270 in 2021/2022).
- Individuals should consider making a net pension contribution of up to £2,880 (£3,600 gross) each year for members of their family, including children and grandchildren, who do not have relevant UK earnings. The government will add £720 basic-rate tax relief.
The end of the tax year is always an important time for clients and advisers to review their financial planning. This year, it will be even more important.
Technical Connection will be producing a Budget Bulletin covering the tax changes that impact on financial planning strategies for clients together with incisive analysis and commentary. For more information, contact Clare at Clare.Thomas@technicalconnection.co.uk (0207 405 1600).
John Woolley is director of Technical Connection/St. James’s Place