A Capital Way of Saving Tax

August 8th, 2008

In 1988 the Conservatives changed the Income Tax rate to a maximum of 40% and aligned the Capital Gains Tax (CGT) rate.  This had a dramatic effect on income tax planning that was in place at the time.  Prior to this the Income Tax rate was up to 60% (super tax) and the Capital Gains Tax rate was 30% (after allowing for indexation).  A large amount of anti-avoidance legislation was in place to prevent income being classified as capital gain.

As paying 30% (capital gains) was preferable to paying 60% tax on income a number of schemes were established to effectively create an income stream, but have this classed as a capital gain.  This type of plan was eradicated by the Conservatives aligning the tax rates for both income and capital gains.

So why does this matter today?  Well the Chancellor has kindly removed this equilibrium by introducing a flat rate of 18% tax for capital gains (ignoring the even better entrepreneur rate of 10%) and this has reintroduced the potential for tax planning by using capital gains to provide income.  The following is an example of how it could work:

Mr Joe Average is a higher rate tax payer and wishes to provide an additional income of £12,000 per year from a lump sum of £200,000.

  • Solution 1 would be to put the monies in a high interest account paying say 6% interest.  This would provide the £12,000, but tax would reduce this to £7,200 (20% tax at source then 20% on the tax return as he is a higher rate tax payer)
  • Solution 2 would be to put the £200,000 into another investment, say a Zero (explained below) which aims to pay £212,000 in twelve months – as the gain is subject to Capital Gains Tax the £12,000 profit is taxed at an 18% flat rate, resulting in a net figure of £9,840 (this could be even less if the annual gains exemption is available to be used).

Solution 2 seems the obvious choice BUT normally the key aspect of an income is that this needs to be stable and not deviate too much.  This is where option 2 has some key issues.  When investing in a bank account the deposit should be safe (although recent history has taught us some lessons in this area) and the interest rate should be a known factor, especially on fixed accounts.  Other investments are subject to investment risk (especially considering the current credit crunch!) and can therefore fall and rise in value.  The question is – is this risk worth the income tax saving? This is where the skills of a financial adviser are paramount to help determine if you can afford the risk, or if reliability is the key.

There are other risks linked into this, from the past few budgets the Chancellor is looking to ensure that the tax take is maximised to help offset ongoing budget deficits.  The Government could therefore create further legislation to remove this tax imbalance, although given the CGT and 10% income tax change controversy this may not be on the immediate radar.

Below are some investments which could provide income in the form of a capital gain:

Zero coupon preference shares – Zero coupon preference shares (´zeros´) in investment trusts offer a pre-determined maturity value at the maturity date, provided there are sufficient assets in the trust at this time.  There was a high profile issue in the first part of this century which saw some zero investors lose their full investment (known as Split Caps) and this highlights some of the risks.  The consensus is that lessons have been learnt from this and therefore it should not be repeated, but this is not guaranteed.

Structured products – The tax treatment of structured products can be complex. Most retail structured products take the form of medium term notes (MTNs), which are normally subject to CGT on gains. If a minimum return on maturity is provided (eg; 115% of the original investment), this element will be subject to Income Tax. However, CGT will apply where there is a digital return, eg 22% at the end of three years, provided the FTSE 100 is not lower than at the start of the term as this type of return is linked to an investment performance.
The structured product market is a weird and wonderful one right now with all forms of exotic investment areas as well as the more traditional being offered, which in itself offers its own risks.

Offshore cash funds – These can be attractive short-term investments from a Capital Gains Tax viewpoint if they are single-priced. There is nothing to stop an investor buying a cash fund immediately after it goes ex-dividend (shares are not entitled to recently declared dividends) and then selling it just before the next ex-dividend date arrives. The fund price will reflect the accrued (gross) income over the period, but the investor’s profit will be taxed as capital gain.
The exercise would be pointless for a basic rate taxpayer as they would have no further liability on the income, but for a higher rate taxpayer it may be worthwhile, particularly if their annual exemption is still available. There is legislation to stop this type of exercise – the accrued income scheme – but it is directed at investment in fixed interest securities, not funds.
It must be remembered that cash funds can fall in value and there is no guarantee that they will always rise, it is therefore possible that no income will be produced.

These investments do not include the same security of capital which is afforded with a deposit account.

As mentioned before this an extremely complex aspect of tax planning and should not be entered into without appropriate financial advice from a professional, both on the tax and the investment elements. The above is merely a brief overview of the subject of using capital gains for income purposes and should not be relied upon in isolation, or as a substitute for advice when making investment decisions
The levels and basis of and reliefs from taxation are subject to change and their value depends on the individual circumstances of the investor.

The Transferable Nil-Rate Band

With regard to Inheritance Tax everyone is entitled to an amount that is chargeable at a nil-rate of tax – the nil-rate band (NRB).  For the current tax year 2008/09 this amount is £312,000.
The Finance Bill 2008 will introduce legislation to allow a claim to be made to transfer any unused nil-rate band on a person’s death to the estate of a surviving spouse or civil partner who dies on or after 9 October 2007, irrespective of when the first person died (including deaths before 1986 when Inheritance Tax was introduced).
The amount that can be transferred is the percentage of unused NRB on first death, and this percentage is then applied to the value of the then NRB when the survivor dies.

The maximum percentage of unused NRB that can be claimed is 100% (which would double the NRB available) and this allowance can be built up from the estate of more than one deceased spouse or civil partner.  The following example may help:
Mr A is married to Mrs B.  Mr A dies and a few years later Mrs B marries Mr C.  A couple of years after this Mrs B dies.

Action available to Mrs B’s personal representatives

Mrs B’s personal representatives on her death could claim any unused percentage of Mr A´s NRB, even though she had subsequently got married to Mr C.
If Mr C had also predeceased Mrs B then her personal representatives could claim any unused percentage of Mr C´s nil-rate band as well, as long as the total amount being claimed did not exceed 100%.
Under the draft legislation as it stands, if Mrs B had out-lived Mr A, but died before Mr C and her personal representatives had not made a claim for Mr A’s unused NRB, then on Mr C´s subsequent death, his personal representatives could only claim any unused percentage of Mrs B´s NRB and would not be entitled to any of Mr A´s unused NRB.
An amendment has been made to the draft legislation and is to be included in the 2008 Finance Bill.  This amendment will permit the personal representatives of Mr C to claim not only any unused percentage of Mrs B´s NRB, but also any unused percentage of Mr A´s NRB which the personal representatives of Mrs B could have claimed, but didn’t – subject to the overall limit that no amount in total can be claimed which exceeds 100% of the NRB.

In order to claim any unused NRB, the personal representatives of the surviving spouse will need to submit a form, IHT 216, to HMRC within 24 months from the end of the month in which the survivor dies. (www.hmrc.gov.uk/cto/iht216.pdf)

This claim form has to be submitted at the same time as the IHT 200 form on the death of the survivor, together with other supporting documents such as:

  • The death certificate of the first to die
  • A copy of the will (if one was made)
  • A copy of the grant of probate
  • A copy of the marriage/civil partnership certificate for the couple
  • If a deed of variation was issued to change the people who inherited the estate on the first to die, a copy of the deed
  • Details of any gifts/transfers which the first to die made in the 7 years before their death (which would become chargeable transfers on death and therefore use up some of their NRB)
  • Details of any exemptions and reliefs, other than the spouse/civil partner exemption, which would be relied upon to calculate the IHT on the estate of the first person to die e.g. business property relief.

The levels and basis of and reliefs from taxation are subject to change and their value depends on the individual circumstances of the investor.