Financial & Tax Planning - A Briefing On Topical Issues, Winter 2006/07

Season’s greetings. In this issue, we provide some food for festive financial thought, as well as some planning ideas and good cheer to help you bring your financial resolutions to fruition. We wish you a prosperous New Year.

Although individuals can now get tax relief on pension contributions of up to 100% of their earnings in any tax year, if they exceed their annual allowance they will be liable to 40% tax.

As a result, high earners are effectively capped by this allowance – £215,000 gross in 2006/07, rising by £10,000 per year to £255,000 gross in 2010/11. Future increases will be at the discretion of the Treasury.

This all looks quite straightforward, but closer scrutiny reveals that it is possible to double up on the annual allowance with careful planning. This is because the annual allowance test is undertaken with reference to ‘pension input periods’ (PIPs) ending at any point in the tax year. By contrast, tax relief is granted by reference to earnings and the contributions an individual actually pays in the tax year.

To find out whether the annual allowance has been exceeded in a tax year, contributions to money purchase schemes and the deemed value of defined benefit accrual are combined to calculate an individual’s ‘pension input amount’ for all PIPs ending in that tax year. If the total pension input amount for PIPs ending in the tax year exceeds the annual allowance, the 40% annual allowance charge applies.

Strictly, the PIP for a new plan commences when the first contribution is made after 5 April 2006 and ends on the anniversary of that date, unless the member notifies the scheme administrator of an earlier end date. If, for example, the first contribution after 5 April 2006 is made on 1 December 2006, the first PIP will end on 30 November 2007. As this falls in the 2007/08 tax year, the pension input amount will be tested against an annual allowance of £225,000 gross, not £215,000 gross. Whilst this gives an additional £10,000 capacity compared to a PIP ending in 2006/07, it also means that the 2006/07 allowance is unused. This could be problematic if the individual is close to retirement and wishes to maximise his/her contributions.

Planning opportunities

The ability to nominate the first PIP end date presents an opportunity for high earners to double their contributions in one tax year, providing they have sufficient earnings.

This is achieved by contributing £215,000 gross into a new plan and nominating the PIP end date as, say, 31 December 2006. As this is in the 2006/07 tax year, the contribution is tested against the annual allowance of £215,000 gross.

A further contribution of £225,000 gross can then be made to the same scheme between 1 January 2007 and 5 April 2007. This PIP will end on 31 December 2007 and the contribution will be tested against the 2007/08 annual allowance of £225,000 gross.

As tax relief is granted with reference to the tax year of payment, not the PIP, the individual will receive relief on contributions of £440,000 gross in 2006/07, providing they have sufficient earnings in the tax year. 22% basic rate relief will be given at source whilst an additional 18% higher rate relief of £79,200 will be due from HM Revenue & Customs (HMRC).

There will be no annual allowance charge as the individual will not have exceeded the annual allowance for either 2006/07 or 2007/08.

It is vital, however, to ensure that any contributions paid into the same plan in the 2007/08 tax year are delayed until after 31 December 2007, and the PIP for 2008/09 has begun.

In an extreme example it would be possible to pay pension contributions of £675,000 gross over four days commencing on 3 April 2007, and obtain full tax relief without triggering any clawback, but this requires very careful planning.

The new pensions regime introduced on 6 April 2006 (A-Day) was designed to simplify pensions. However, the rules for pension funds investing in unquoted shares remain complex.

Putting private company shares into a SIPP might sound like an attractive idea, but there are significant tax and other potential traps for the unwary.

Even if the traps can be avoided, trustees will need to ask themselves whether such shares are really a suitable investment for a pension scheme.

If a pension scheme holds shares in an unquoted company that buys residential property or moveable assets costing more than £6,000, the pension scheme may be deemed to have purchased those assets direct. In these circumstances a scheme member faces a tax charge of 40% or 55%. The pension scheme also faces a tax charge, typically of 15%, and a further charge of 40% will be levied on any income and/or gains subsequently arising on that asset. This means that if the company buys plant and machinery, for example a company car, costing more than £6,000, this could trigger substantial tax charges.

These rules will automatically apply unless the unquoted company is able to satisfy all of the following conditions.

• The company must be carrying on a trade, profession or vocation. Investment companies do not qualify for exemption.
• The company must not be controlled by the member, persons connected with the member and/or the SIPP either individually or together. This applies not only at the time of the initial investment, but has to be monitored on an ongoing basis.
• Neither the member nor a person connected with the member is a controlling director, otherwise the ownership threshold is reduced from 50% to 20%.

In addition to the threat of substantial tax liabilities arising from ordinary day-to-day transactions there are other practical considerations.

Agreement of valuations with HMRC for tax purposes is notoriously difficult and can involve substantial professional fees. HMRC applies its own criteria, particularly where minority holdings are involved, which may mean they bear little resemblance to open market valuations.

In many companies the shareholders are required to enter into an agreement which sets out the internal rules for governing the company and the arrangements for future share transactions. Pension trustees will need to understand the legal framework and take care to protect pension scheme members. If there is a shareholders’ agreement in place already the trustees will need to consider how onerous its obligations are and whether it provides sufficient protection for the SIPP. This again could lead to substantial professional fees.

Many companies now have schemes which involve staff being granted options to acquire shares. Share transactions involving a SIPP could provide a benchmark valuation for those employees exercising their options which affect their tax liabilities accordingly.

Where a company is sold the purchaser will normally require indemnities and warranties from the vendors and that could create problems for the SIPP trustee.

We have launched the Smith & Williamson SIPP which contains all of the wider investment freedoms available post A-Day. It is aimed at those individuals who would like their pension fund assets to be managed by Smith & Williamson.

Fees are designed to be both competitive and transparent. Basic SIPP fees are £250 for the initial set-up costs with a £300 annual fee, both subject to VAT. Smith & Williamson Investment Management fees within the standard SIPP are set at 1% + VAT on the first £1 million and on a reducing scale thereafter.

We believe that interest in the SIPP market will continue to grow and having been involved in the selfinvested personal pension arena for over 25 years, no other organisation has a longer track record. With over £400 million already under management in self-invested pension funds, we understand how to manage SIPP portfolios. We take care to understand our clients’ individual needs so that the SIPP portfolio is specifically tailored towards clients’ bespoke objectives, taking into account their risk profile.

For further information, visit our website www.smith.williamson.co.uk, or speak to your usual contact at Smith & Williamson.

For many years, anyone buying property in France, Spain or Portugal, among other countries, was advised to do so by purchasing shares in an offshore company which, in turn, owned the property. The main reason for this was to avoid the impact of local succession laws or taxes, rather than for UK tax planning purposes.

However, in 1999, two high-profile cases highlighted that in certain circumstances, an individual who bought offshore property in this way could end up with a UK income tax liability on a hypothetical benefit in kind.

UK tax law states that a benefit arises where living accommodation is provided for an employee by reason of their employment and this extends to directors and shadow directors. A shadow director is defined as "any person in accordance with whose directions or instructions, the directors of the company are accustomed to act".

The definition of a shadow director was reviewed in great depth in 2000 in a case brought by the DTI under the Company Directors Disqualification Act. The judge ruled that a shadow director was someone that the Board was accustomed to act on the directions or instructions of. In that particular case, the directors listened to the taxpayer, his advice had the potency of directions and his suggestions, when given, were adopted. It was questioned whether the Revenue intended that those rules should also apply to purely domestic arrangements where an individual sets out to buy a retirement home overseas and whether the only way that he/she can do so is by buying the shares in a company which owns the property.

The Revenue’s response made it clear that if an individual fell within the definition of a shadow director, then it would charge a benefit in kind which wouldn’t depend on whether or not UK tax mitigation was the motive. Its manuals provide that the individual firstly ascertain the market rental for the overseas property and assess the whole year’s rent, even if the ‘directors’ are only able to use the property for four weeks.

If investors can demonstrate that the real purpose of buying a property was commercial letting and there is good evidence to support that contention, they will be assessed on the market rental based on the number of weeks they actually use the property.

Despite recent representations, there has been no change and this continues to be a real problem. Arguably, the best advice for anyone planning to buy property offshore is to avoid doing so through a limited company or vehicles such as SCIs in France, which are regarded by the UK authorities as companies for this purpose.

Offshore investment bonds benefit from unique tax treatment, but are often overlooked as a tax planning tool.

An offshore bond is effectively a collection of investments held under the wrapper of a non-qualifying insurance policy, which is governed by its own tax rules. They can be highly efficient tax and investment planning wrappers.

Although certain dividends may be subject to withholding tax in their country of origin, offshore insurers are not subject to UK income or capital gains tax (CGT) – so that the investor can benefit from gross investment returns.

An assignment of the bond does not give rise to a tax charge, unlike assignments of assets subject to CGT. However, an individual’s CGT exemption and taper relief is not available to reduce any amount subsequently chargeable to tax.

Investments switches within the bond are not subject to CGT and can be made without concern as to whether a tax liability will arise.

If annual withdrawals do not exceed 5% of the original investment there is no tax liability when they are made. This 5% allowance is cumulative, although it ceases once total withdrawals equal the amount originally invested. On full encashment, or if withdrawals exceed the 5% allowance, the full amount of any gain or excess is subject to savings rate tax at 20%.

Higher rate tax may also be payable, although this will depend upon the number of years the policy has been in existence and other income of the policyholder in the year of encashment. With careful planning one or both of these liabilities can be avoided.

It should be stressed that individual investment portfolios might be better suited to investments subject to CGT as both taper relief and annual CGT exemptions can be utilised. It is important therefore that financial models are built to compare these two investment wrappers and judge their appropriateness in different circumstances.

Tax arising on chargeable events will be payable by the trustees at 40%. Where trustees are non-resident the tax is payable by UK resident beneficiaries of the trust. Where both the trustees and beneficiaries are not resident, no UK tax is payable.

A bond may be attractive to individuals who have, for example, used their lifetime allowance for pension purposes. When they get to retirement they can defer taking their pension, thereby reducing their income to nil, at which time segments of the bonds can be encashed with a view to limiting the tax charge to no more than 20%. To help this process an assignment can be made to a spouse who would be able to make use of their own 20% band.

All administration and paperwork is handled by the offshore insurers and funds can be switched or sold within the bond via simple written instructions. As they are non-income producing assets, no trust tax returns would be required, which reduces the administrative burden on the trustees.

Trustees can also assign the bond, or individual segments of it, out to beneficiaries who would then be able to encash it, paying tax at their own marginal rate which, in some circumstances, will mean that tax on growth can be avoided altogether.

In recent years, lower interest and annuity rates have reduced the income of many retired homeowners and, as such, property prices have increased and many people find themselves ‘property rich and cash poor’.

On paper, homeowners are wealthier than they have ever been, but because their wealth is tied up in their main residence, it cannot be used to help with living expenses or pay for those occasional treats and luxuries they were hoping to enjoy in retirement.

Whilst moving down the property ladder is a choice that suits many, those who wish to remain in their existing home can access some of the equity in their property by using an equity release scheme.

There are two main types of equity release scheme. One involves taking out a lifetime mortgage against the value of the property. The other, known as a reversion scheme, involves selling all or part of the property to an investment company, whilst allowing the owners to live in their home rent free for the rest of their lives. In either case, occupancy can continue until the owner dies or moves into long-term care.

A lifetime mortgage is a special type of loan that is designed to run for the rest of the borrower’s life. Funds are borrowed against the value of the property and taken in the form of a lump sum and/or a regular income. Currently, there are two types: interest-only or rolled-up interest. The former is for those who can afford to pay interest monthly but require capital for a particular purpose, whilst the latter is for those who cannot afford or do not wish to pay the interest, which is rolled-up into the debt and paid on death or when moving into long-term care. The interest rate is fixed at the outset and guaranteed for the life of the facility.

With a reversion scheme, all or part of the property is sold for usually between 20% and 50% of its current value, depending on the age of the owners. In return, the reversion company provides an income or a lump sum and a guarantee that the owners can stay in the property completely rent free for as long as they live or until the property is sold.

There are interesting tax planning opportunities for those letting a property which was previously their own home.

Since 1996, income from property has been taxed as though it was income from a trade or business, even though it is still reported separately from trading profits on the annual tax return.

This is a very simple piece of tax planning but can be very effective, as illustrated below.

Mr & Mrs A bought a flat in London in 1995 for £200,000. In 2005 they moved to a new house in the country and started to let the London flat. At the time of moving out, the flat was valued at £500,000.

Mr & Mrs A have changed the use of the flat from private occupation to letting, which is deemed to be a trade. The flat’s current value of £500,000 is equivalent to the amount that would be shown on a businesses balance sheet representing the ‘cost’ of the property.

A business can finance this in any way it chooses, for example, with either personal capital or bank borrowings of up to 100% of the value of the business.

Applying this basic rule, Mr & Mrs A can now borrow up to £500,000 against the flat and take out any surplus cash as drawings as and when they please, whilst the interest on the loan will be an allowable deduction from the rents they receive.

The 2006 Budget signalled major changes to the EIS and VCT regime. Now that the market has had time to digest these changes, we consider the merits and pitfalls.

The changes announced in April 2006 seem likely to herald the end of a boom period for the Venture Capital Trust (VCT) market. VCTs raised over £1.2bn from private investors in 2004/05 and 2005/06, the primary attraction being the 40% income tax relief on investments up to £200,000.

Relief has been reduced to 30% as of 2006/07. In addition, the size of qualifying companies has been reduced, presumably in order to focus investment on the smaller end of small companies. Investors are now required to hold VCT shares for a minimum of five years as opposed to three.

We will have to wait and see what effect these changes will have on the VCT market, but it is bound to dampen demand, which is clearly what is intended. Commentators suggest that the size of the market will reduce to £200m in 2006/07, roughly a quarter of last year.

Enterprise Investment Schemes (EIS), long considered the poor relation of VCTs, deserve a better press. The income tax relief on investments of up to £400,000 in 2006/07 may only be 20%, but EISs offer three things which VCTs don’t: capital gains deferral, inheritance tax exemption (after two years of ownership) and loss relief. The only thing they don’t provide is tax free dividends. The mere mention of loss relief can send shivers down the spines of investors, but if approached on a portfolio basis, which is the logical method, losses can be set against gains.

There were comparatively few gains in the period 2001 to 2004, although there has been a strong revival in the last two years. Capital gains are often made on unquoted securities or family business holdings and are now subject to accelerated taper relief, the effect of which is a 10% tax liability rather than 40% (assuming a minimum period of ownership of two years). Having said this, following the recent upturn in the stockmarket and substantial increases in the property market, there are now increasing numbers of people with good gains on personal assets which are subject to tax at 40% – and these are sometimes substantial.

Remember, to defer a CGT liability, you need only to invest the value of the gain or the profit itself and not all of your disposal proceeds. So, if your gain is £10,000, you need to invest £10,000 in the EIS, and in the process you defer or freeze the £4,000 CGT liability you would otherwise have to pay if it was subject to tax at 40%. It should be noted that this is a deferral, not an outright relief. When the EIS shares are disposed of, the original CGT liability is re-triggered, but can be re-deferred by reinvesting the value of the original gain.

It should also be remembered that the EIS provides unlimited CGT deferral (the raised £400,000 annual limit is only in respect of income tax relief) and this can be in respect of gains realised in the previous three years. What’s more, if you have already paid the CGT on those gains, you can reclaim it (plus interest!). Finally, EIS companies (even those on AIM or OFEX) are exempt from inheritance tax on death, assuming the shares have been owned for two years, unlike VCTs which are fully taxable, along with most other classes of asset. So the lesson here is that whilst VCTs may be good for providing tax-free lump sums in later life, try not to die with one!

Building up an EIS portfolio can be difficult for a private investor. Investments can only be new share issues and it is difficult to access new share deals, even if you can find out about them The answer is to enlist the help of a manager specialising in EIS with access to deal flow, who can build up a portfolio of investments for you.

EISs are often dismissed for their low quality. However, the standard has risen steadily in recent years and today there is a reasonable choice of good quality investments. There are still some assetbacked trades which are allowable for relief. Children’s nurseries were all the rage as EIS investments a few years back, but more recently the favourite has been pubs, which have a business model most investors can understand!

Over the last decade, AIM has developed into the most successful growth market in the world.

The Alternative Investment Market opened for trading in 1995 with just 10 companies. Now it comprises over 1,500 companies with a market value of about £80bn.

A key driver for the Alternative Investment Market’s (AIM) growth has been its simplified regulatory environment which allows AIM-listed companies to access public markets with less red tape and lower cost. This helps directors concentrate on growing their businesses and maximising value for shareholders. Once dominated by high-risk micro-cap stocks, the perception and make up of AIM has now changed. Institutional investors now make up over 40% of the market; but it is the private investor who benefits from the unique tax breaks given to stocks traded on London’s junior market.

HMRC classifies AIM-listed securities as ‘unquoted for tax purposes’ and, provided that the company in question is deemed to be a trading company (i.e. not an investment company), these shares may qualify for Business Property Relief (BPR). If held for not less than two years prior to death the shares will not form part of an individual’s estate for inheritance tax purposes. In addition, BPR will apply if one qualifying stock is sold and replaced with another, provided that the aggregate holding period is two years out of the five years prior to death. This means that an investor can make investment switches without restarting their BPR clock and losing the IHT benefits.

Many AIM stocks also attract Business Asset Taper Relief for CGT purposes. This means that once a share has been held for two years, any profit made in its disposal is subject to only 10% CGT.

Whilst AIM has grown in stature and importance, around three quarters of its constituent companies have a market value of less than £50m. Therefore, careful research and a clear investment policy is required to ensure that investors are protected against risk. By investing in a portfolio of the more established well traded stocks, investors are able to gain access to companies with potential for growth whilst the investment risks more commonly associated with AIM can be diversified.

It is also possible to take out life insurance to cover the two-year period prior to the IHT exemption being triggered. Finally, there are ways to hedge against losses and we will shortly be able to offer a capital ‘lock-in’ service for new and existing AIM holdings.

Over the past quarter, global equities have overcome their May setback and are closing in on their 2000 highs, despite some economic cross-currents that made the oil and mining sectors particularly volatile.

The fears of a US slowdown driven by the housing market were alleviated by the ongoing weakness in the oil price as inventories rose and the risk of disruption from hurricanes or Middle East tensions faded. The US housing market and the US economy no longer seem to be heading for a hard landing. Corporate earnings are not under pressure, and equities have become more attractive.

Global fund managers are divided about prospects. The latest Merrill Lynch regional survey shows a general consensus that the global economy and corporate earnings are slowing. Although regarding European, and especially US equity markets as undervalued, managers have lacked the courage of their convictions to run down their overweight cash positions. They should. We see further upside potential, based on a still healthy world economy, modest valuations and ongoing growth in corporate earnings. Most of all, we continue to see world markets being driven by liquidity which is fuelling merger and acquisition (M&A) activity.

We believe that the risk of recession has been significantly reduced by the fall in both the gasoline price and mortgage rates, and the current slowdown looks increasingly like a mid-cycle correction rather than anything worse. Indeed the Conference Board Leading Indicator rose in September for the first time in three months. The Dow has risen above the 12,000 level, and share price volatility is back to a 13-year low, suggesting that investors believe that economic cycles have become less extreme. The corporate results season passed with few unpleasant surprises, and we believe the market has further upside. Investors have still to evaluate the impact of the recent Democrat victories, but this is a story for 2007.

Despite a strong third quarter GDP number, which saw the economy growing by 2.8%, this has yet to translate into a healthier budget position; the latest monthly deficit, £12.3bn, was the highest September figure on record. VAT receipts are still suffering from carousel fraud, but corporation tax receipts are booming, and companies are beginning to protest. Companies domiciled in the UK are trying to mitigate tax by moving to lower-tax domiciles. This will put pressure on the Chancellor to find ways of reducing the tax burden on companies, but there is no suggestion from the Treasury that government expenditure will decline pari passu. Accordingly, we cannot expect the Chancellor to be generous to his captive market – individual taxpayers – few of whom are in a position to change domicile.

Meanwhile the Bank of England Inflation Report was surprisingly dovish. The Old Lady had feared that the economy is growing too fast for comfort, and that interest rates will have to rise, but has been forced to admit that, while immigration has boosted growth, it has also put downward pressure on wages – a view we have held for some time. We believe rates are now on hold. Equity valuations remain attractive.

The recovery in the economies is yielding unexpected bonuses for beleaguered governments. For the first three quarters of the year, German tax receipts have risen by 7.8% year-on-year and the budget deficit will fall well below the 3% of GDP threshold required by Brussels, a year ahead of schedule.

Despite the disappointing Italian Budget, which has made two rating agencies downgrade its credit rating, and the failure of the French Government to introduce labour reform ahead of the 2007 election, we remain optimistic of the Eurozone as a whole. We believe that growth will continue to surprise on the upside – as will M&A activity.

China’s growth is becoming monotonous – third quarter GDP grew by 10.4%, while industrial output grew by 16.1%. Retail sales rose by 13.9%, powered by a strong rise in both urban and rural incomes. Indeed, we expect the growing importance of the Chinese consumer to offset the US slowdown in 2007.

Indian growth is also accelerating – August industrial output rose by 9.7% year-on-year – despite a relatively stagnant agricultural sector, and the determined opposition of the government’s communist coalition partners to attempts to modernise the economy.

Clearly there is a lot of liquidity in Asia at present. The world’s largest individual public offering, for ICBC, China’s third largest bank, generated global orders of over $400bn, making the issue more than 20 times oversubscribed. Data out of Japan, however, remains somewhat disappointing, and despite the upbeat Tankan report and the undervalued yen, we would like to see some better news before committing new funds.

Disclaimer: This document contains information from sources believed to be reliable but no guarantee, warranty or representation, express or implied, is given as to its accuracy or completeness. This is neither an offer nor a solicitation to buy or sell any investment referred to in this document. Articles in this publication may contain future statements which are based on our current opinions, expectations and projections. Smith & Williamson does not undertake any obligation to update or revise any future statements. Actual results could differ materially from those anticipated. Appropriate advice should be taken before entering into any transactions. Some of the investments mentioned in this publication are not suitable for all clients and they may contain a risk that some or all of your capital could be lost.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.