the 50% rate of tax

The Chancellor announced in this year’s Budget that the higher rate of income tax would be raised to 50% from April 2010. This rate will be applied to income over £150,000.

These notes look at how the new rate will work and what possibilities there are to mitigate its effects.

The new rate applies to total income in excess of £150,000. In addition the personal allowance, currently £6,475 is being withdrawn. The withdrawal is staggered, starting at income levels of £100,000 and being fully withdrawn for income levels of broadly £113,000 and above.

 

There are a number of opportunities to minimise your tax rate depending upon your circumstances. Below we have looked at the opportunities for individuals, employed and self employed individuals including directors and partners and trustees. We have also looked at tax efficient investments. Pensions have become extremely complicated for the next two years due to the anti-forestalling provisions, so we have included a separate datasheet on this area.

employees and directors

• dividends: Dividends might be brought forward to be paid in the current tax year, that is before 6 April 2010. With the benefit of the tax credit the effective rate of higher rate tax paid on a dividend currently represents 25% of the cash dividend received. With the introduction of the additional rate from 6 April next this will increase to 36.11%. Where dividends are to be paid in respect of profits earned in the current tax year these should be paid before 6 April 2010 to benefit from the current lower marginal rate. Where available cash and distributable reserves permit, consideration might be given to the payment of interim dividends in the current tax year “on account” of next or future years’ profit. In appropriate circumstances these dividends might be loaned back to the company by the recipient shareholders to assist the company’s cash flow.

• bonus payments: Similar considerations apply where discretionary bonuses are to be paid in respect of profits earned in the current tax year. Such bonuses should be paid before 6 April 2010 in order to secure that the bonus is taxed at the lower marginal rate in the current tax year. Consideration might be given to accelerating bonus payments with respect to future years or making payments “on account” of such bonuses in the current tax year

• accelerated payments: It may, in appropriate circumstances, be possible to accelerate other contractual entitlements to employment income or benefit. Rights occurring under employee share participation arrangements might be vested in the current year, again with the view of taxing the resulting income at a lower marginal rate.

• share schemes: Employee share schemes which afford a capital return to employees on a sale of their employee shareholdings are made significantly more attractive with the rise in marginal rates of income tax. Share option schemes, such as the Enterprise Management Incentive (EMI) and the Company Share Ownership Plan (CSOP) afford employees the opportunity of receiving shares in their employer companies without income tax charge and with the potential to enjoy a capital return (taxed at CGT rates of currently 18%) on sale of the shareholdings acquired.

• salary sacrifice: A successful salary sacrifice entails you, as an employee, giving up your right to receive salary in exchange for a non-cash benefit, most often a pension contribution. The use of a salary sacrifice in exchange for a non-taxable benefit would reduce the liability to tax at the 50% rate.

• income splitting: In the Arctic Systems case HMRC challenged, under the settlement provisions, the situation where shares in a company are held by one spouse and all the value is added by that individual’s spouse. An example would be where a wife owns shares in a company through which the husband conducts his business. The House of Lords held that the dividends would be treated as income of the spouse who owns the shares because it fell within an exemption for ‘outright’ gifts between spouses. HMRC have twice deferred introducing legislation to deal with this although it remains clear that they consider income splitting to be “unacceptable and unfair”.

individuals

• equalisation of income tax between spouses: Since independent taxation was introduced, tax planning has included the equalisation of income. The object of the exercise being to ensure that both spouses utilise their personal allowances and lower rates of tax which is normally achieved by transferring cash or other assets between spouses to bring about equalisation. However beware of income splitting (see above). This is perhaps more significant following the introduction of the 50% rate of tax.

• gift aid: Payments made to charities under the gift aid scheme reduce the tax payable at the higher rates of tax which after 5 April 2010 will be 50%. This will not affect the tax that can be claimed by the charity.

• trustees: Trusts subject to the trust rate of tax will also be affected by the increase in the higher rate of tax effective from 6 April 2010 as all of their income except dividends will be taxable at 50%. The dividend trust rate will be 42.5%, providing the dividends are accumulated. Any distribution of income will carry a tax credit at 50%. The individual beneficiaries’ personal tax circumstances should be borne in mind when considering what can be done as this may affect the trustee’s planning. The terms of the trust will dictate what the trustees can do (assuming that they do not have an unused tax pool brought forward). Perhaps the first thing the trustees may consider doing is to make distributions before 6 April 2010 to beneficiaries. If a trust can still accumulate income and make capital payments then the trustees could consider making a distribution of income that is the maximum possible without incurring an additional tax liability. The balance could then be accumulated and distributed as capital. Consideration could be given to giving beneficiaries an interest in possession in income (on a revocable basis in case of subsequent changes) which will, as well as benefitting beneficiaries, reduce tax compliance costs due to the simplified trust return.

self employed individuals and partners

• incorporation: The introduction of the 50% additional rate means that the differential between the highest marginal rate of income tax (50%) and corporation tax (28%) will rise to 22% from 6 April next. This differential may be significantly greater where account is taken of the effect of national insurance contributions on employment and trading income and that the benefit of the small companies’ rate of corporation tax may be available. Unincorporated businesses might therefore consider the advantages of incorporation with a view to sheltering profits at lower rates of corporation tax. Clearly, incorporation has profound commercial consequences in terms of the ownership and management of a business and incorporation solely to enjoy the benefit of lower tax rate will generally be inappropriate.

• change of year end: If you have an accounting year-end other than 5 April (or 31 March) then you could consider changing your year-end to that date. The benefit of this would be that you are moving profits from the 50% rate of tax due next year to the current lower rate of 40%. The additional profits this year could be reduced by any overlap relief that is available for set off against the profits. The downside to this is that you will be paying tax on the profits for the period from the end of your current accounting date to 5 April, less any overlap relief, a year earlier than you currently would do.

• corporate partner: Partnerships for whom incorporation is inappropriate might consider introducing a corporate partner (or member in the case of an LLP) with the view of profits being sheltered at lower corporation tax rates. It is anticipated that the corporate partner or member would be owned by the partners and reflect their profit sharing arrangements. The corporate partner or member might provide other commercial facilities to the partnership with the view of extracting profit into the company tax regime.

investment

Notwithstanding the increase in income tax rates, capital gains tax rates are still at 18%. We do not know how long this will last but while it does it makes sense to try to utilise this rate where possible.

Firstly, it is worth re-stating the old adage that you should not let the tax tail wag the investment dog. The type of investment chosen should be based on your objectives and your attitude to investment risk. If you can then package the appropriate investment in a suitable tax wrapper, all well and good.

There are a number of tax wrappers that enable the generation of tax free or at least tax efficient income and these are summarised below.

Some investments are designed to produce capital growth rather than income. They can still be used by investors looking for income by putting together a portfolio of such investments maturing at regular intervals and treating the growth in value as income. Capital Gains are currently taxed at no more than 18%.

(i) ISAs: It is possible to invest up to £7,200 each tax year in ISAs (£10,200 from 6th April 2010 or from 6th October 2009 for the over 50s). Income and capital gains from ISAs are tax free. By making use of the allowances each year it is possible to build up a significant portfolio. Investment can be in cash and stocks and shares ISAs depending on how you want to invest and the amount of risk you want to take. 

(ii) investment bonds: Investment bonds issued by insurance companies enable you to invest in a wide range of assets. The bonds are tax efficient in that the underlying funds are generally taxed at no more than 20% on income and gains. It is possible to withdraw up to 5% per annum of the original investment for up to 20 years with no further tax liability. Any withdrawals in excess of this will be liable to tax at your top rate less 20%. In the year of encashment there is a potential liability to higher rates of tax. Thus it is possible to defer higher rates of tax for 20 years or more and, by careful planning, the tax on final encashment can be reduced or avoided altogether. These bonds can be arranged offshore and in this case the funds do not suffer tax but will not be able to recover any withholding tax (eg. on dividends). The same tax deferred 5% per annum regime applies. On final encashment, there is a potential liability to basic as well as higher rates of tax.

(iii) unit and investment trusts: Dividends from unit and investment trusts are treated in the same way as dividends from shares – in other words there is a credit to cover the basic rate tax liability but, if you are a 50% tax payer, the dividend will be taxed at the additional rate of 42.5%. However, there are some opportunities for avoiding tax on income. Split capital investment trusts attracted a poor press some years ago because of the closely inter-related structure of some trusts and their failure to perform. However, the theory of these trusts is sound and those trusts structured to generate no income but capital gains could benefit from a renaissance. Trusts investing in overseas equities do not generate much by way of dividends, focusing on capital growth instead. Unit and Investment Trusts are a good way of investing in overseas stock markets.

(iv) zero coupon bonds: A zero-coupon bond is a fixed interest investment or debt security bought at a price lower than its face value, with the face value being repaid at the time of maturity. It does not make periodic interest payments, or have so-called “coupons,” hence the term zero-coupon bond. Investors earn a return from the compounded interest all paid at maturity plus the difference between the discounted price of the bond and its par (or redemption) value. Examples of zero-coupon bonds include U.S. Treasury bills and U.S. savings bonds.

(v) national savings: Many National Savings products (but not all) provide tax free returns. Examples are Premium Bonds, Fixed and Index–Linked Savings Certificates. Furthermore they offer high levels of security. However, generally the returns are poor – the prize fund for premium bonds is currently only 1% and Savings Certificates offer a maximum return of 1.9% per annum over 5 years. Having said that, if we are in for another bout of high inflation, Index Linked Certificates offering inflation plus 1% per annum tax free could be attractive.

(vi) pensions: The attached datasheet from haysmacintyre Financial Planning gives detailed advice on the planning opportunities and the anti-forestalling provisions.

Anne Gregory-Jones
tax partner | 020 7969 5520
agregory-jones@haysmacintyre.com