Tax avoidance often focuses on taking advantage of loopholes in legislation, so that the actions taken aren’t technically illegal. But such actions are still seen as against the ‘spirit of the law’ and unfair to the vast majority of taxpayers who pay their fair share. Aggressive tax avoidance is increasingly being categorised with tax evasion under the heading of ‘tax non-compliance’.
Retrospective action by HM Revenue and Customs HMRC can leave an investor financially worse off than if they had done nothing, not to mention the inconvenience of having to go through a disruptive and lengthy investigation.
In contrast, tax planning focuses on making best use of those allowances and schemes that are explicitly allowed within legislation. The adviser and client can then sleep soundly at night knowing that HMRC is comfortable with the methods used.
In taking this approach when carrying out tax planning, it is not always appropriate to save every penny possible. There is often a non-financial trade-off to consider.
Income tax planning
There are two aspects to income tax planning: firstly, reducing the immediate tax liability in a particular tax year, and secondly the longer-term target of reducing the level of taxable income in subsequent years.
Where both the income and capital are required, use Isa allowances every year as far as possible, even if this is to be held in cash at today’s underwhelming interest rates. Using the allowance now will shelter the capital from income tax and capital gains tax (CGT) for years to come.
For couples who are married or in a registered civil partnership, transferring ownership of income-producing assets can take advantage of two sets of personal allowances and basic rate bands. In addition it can avoid the 60 per cent effective tax rate suffered in the personal allowance trap which applies to taxable income falling between £100,000 and £120,000 in the 2014/15 tax year (subject to the personal allowance being £10,000 in 2014/15, which has been assumed for the purposes of the example in Box 1).
The 10 per cent dividend credit is non-reclaimable in tax wrappers, meaning that basic rate tax is effectively paid even where dividend income is received within an Isa or pension wrapper. Preferentially holding interest-bearing assets within tax wrappers allows that savings interest to be received gross. Any dividend-producing assets held outside the tax wrapper will offset the basic rate dividend credit against income tax.
Investment bonds can be used to provide a tax-deferred ‘income’ stream. Any chargeable gain triggered by a bond encashment is top-sliced by the number of years the bond has been held to apportion the gain between the tax bands. However, the entire gain is added to the individual’s taxable income to determine their entitlement to the personal allowance. If this takes the individual into the age allowance or personal allowance trap they will indirectly incur more income tax. In this situation it may be appropriate to stagger encashments across tax years, as illustrated in the example in Box 2.
Where a bond encashment has already been made and the gain on the bond is falling into higher rate tax bands, a personal pension contribution may extend the basic rate tax band to allow part or all of the bond top-slice to fall into lower rates of tax. However, this will not avoid the personal allowance trap described above.