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.
Where the income is surplus but the capital is not
Switching income-producing assets to growth assets will simply delay taxation, since gains will eventually be assessed through CGT. However, it does give the investor more control over the timing and amounts of tax payable. Additionally, CGT tax rates are lower than their income tax equivalent.
Using the ‘normal expenditure out of income’ exemption to make IHT-efficient gifts won’t reduce the immediate income tax liability, but it will prevent the surplus income compounding. This can have a significant effect in reducing future potential tax liabilities - not just income tax, but also CGT and IHT.
Where both the capital and income are surplus
Gifts of capital to individuals and trusts will help to reduce future income tax, CGT and IHT liabilities.
Remember that for effective tax planning, this must be an outright gift, so ensure the capital is genuinely surplus to the client’s needs, both now and in the foreseeable future. Gifts may trigger CGT and/or IHT liabilities on the donor which must also be balanced against any potential future income tax saving.
Seeing the benefit of the income tax planning
Where steps have been taken to reduce the income tax liability, for example through pension contributions or charitable gifts, it seems obvious to state that the individual then needs to actually claim the tax relief from HMRC. However, every year taxpayers fail to claim the higher rate tax relief that they are entitled to, negating any benefit of tax planning.
Where tax relief is due, the individual can contact HMRC to claim the refund sooner, rather than waiting to claim it on their annual tax return. An adjustment to the PAYE code will allow ongoing regular pension contributions to gain immediate tax relief.
If total taxable income is lower than the personal allowance and likely to remain so, filling in Form R85 allows the individual to receive their savings income gross. This removes the need to apply (and wait) for a refund.
Victoria Harman is a chartered financial planner at Hargreaves Lansdown
