Tax

This is traditionally the time of year when the marketing and selling of Venture Capital Trusts and Enterprise Investment Schemes go into overdrive.  Never mind that they are available year round, as the end of the tax year approaches, investors and their advisers start to focus on the tax planning aspects to these investments.

VCTs and EISs differ in detail but both offer tax breaks in return for funding small and start up businesses.  There is deemed to be an economic benefit to the country as a whole in having a healthy environment for people to create businesses and, mainly because it can be fearsomely risky to give them money, generous tax reliefs are on offer.

The risks are twofold; firstly, there is the obvious risk that these businesses are more likely to fail than more established entities and, secondly, their shares are highly illiquid.

There are ways of mitigating these risks, though.  The first is to diversify your holdings across a number of different offerings and managers.  There may also be some sense in selecting a manager for your VCT (which hold shares in a number of companies) who has demonstrated some past success, not that we can take this as indicative of future performance but a consistent loser may be best avoided.  For an EIS (which constitutes only one small business), having a reputable firm behind the offering should be high on the list of wants.

The liquidity risk is more problematic.  There is no real secondary market for these shares so it is wise to be realistic about when you may see your investment again.  There is the prospect of tax free dividends over the long run, to say nothing of the other tax benefits, which may include income tax relief and IHT exemption (for EISs) but investors should be sensible about how much they commit and be prepared to be in it for the duration.

For a long time, the UK has been something of a tax haven for foreigners working or residing here.  The fact is that non-domicile residents are not taxed on overseas earnings or assets so long as the money remains offshore (there is a bit more to it than that, but that is the gist of it).  This has long annoyed many people, including the Unions, and Labour promised to do something about when they were elected back in 1997 but it has proved more problematic than expected.  Many non-domiciles (domicility is normally taken from the father and is usually permanent and difficult to change and is different to residence) do not have much stashed away abroad but some have a great deal.

One difficulty is that those with a lot of money overseas find tax optional, anyway.  They are highly mobile and are able to spend freely on advice.  They also tend to spend freely in the UK and the Government is keen not to see that money being spent elsewhere as it is useful to the economy and generates much tax indirectly.  

I suspect that some of the most vocal opponents of this tax break were the very people who have, themselves, benefited whilst working abroad or plan to move to Spain but keep their cash hidden in Gibraltar.  Anyway, 'something' had to be done so the Treasury seems to have come up with a fudge.  To retain non-domicile status will require a payment to the tax man of £30,000.  To a billionaire, this is a mere bagatelle, but to the majority of people working here (and paying National Insurance and Income Tax, from which they may derive few benefits) with a few thousand oversees, this will be punitive.  Of course, those here for a few years may just take a gamble and not disclose their overseas money but a few hapless people will be forced to give up their tax break.

It is hard to see that it will raise much for the Treasury but it may just make the UK a slightly less attractive place to do business and a number of competing countries are rubbing their hands in glee.

It seems that the Insurance Companies are getting a bit desperate about the plight of their Investment Bond sales.  It is worth bearing in mind that these are hugely profitable for the insurers because they lack complete transparency in most cases, so they can be loaded up with high charges, and they cannot be transferred to another company without triggering a tax charge (unlike, for example an ISA).  They have also proved to be a bit of a wheeze when it comes to commission because they can make a big payment to the adviser upfront (which means lots of sales) whilst neatly disguising its impact from the victim (sometimes called an investor). 

• Firstly, no client ever understands the taxation, either internally or externally and this causes problems for them.
• Secondly, the internal tax (which is deemed to be equivalent to basic rate tax) on onshore investment bonds is unavoidable.
• The investment bond and the investments it holds cannot be transferred to another provider, it must first be surrendered.

That is not to say there is never a case for using them, it is just that those occasions are relatively rare.

• be a basic-rate tax payer in the year of encashment,
• assign all or part of the bond to someone who is a non or basic-rate tax payer, or
• plan to cash in the bond after they retire abroad.

It states confidently that a higher rate taxpayer is unlikely to pay 40% on the gain (in this instance on an offshore investment bond) because they may be a basic rate taxpayer, have assigned it to a basic rate taxpayer or will have retired abroad.  ‘Abroad’ is presumably a place where no tax need be paid.  Of course, it is possible that some people will retire to countries where no tax is levied but many, if not most, will not.  Also, assigning an investment bond to a basic rate or non taxpayer is all well and good but there would have to be a high degree of trust, something that does not always exist even between spouses, as the investor will have, effectively, given the money away.  Finally, what if they are not a basic rate taxpayer, remembering that the full value of the surrendered investment bond is added to their income if is an offshore bond?

In Alistair Darling's first Pre-Budget Report, delivered to Parliament yesterday, one of the surprise moves was the removal of Indexation Relief.  This enables those disposing of assets acquired before April 1998 to make some allowance for the effects of inflation when calculating the Capital Gains Tax.

This may mean that for people in this position, some assessment of the likely impact would be advisable well before 5th April 2008.

Whenever a Government announces it is ‘simplifying’ something, it is almost always worth running for cover. At first sight, however, the changes to the Capital Gains Tax regime are fundamental and, indeed, represent a simplification. Most private individuals are unfamiliar with the workings of CGT, the annual exemption remains one of the least used tax breaks available and, despite a degree of simplification in recent years, it can be complicated.

At the moment, there are two types of gain, those which count as business gains, including the much publicised gains made by the Private Equity industry, and private gains, which include those made on listed shares and buy-to-let properties, for example. These gains are further subdivided into those made pre and post April 1998. The present system was supposed to favour those who held onto their assets for a long time (although, I am not sure why) and those whose gains resulted from a degree of greater risk such as entrepreneurial endeavour or buying shares in unlisted companies. It also bestowed a tax advantage on those owning shares in the company employing them, nice, if you happened to work for a listed company.

The tax on business gains could be as low as 10% and personal gains 25% but, in the case of the latter, only if held for at least ten years. Also the rate of tax depended on the level of income tax.

Now, it seems, all of this is to go being replaced by a flat rate of 18% on all gains. We shall have to see whether this simplification survives intact as many of these initiatives fall prey to the law of unintended consequences and it often looks like policy is made up on the hoof. Also, the problem it was designed to cure, namely, the ‘unseemly’ profits made by the Private Equity industry, may be about to disappear, victim to the global credit crunch.

Quite how these changes will affect investor behaviour will only become apparent in the longer run.

It seems that the tax position on buy to let properties is under attack. Private investors buying properties to let enjoy significant tax advantages compared with those buying other assets. The worry is that this is distorting the market and lining the pockets of the rich, i.e. property owners.

The current rules allow for any interest payments and other costs to be deducted from the rental income for tax purposes. In the eyes of many this is an unfair subsidy on those who take out hefty mortgages to buy a property for investment purposes.

Almost no other investments allow this. If you were to borrow to buy a share portfolio, any dividend income would be taxed with no provision allowed for the deduction of interest payments or the running costs of the portfolio.

Seeing something as iniquitous is one thing, doing something about it quite a bit different. For professional property investors, usually investing through a limited company, allowing the deduction of interest payments is comparable with someone running any other company. Also, the treatment of capital gains is different for limited companies.

This story is not new but will the Government act now? It will have to weigh up very carefully any impact on property owners, partly because many are landlords, or aspire to be, and partly because it would not want to start a rout in the housing market. That would hardly win it any votes, even amongst wannanbe first time buyers.

Once upon a time, death duties affected only the rich. One or two very rich people could happily be punitively taxed without any risk of losing votes. Also, in the days of exchange controls, there was very little that people with assets in the UK could do to avoid tax.

Nowadays, things are very different. There are no exchange controls and those with money can move it anywhere in the world, indulging in a bit of revenue arbitrage. Death duties, or Inheritance Tax as it is now called, have become much more democratic. With the Nil Rate Band currently set at £300,000, even those who do not read the Daily Mail have come to realise that they may struggle to pass on their wealth to their heirs.

This problem has been compounded by the fact that much of this wealth is in the family home and the value of granny’s semi has shot up over the last twenty years. Also, retired people are now the first generation of the property owning democracy, their parents will often not have owned a home. All of which makes this a very emotional topic.

The very rich do not pay much tax these days, often because they can afford to give much of it away well before they die, avoiding IHT. If you happen to live in your wealth or need it to live on, that option is hardly open to you. The financial world, particularly, the life insurance industry, has exploited this by marketing schemes to allow people to have their cake and eat it, using trusts and insurance in combination. From a cynical perspective, one of the reasons why some of these schemes work at all was that the charges ate away at the wealth, reducing the value of the estate. The trouble is that many of these schemes have been banned by the Government, often retrospectively, causing more and more prime voters to worry about passing their money on.

In many ways, IHT is quite fair. Families are evened out a little on death and taxes on those working are kept down, helping to reward those not born to an inheritance. The trouble is that the tax system has rarely been successful at this type of social engineering, partly because voters will not wear it. We all aspire to do well and hope for the same for our families. IHT also distorts behaviour, often negatively, and the main problem is that for ‘Middle England’ much of the money is in the house. It is not always desirable or practical to trade down to release the capital. Someone living in a £400,000 house in London can hardly trade down very far without moving away.

It also means that people will have to decide whether to give wealth away. All very well if you are sitting on Millions but more problematic for smaller sums when the future is full of uncertainty over life expectancy, health, nursing care, etc.

Perhaps it would be better to merge IHT in the Capital Gains Tax regime, as it is in many countries. Many investments, such as the home, could be exempt and there would be no need to give money away before death. Initially, at least, less may be raised but I am sure a way will be found to plug the gap. Whether we end up disliking that more is another matter.