Investing beyond the tax "no brainers"

Learning Objectives:

• To understand and be able to factor into financial planning strategy the key changes made on the Autumn Statement affecting investment wrapper decision making
• To understand the new levels in relation to income and capital gains and what they mean in relation to securing tax free returns from unwrapped equity and fixed interest investments
• To clearly understand the capital investment levels at which investment bonds are worth considering as tax deferment and tax management structures

Most investors and all advisers appreciate that if you can invest in a way that:

• gives you tax relief on what you invest – thus reducing the cost,
• avoids or reduces tax on the income that the investment generates,
• avoids or reduces tax on the capital gains that the investment generates,
• avoids or reduces the inheritance tax otherwise payable when the investment is transferred,

then the financial outcome is going to be improved. 

The investments that most readily spring to mind in this context are the so called “no brainers”, the “Big Two”, pensions and ISAs, followed by venture capital trusts (VCTs), Enterprise Investment Schemes (EISs) and Business Relief qualifying investments.

Fortunately, no changes to the fundamental tax efficiencies of any of those were proposed in the recent Autumn Statement.

As a quick reminder – as if you need it:

Pensions

Tax relief on contributions, tax free gains and income at fund level, some tax free cash (the “PCLS”) and freedom from IHT. Yes, of course, there are some limitations, but it’s a pretty “rosy” tax picture we think you’ll agree – as do most clients who “get it”.

ISAs

No tax relief on the amount invested, but tax free capital gains and income. Maximum annual investment £20,000.

VCTs

On investments up to £200,000 each tax year: 30% tax credit; tax free dividends; and capital gains tax (CGT) free capital gains.

EISs

On investments up to £1 million each tax year (or up to £2 million if the shares were issued after 6 April 2018 and at least the second £1 million is invested in knowledge intensive companies): 30% tax credit; CGT deferral on reinvestment of funds into the EIS; and capital gains exempt after three years. And, as EIS shares must be unquoted shares in a trading company, they should qualify for 100% Business Relief after two years.

Business Relief qualifying investments

The Autumn Statement brought no changes to IHT, other than a further extension, of two years, to the end of the 2027/28 tax year, to the freezing of the nil rate band and residence nil rate band.

Freedom from IHT (whilst the investor retains ownership) remains on qualifying investment after two years ownership.

Beyond the tax “no brainers”

So, once you’ve duly considered, and to the extent you want to or can invest in, these “no brainers” what else is there to deliver tax efficiency?

This is a question that may be asked by more than a few clients, especially as we start the approach to the end of the tax year. And there are some interesting possibilities.

However, you have to accept that once you get past the immediate “tax gratification” delivered through a near to year end pension contribution, an ISA investment to ensure you use this year’s allowance or a VCT/EIS to trigger a 30% tax credit, any other tax efficiencies (and there definitely are some to be had) are going to take a little longer to realise. In other words, these investments will be more strategically tax efficient than tactically tax rewarding – but be in no doubt of the value in deeply considering those strategic tax advantages that, over time, can materially add to your financial “bottom line”.

So, what are they, these “slower burn” possibilities? Well, consider these:

1. A simple equity based collective investment (e.g. an OEIC or unit trust) invested as to 40% or more in equities

If the investor’s dividend allowance has not been used, then up to £2,000 of dividends (£1,000 from tax year 2023/24 and £500 from tax year 2024/25) would be tax free every year. Add to this the £12,300 of capital gains that can be made this tax year (reducing to £6,000 in 2023/24 and £3,000 from 2024/25) and you have an investment to compete tax wise with an ISA, but only up to these materially diminishing limits since the Autumn Statement. Of course, it’s not quite as simple and you have limitations (the level of the two stated exemptions), but this could mean that additional amounts invested outside of an ISA could still generate tax free returns.

Say £16,000 were invested and the dividend yield were 3% p.a. then the £480 dividend generated would be tax free now and though 2024/25. Managed properly, with annual disposal and reacquisition so as not to trigger the “bed and breakfast” anti-avoidance rules, the base value of the investment should be regularly increased within the annual CGT exemption, so minimising the chance of any chargeable capital gains on eventual disposal.  

For a couple, based on these assumptions, this could mean £32,000 of capital investment generating tax free income and capital gains. And remember, any income (even though tax free within the dividend allowance) that is reinvested into the investment will be counted as a fresh capital investment and so will not, of itself, enhance the eventual capital gain.

2. A simple “fixed interest collective investment (e.g. a unit trust or OEIC) invested more than 60% in fixed interest investments

The income generated from such an investment would be tax free to the extent that it fell within the investor’s personal savings allowance (£1,000 for basic rate taxpayers and £500 for higher rate taxpayers) and their 0% starting rate band of £5,000, subject of course to the reduction of this starting rate band amount to the extent that the investor has any other income above the personal income tax allowance of £12,570 - frozen until the end of the tax year 2027/28.

With interest rates and bond yields on the rise recently, this is something worth considering.

The CGT savings opportunity is the same as for the equity collective - taking due account of the scheduled progressive reductions in the CGT annual exemption.

Of course, in determining whether and, if so, to what extent, to invest in equity or fixed interest collectives then, while the respective tax savings opportunities for each are interesting, the predominant determinant will be investment appropriateness.

3. Investment bonds

To the extent that complete tax freedom is not possible through investment into collectives, then the tax deferment and tax management opportunities offered by UK (onshore) and international (offshore) bonds are definitely worth considering. This is especially (but not exclusively) so for higher and additional rate taxpayers.

The investment bond (UK or offshore) will deliver complete freedom from tax on UK dividends generated by the investments at life fund level with no limit. Compare that with the 33.75% or 39.35% payable by higher rate and additional rate taxpayers respectively on dividends received from collectives or direct equities – regardless of whether they have been reinvested or not.

The UK bond will also deliver a lower “internal” tax rate (20%) on non-dividend income and capital gains. And, in relation to the latter, tax will probably be reserved for at a lower rate than 20% on deemed (unrealised) gains on collectives held within the life fund.

A full 20% basic rate tax credit will be available for any chargeable event gains realised by the investor.

As well as tax freedom on dividends at life fund level, an offshore bond will of course also deliver tax freedom at fund level on non-dividend income and capital gains. However, it will not deliver a basic rate tax credit for the investor when they realise a chargeable event gain.

Both UK and offshore bonds offer the ability to manage the eventual tax outcome, and this is where the real benefit of the tax deferment is realised. To be able to withdraw or encash at a time that “tax suits” the investor. Essentially, when other income is low or non-existent.

As well as the well-known 5% tax deferred withdrawal opportunity, there is the potentially incredibly powerful “top-slicing” relief that can operate to keep the chargeable event gain outside of the higher/additional rate tax band.

As to whether a UK or offshore bond (or a combination) is best depends on the current and, perhaps more important, expected future tax position of the investor.

So, three (arguably four if you count UK and offshore bonds separately) simple, but highly effective, ways to invest tax efficiently beyond the so-called tax “no brainers”.

Self-evidently, informed advice is absolutely essential in order that investors are aware that these choices exist and then to have the right choices made for/with them based on deep knowledge of:

• the investor’s current and future financial and tax position; and
• the tax treatment and planning opportunities for the available products.