As happens every 6 April, the new tax year begins. This also gives the availability to use that year's allowance. For most of these allowances it's a 'use it or lose it' scenario for the tax year in question.
This article is part of Oracle Technical September 2017.
A common theme that we raise in the team is that wrapper switching can be beneficial and an essential part of planning and subsequent reviews. Also with remakes in Hollywood on the increase, it felt like an opportune time to dust this off.
With that in mind here is a canter through a 'magnificent seven' reasons why wrapping up authorised investment funds (AIFs) such as Unit Trusts/OEICs/Investment Trusts may be of benefit.
1. Your client is exceeding the dividend allowance
The dividend allowance (as it's commonly known) is a rate of zero taxation on dividend income. This is currently £5,000. Anything after that is taxed at 7.5% for a basic rate taxpayer, and for higher and additional rate taxpayers this is 32.5% and 38.1% respectively. At time of writing, the government have just released the new Finance Bill confirming the intention to reduce the dividend zero rate to £2,000.
Therefore, should a client exceed this £5,000 (or with an eye on the future, exceed £2,000) of dividend income then this may be better placed in an investment that doesn't produce an income, to reduce the client's tax bill. This could also be helpful for a basic rate taxpaying client as they ordinarily don't have to complete a tax return, but would have to sort out their tax on dividend income above the allowance by completing one.
2. Avoiding tax traps
Although the dividend allowance gives you £5,000 of dividend income tax free, thinking of it as anything other than a zero rate of taxation could create issues. This is because the dividend income is still calculated in amongst your adjusted net income. Therefore, someone with a salary of £99,000 and their only other source of income is £5,000 of dividends will have an adjusted net income of £104,000. This would lead to a loss of £2,000 of the personal allowance and in effect suffer 60% tax on the £4,000 adjusted net income above £100,000.
Switching wrappers to a bond, ISA or a pension could reduce the taxable dividends being paid and reduce the effect of this trap.
3. Using ISA allowances
Income and gains from an authorised investment fund are taxable for the investor. ISAs can invest in these funds and the gains and income from these are tax free on the investor (it's important to remember that they may not be tax free depending on the IHT situation of the client).
4. Using the capital gains annual exempt amount
Although you can carry forward capital losses from previous tax years indefinitely until they are used up, in year losses are used up before the annual exempt amount (AEA) for CGT gains can be used. But the AEA (currently £11,300) disappears at the end of the tax year and this is not available to be carried forward.
Therefore, making use of the AEA with collectives is a handy way to reduce future gains rather than leave the client's money in one fund for a long number of years and having a potentially substantial gain. But is important to remember the 'Bed and Breakfasting' rules that can apply to this. Under this you cannot crystallise the gains in one fund and re-purchase the fund within 30 days, or else the purchase price of the shares is effectively not altered for CGT purposes.
However, you can Bed and ISA and/or Bed and SIPP and keep the same fund just in a different wrapper. Beware though, an in-specie contribution to a SIPP may create issues with HMRC.
You could also Bed and Spouse, whereby you sell the collective, and your spouse purchases same value of shares on the same/next day. Then going forward they can also use their AEA to mitigate future gains.
5. Reducing trust admin/tax returns
Trustees have to complete a tax return for all income-producing investments (such as OEICs and unit trusts). The trustee rates of taxation are a lot less generous than they are for individuals. To cut down the extra admin a non-income producing asset can be extremely useful.
Investment bonds are non-income producing and would save on trust admin until a chargeable event occurs. Open architecture bonds will also let you use collectives as the investment wrapper if ordinary life funds are not suitable.
6. Tax relief (or its equivalent)
AIFs can be gradually moved over to an investment (either as an in-specie contribution or a sale and buy back within a new wrapper as detailed in point 4). The benefits of this is that by using a pension as a new wrapper you would get tax relief at marginal rates. There is now also the option of the Lifetime ISA (LISA).
LISA contributions (up to the £4,000 annual limit) will get a government bonus of 25% of the contributions (e.g. contribute £1,000 and the government will add £250). It's also important to note that the 25% bonus mentioned earlier effectively mirrors the basic rate relief given to a relief at source contribution, even though that’s referred to as 20% relief. But there is no further 'relief' for higher or additional rate taxpayers as per a pension.
It's important to analyse the situation, as for a pension contribution annual allowance and lifetime allowance come into play, and the overall net benefit to the client upon extraction must be analysed.
Access would also need to be factored in, as for both a pension and LISA there are limitations on when these can be accessed.
7. Tax-free fund switching
Whilst AIFs offer a wide range of funds for those that use model portfolios, regular reviews of the funds and the subsequent rebalancing can then create CGT issues depending on the size of the portfolio. Gradually moving these investments over to assets that can fund switch with no personal taxation implications. So by incorporating ISA, pension and bonds within the model portfolio stratagem you can maintain the required balance of investments with no CGT implications.
Whilst the tax tail cannot wag the investment dog, and vice versa, careful and holistic planning around the use of funds and the (combination of) wrappers around them is essential. Or to put it another way (and quoting Vin from the Magnificent Seven (played by the late great Steve McQueen)) "All I'm saying is that sometimes you bend with the breeze, or you break."
Part of the balancing act is the effect of taxation on switching, along with any associated advice charges, the ongoing taxation and the charges within the wrapper of choice.