Loopholes You Can Exploit... And those you can’t
Let’s face it, last year’s budget speech was a bit of a pussycat. It curled itself up on your lap, it made a few contented purring noises at you, and then it went to sleep. It was so bland and so inoffensive that it left the Conservative opposition floundering for anything bad to say about it. This year, however, the cat is well and truly back on the attack. Public spending is overreaching itself horrifically, tax revenues are stagnating, and consumer confidence is on the slide. Mr Brown is now a desperate man with a very large hole to fill.
Which is why the cat’s now running round the kitchen trying desperately to round up any of those cheeky mice who might have been hiding up in the tax loopholes in the skirting boards. Not to mention those clever rodents who’ve been using all the foreign bolt holes out in the neighbours’ garden.
TAX: THE GOOD, THE BAD AND THE UGLY
Once again, income tax bands have risen generally in line with inflation this year. You pay 10% on your first £2,090 of taxable income, over and above your personal allowance, compared with £2,020 in 2004/2005. Then it’s 22% on the next £30,310 (2004/2005: £29,380). The 40% tax threshold has risen accordingly from £31,400 in 2003/2004 to £32,400 in 2004/2005. National insurance contributions will henceforth be payable on earnings of between £94 and £630 a week, up in line with inflation from £91 and £610 a week in 2003/2004. But if you’re earning more than £630 a week you’ll pay an extra 1% on the excess.
The basic personal allowance has also risen broadly in line with inflation, from £4,745 in 2004/2005 to £4,895 for 2005-2006 — a 3.1% increase. Pensioners get a slightly bigger increase, with their income tax allowances rising by 3.8, so that the allowance for people aged 65-74 has now gone up from £6,830 in 2004/2005 to £7,090 in 2005/2006. People aged 75 or over will get a £7,220 allowance, up from £6,950.
The means-tested threshold for judging your eligibility for age-related allowances will rise by 3.1% from £18,900 to £19,500 — meaning that if your income exceeds that figure then you’ll lose £1 of benefits for every £2 by which you beat the threshold.
Married couples’ allowances have risen by another pathetic £70 a year to £2,280 a year, and the allowances for 65-74 year olds and 75+ couples have now risen to £5,905 and £5,975 respectively. On the plus side, however, both sets of people get additional bonuses in the form of better childcare credits for parents and a one-off £200 payment to help the over- 60s with their council tax bills.
Some of the other bonuses are so pathetic as to be laughable. If you buy a bike or a computer from your employer to help you with your job, you can get tax relief on them. If you use the buses, and if you actually have some in your area, you can get free offpeak travel as long as you don’t cross your local county line. (Tough luck if the local shops are in the next district.) And so on.
There are, however, a few worthwhile proposals on the table, and it would be churlish of us to ignore them completely. ISAs are getting a reprieve in more ways than one. New ways of investing in property are on the agenda, with the final preparations for the introduction of Real Estate Investment Trusts (REITs), probably in April 2006. He has created new and better childcare allowances for working parents. He has doubled the stamp-duty exemption limit on houses from £60,000 to £120,000. Capital gains tax exemptions are set to rise from £8,200 to £8,500 in 2005/2006. And there’s a decent 14.1% rise in IHT thresholds scheduled for the next three years.
ISAS REPRIEVED
All hell broke loose last year when Mr Brown announced that the limit would be coming down to £5,000 in April 2005; but he’s now seen fit to mend his ways. As before, you can put £3,000 into the cash component or as much as £7,000 into an equity mini- ISA — but what’s changed is that you can now invest until at least 2010. You do need to remember, however, that the tax relief on dividends is now extinct, so the only real advantage of an equity ISA or maxi-ISA is its potential for tax-free capital appreciation.
From April 2006 you’ll have some additional options at your disposal. Both ISAs and child trust funds will be allowed for the first time to invest in any retail collective investment scheme that’s been authorized by the Financial Services Authority. One of the bigger benefits of this is that you’ll be able to put your ISA into funds that invest in property.
NEW TAX EFFICIENT PROPERTY INVESTMENTS TO WATCH OUT FOR
So-called REITs (Real Estate Investment Trusts) have been in the pipeline since 2002, but it has never been clear up till now how they would be structured. It now seems as though Mr Brown has something along the lines of American REITs in mind, and we can expect to see them coming into force in April 2006.
There’s a consultation process currently going on which will end on 26 May, so keep your ears open. They look like a thoroughly good bet for your selfinvested pension funds.
REITs are a complicated subject. Essentially, they’re like closed-ended investment trusts (i.e. they can only raise money once, then they have to close their doors), and the shares can be freely traded once the trusts are up and running. Most importantly, however, the REITs themselves enjoy complete freedom from capital gains tax or income tax, which allows them to grow much faster than ordinary funds. That means that, although you’ll have to pay income tax on the dividends they pay you, they won’t pay tax on anything. An important bit of double-taxation has been eliminated.
REITs can invest in any property, in Britain or abroad. But one of the key points about them is that they’re mainly intended to generate income, not to make capital gains. (This is why your pension funds will be so keen on them.) Mostly they’ll be buying commercial rented property such as hotels, factories or shops, but they’ll also be allowed to put 25% of their cash into capital products such as construction or property speculation. This is more generous than most of us had been expecting. But the absolutely rigid rule is that the REITs must always return 95% of their incomes to you, the investors, every year.
AND THE NEW INHERITANCE TAX THRESHOLDS ARE
It has been calculated that if the IHT threshold had been kept in line with inflation over the last 20 years it would now be comfortably over £500,000. So it was at least some comfort to see Mr Brown raising the threshold by 4.5% this year, from £263,000 to £275,000. He also promised that it would rise again to £287,000 in 2006/2007 and to £300,000 in 2007/2008 — an overall increase of 14.1% over the three-year period. As pre-election sweeteners go, this one was worth having.
FORGET ABOUT THOSE SCHEMES TO AVOID IHT ON YOUR HOME!
However, final confirmation came of what we already knew from last year’s Budget: that the tried and tested IHT avoidance technique of vesting your family home into the hands of somebody else, usually through a trust, would no longer automatically get you off the IHT hook. Or rather, that if you’ve given away your home to your children you will now be liable to an annual income tax charge on the ‘preowned asset’ that’ll make you wish you’d hung onto it instead.
Last year Mr Brown caused outrage in the accountancy profession by insisting that many of the IHT schemes implemented quite legally since 1986 would now be considered retrospectively as unacceptable forms of tax avoidance, and that people who had committed this heinous sin would now receive income tax bills which effectively treated the rent they would have paid on their homes (had they been renting them) as undeclared income. Thus, if your home was worth £400,000 and the going rental return on buy-to-let property in your area was 8%, then you’d be liable to pay a 40% income tax charge on an imputed rent of (£400,000 x 0.08) x 40 / 100 ) = £12,800 a year. Ouch.
All these figures are notional, incidentally, because the actual formulae are likely to vary. Pensioners who have innocently put their homes into such ill-starred trusts have until January 2007 to unwind them. The imputed rents, however, come into force on 6 April 2005.
IHT — WHICH SCHEMES STILL WORK?
However, all is not lost. The law is still being tested as we write this, but it looks as though some forms of IHT avoidance are still in working order and capable of protecting you. Don’t take our word for it please — it’s essential to get expert legal advice before undertaking any of the following:
Deeds of variation
Contrary to what you might suppose, it’s possible to alter the terms of your spouses’s will after their death. If you’ve inherited the whole equity of the house from your deceased partner (which is the normal default situation), you are still free to transfer ‘their’ half into a discretionary trust (see overleaf), so that it does not form part of your own estate after your own death.
Home sharing
If you have a family member living permanently with you, it is possible to transfer part of the house into their name so that it bypasses your estate. The main provisos are firstly that the relative must remain living in the house and sharing in its running costs, and secondly that you must live at least seven years after making the transfer.
Equity release schemes
Some of the equity release schemes that the elderly have been using over the last 15 years or so are still valid, but the Revenue is still figuring out which ones will escape and which ones will get the income tax charge. Initially the Chancellor wanted to slap the charge on all equity release schemes, under which you normally sell all or part of your house to an investor in return for a lifetime income. But the uproar was enormous, and it now seems that you will escape the charge if you really have received the full market value of the house. All that remains is to find a way of giving the cash away to your heirs before it goes into your estate and collects IHT the other way. Hmmmm. Tricky.
Discretionary will trusts
Probably the best way of minimizing your IHT.
Also known as a nil rate band loan trust, a discretionary trust works best when a husband and wife have also rearranged their property ownership so that they become tenants in common, rather than joint tenants (the default situation). Tenants in common have the absolute freedom to leave their half of the house to anyone they like — and, if a deceased husband has given his half to a discretionary trust in favour of his children, his surviving wife will be able to continue to live in the house by agreeing to owe a debt worth half the houses’s value to the trust. Then, when she dies, this debt is deducted from her estate and her IHT liability is effectively limited to half the house’s value.
IF YOUR PLANNING TO SKIP TO SPAIN FOR A WHILE TO AVOID THAT TAX BILL. TIME FOR A RETHINK
Elsewhere, sadly, the clang of closing loopholes is unmistakable. This year, one of the loudest clangs has come from the ending of a rule that allowed UK citizens to take up temporary residence abroad in an elaborate move to avoid paying capital gains tax on properties (or companies) that they were selling while they were away. It was always a rather odd dodge, but it could often save you millions on a large transaction, and it still bears eloquent witness to the continuing value of having a good financial adviser if you move about a lot.
Normally you don’t get exempted from British taxes unless you live outside the UK for at least five years, and even a temporary return can land you with a huge bill if you outstay your welcome by a single day. But if you were prepared to take yourself off to Belgium or Spain (where they charge little or no CGT) for the short duration of your property sale in the UK; if you then transferred the proceeds of the sale into those countries; and if you could prove that those countries had double-taxation agreements with the UK which made it impossible for the UK to charge you as well, then you would probably get away with it.
Alas, no more. Subject to ratification in the Finance
Bill (and the Government’s wording is still pretty woolly), you will now be charged 40% CGT on your sale unless you genuinely do take up five years’ residence outside the UK. For some people, this new ruling might be all the persuasion they need to pack their sombreros and truly emigrate. And who would we be to blame them?
Michael Wilson has over 20 years experience as a financial journalist.
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