Tax Efficient Investments
Tax-efficient investments include Individual Savings Accounts (ISA), Child Trust Funds (CTF), the new Junior ISA, Venture Capital Trusts (VCT), Enterprise Investment Schemes (EIS), and AIM portfolios. ISAs provide relief from income and capital gains tax. VCTs and EIS schemes provide tax relief on the contributions as well as other tax benefits. AIM portfolios are designed to mitigate inheritance tax.
Tax-efficient investments are a potentially important part of the overall financial plan, and can complement savings into pensions.
ISAs
To contribute to an ISA, you must be resident in the UK, or a non-resident Crown employee working overseas. If you are resident overseas, you can keep any ISAs you have, but not add to them. The contribution limits are currently £10,680 for the 2011-12 tax year, of which up to £5,340 can be invested in the cash component. The contribution limit will increase in future years in line with RPI inflatio. The amount for 2012-13 will be £11,280.
The stocks-and-shares portion can be invested in almost anything other than cash, so it can include gilts, provided they have at least 5 years to redemption when bought. On 6 April 2008 PEPs were merged with ISAs. It is possible to transfer a cash ISA to the stocks-and-shares component, which is proving popular at the moment because the interest rate on cash is low, and there are better opportunities in fixed interest investments and equities. If you contribute to an ISA every year, you can build up a fund that can provide tax-free income in retirement, to add to your pension. It usually makes sense to put the fixed interest component of your portfolio into an ISA, so that the interest accumulates tax-free. The more growth-oriented investments in your portfolio can sit outside the ISA, giving you the chance to take advantage of the capital gains tax allowance, which is £10,600 in 2011-12 for individuals and estates (half that for trusts).
Child Trust Fund (CTF) and Junior ISA (JISA)
The CTF is a long-term savings account for children born between 1 Setpember 2002 and 2 January 2011. The child must live in the UK, and Child Benefit paid for that child for at least 1 day before 4 January 2011. The voucher is for £250 if the child became entitled before 3 August 2010, and £50 after that date. The money belongs to the child, but cannot be taken out until age 18. Parents, family and friends can add money to it up to a new limit of £3,600 per year from 1 November 2011 (previous limit £1,200). No tax is payable on either income or gains.
The Junior ISA has been introduced from 1 November 2011. It is available for children living in the UK who do not have a CTF. The Government will not make any contribution. Like ISAs it has a cash and a stocks and shares component, with a yearly limit of £3,600 for all contributions. Both JISA and CTF limits will be index-linked from April 2013. At age 18 the JISA will become an ISA.
VCTs
VCTs (Venture Capital Trusts) offer 30% income tax relief, in the form of a tax credit, on the contributions to buy new shares up to £200,000 in a tax year. You have to hold the shares for at least 5 years to keep the tax relief. The VCT itself has 3 years in which to invest 70% of the funds in qualifying investments. The dividends are free of income tax, but the tax credit cannot be reclaimed, which is the same as for ISAs and pensions.
VCTs tend to pay very good dividends, because this is the main way in which they reward the investor. Indeed, the longer term returns of some of the established VCTs such as Baronsmead and Proven have been very good.
The shares can be sold in the secondary market, but they tend to trade at a discount to net asset value. Information on VCTs available in the secondary market can be found on Trustnet (www.trustnet.com) . They can be bought without the initial tax relief, but with the tax relief on income and capital gains.
They provide a useful addition to pension savings, because of the additional tax benefits, and the recent tax changes are likely to make VCTs particularly attractive for people with incomes over £100,000.
There are a number of VCTs available for subscription between now and the end of the tax year 2011-12. In the Generalist sector, these include the Albion VCTs Linked Top Up, Northern 2 VCT, and Proven VCT. In the specialist sector, they include the Downing Planned Exit VCT, and the Ingenious Entertainment VCT. For more information, see our Blog.
In the draft Finance Bill 2012, the Treasury confirmed that the definition of qualifying investee companies for VCTs and EIS (see below) will be broadened to include companies with up to 249 employees and gross assets of up to £15m, seeking up to £10m per year from investors. Previously the limits were 49 employees, £7m in assets and £2m annual fundraising.
EIS
EIS (Enterprise Investment Schemes) offer 30% income tax relief from 6 April 2011 on contributions of up to £500,000. The maximum annual amount will increase to £1m in April 2012. Relief is given as a tax credit against your income tax liability, and this is lost if the shares are sold within three years. It is possible to carry back some of the tax relief to the previous tax year.
A major attraction of EIS is the ability to defer capital gains tax, and after two years the holding will qualify for 100% business property relief from inheritance tax (IHT). To defer capital gains tax, you must buy the EIS within 3 years after the gain was realized, or one year before. When the EIS is sold, the deferred capital gain becomes taxable. Any gain realized from the EIS investments is tax free, and if there has been a loss, it can be offset against other income or capital gains.
You can defer a capital gain indefinitely by keeping an EIS until death, at which point it will no longer be taxable, and nor will the EIS be included for inheritance tax. The problem is the risk of investing in the sort of unlisted investments that qualify for EIS. There are, nevertheless, some lower risk or protected versions available in the market. Smaller companies are more sensitive to economic changes than large companies, but their share prices tend to increase more rapidly when the markets recover.
The basis for government policy in this area is to provide small companies with a source of finance to help them grow. Such companies may find it difficult to raise finance from more traditional sources. For both EIS and VCTs there will be changes in the Finance Bill 2012 to increase the size of a qualifying company and the amount of money that can be raised by such companies.
In addition, up to £100,000 can be invested per year in smaller start-up businessesfrom April 2012 via the new Seed EIS (SEIS), which was announced in the autumn statement. The income tax relief on contributions will be 50%, with a cumulative investment limit of £150,000. There will also be CGT exemption on gains realised in 2012-13.
To focus EIS and VCTs better on higher-risk activities, some business activities will be disqualified from April 2012, for example companies set up to receive feed-in tariffs or other subsidies for wind and solar power generation.
AIM Portfolios
Most AIM shares qualify for 100% Business Property Relief, and after holding them for 2 years they are no longer liable for inheritance tax. The shares can be traded without losing the inheritance tax benefit, provided the proceeds from selling are used to buy another eligible share. Although possibly higher risk than using a trust to mitigate inheritance tax, because the investment is in smaller companies, an AIM portfolio can complement other elements in your portfolio, and it is the simplest and quickest way of taking assets out of inheritance tax.