David Ingram, a partner at threesixty, concentrates on the tax treatment of an investment product while evaluating a client's portfolio
One of the most boring clichés of the financial planner's world is that the &tax tail should not be allowed to wag the investment dog&. Like most clichés, this is true, but investment dogs, like the real thing, look happier and healthier with their tails.
The enormous increase in 'open architecture' that we have seen in recent years, together with the gradual arrival of wraps and other platforms, means that, increasingly, the fund selection side of financial planning need be little different whatever product is selected. So, in fact, the tail may be more important now than ever before.
The degree of importance to be placed on the tax treatment of a product will differ according to the tax position of the investor; the three main investor types being individuals, trustees and corporate bodies. Here I am just going to look at individuals.
Even with that restriction, there are still a number of tax factors to consider before getting anywhere near a product. Does the client pay income tax? At what rate? Does the client have a partner who pays tax at a lower rate? Does the client use their annual capital gains tax (CGT) exemption? Is inheritance tax planning important to the client; and if it is not, should it be?
Firstly, CGT. Estimates vary enormously, but all commentators seem to agree that the vast majority of UK taxpayers do not use their annual CGT exemption; indeed they seem to have little or nothing to do with chargeable investments. According to the Office of National Statistics, there were 30.7 million income taxpayers in 2003/04 and only 151,000 individuals made chargeable gains.
A higher rate taxpayer not using their CGT exemption and with capital available for investment should consider the potential advantages of investing in Oeics or unit trusts directly, rather than in almost identical funds via bonds.
By investing in growth funds they can defer income, as with a bond, and they will be able to encash units within their annual exemption to generate one-off or regular payments. Remember that it is the tapered gain that must be limited to the annual exemption, not the withdrawal. This actuallycompares very favourably with the 5% withdrawal entitlement from a bond - especially since the 5% is added back on final encashment. Broadly, this means that clients fitting this particular profile should be recommended to invest in collectives rather than bonds.
Non-taxpayers should probably also be steered towards collectives. This is because if they use a bond then they must pay tax which they cannot reclaim, while collectives, unless they use equity-based income funds, the tax treatment is much friendlier.
Obviously the tax advantages are of greater benefit to higher rate taxpayers than non-taxpayers. However, while tax sheltered investments are important, they must not be seen as the panacea for all investment needs.
Pensions reform also provides tremendous tax planning opportunities, with most clients under the age of 75, subject to concurrency restrictions prior to A-Day, being eligible to put at least &3,600 (2005/06) into a pension plan and receive tax relief of at least 22% on the contribution. Growth in the fund is free of CGT and income received in the fund is not taxable (no reclaim in respect of tax deducted at source on dividend income).
Pension funds also have inheritance tax benefits and while these are currently under review they look likely to continue to at least age 55 (earliest retirement age when A-day changes are implemented), if not later.
In essence, advisers need to consider each client's circumstances individually to determine whether money should be invested in an Isa or a pension, with particular reference to tax reliefs and the tax treatment of proceeds.
The right choice
Investment in enterprise investment scheme (EIS) or venture capital trusts (VCT) arrangements is another topical area. These arrangements are for larger investments with a contract minimum of around &10,000. Investors can invest up to &200,000 in a VCT, as well as &200,000 through the EIS in the current tax year. Anyone with more than &200,000 to invest should probably consider investing in both, but for the rest it is important to use the correct vehicle to provide the tax advantages that are most appropriate to them.
Any investor who has made a chargeable gain for CGT purposes should certainly look at EIS before VCT, since it is possible,within fairly strict limits, to defer CGT through investment in the EIS.
The EIS also wins for investors seeking inheritance tax (IHT) benefits as shares are eligible for business property relief after two years ownership.
If income tax relief is the priority then VCT is probably the favoured route. Both EIS and VCT investments are eligible for income tax relief but for the 2004/05 and 2005/06 tax years the rate of relief on VCT is up to 40% against 20% through the EIS. In both cases, the actual amount of tax relief is limited to the lower of the investor's actual income tax assessment for the year (before the investment) or the appropriate rate of relief on a &200,000 investment.
Dividend payments from a VCT scheme are not treated as income for tax purposes and clients needing income may find this an attraction. Both investment types offer the client growth free from tax, provided they continue to qualify, and are thus very attractive. The VCT is generally seen as less risky since it is a form of pooled investment.
Where IHT is the priority it is perfectly possible to use bonds or unit trusts/Oeics in conjunction with appropriate trusts, usually through discounted gift schemes or gift and loan arrangements. The choice of investment in these instances is more complex.
There are also some investments which have been developed specifically for IHT mitigation. They are built around the availability of business property relief and thus become fully effective after just two years, rather than the seven years taken by Property Enterprise Trust based schemes. These can also provide the wealth owner with a continous income through dividends, which, since no gift is involved, are not caught by gift with reservation or POAT charge rules. These are generally property-based investments. The main risk here is of some future change to business property relief.
This is far from an exhaustive summary of tax-related points to be considered when evaluating a client's portfolio. However, for those who haven't already, it is perhaps time to recognise the importance of that tail after all.
£300bn of liabilities
View from the front row
Transfer from occupational scheme
Appointed by FCA and PSR boards