How to get tax relief when investing
In this age of austerity, the government isn't offering many handouts, which is all the more reason to snap them up where they still exist.
Investing through a tax-efficient vehicle, such as an ISA, pension, venture capital trust (VCT) or enterprise investment scheme (EIS), can give a significant boost to an investment portfolio, but they have to be used judiciously and blended with an appropriate investment strategy to give the best outcome.
SIPPs & ISAs
ISAs and pensions will usually form the core of any investment portfolio. ISAs offer huge investment flexibility, and all income and capital gains are free from further tax, although the 10% tax at source on share dividends paid within ISA funds cannot be reclaimed.
For higher-rate taxpayers, income tax rates are more than double those for capital gains tax (CGT), so it can make more sense for them to put income-generating investments such as equity income funds or corporate bonds into their ISA. In this way, they can generate a long-term, tax-free income stream.
Income from a pension, in contrast, is taxable, but investors get tax relief on their initial investment. The key advantage of a pension is that it is very long term and all capital gains are free from tax. This allows investors to take greater risks and therefore perhaps look at investment areas such as emerging markets or smaller companies, which are more volatile but may have higher growth characteristics over the long term.
Self-invested personal pensions (SIPPs) allow greater investment flexibility than conventional pensions and investors can build a more personalised portfolio.
David Jeal, product manager at Selftrade, says: "Either income or growth can be efficiently held in an ISA or SIPP, although income-generating stocks might seem the more obvious ISA choice in terms of avoiding income tax, and they could also be a good choice for your later years when income becomes a priority in retirement.
It is worth reinvesting dividends in the early stages as the effects of compounding can be very beneficial.
"ISAs can't hold gilts and bonds with less than five years to maturity at the time of purchase, nor can they hold small-cap stocks listed on the Alternative Investment Market (AIM) or the PLUS Stock Exchange."
Jeal adds that investors should not forget about regular investing into ISAs and SIPPs.
For those interested in investing in the UK's small companies, there are some extremely tax-efficient options. Danny Cox, head of advice at Hargreaves Lansdown, says: "VCTs are a highly tax-efficient way to invest in some of the most dynamic, entrepreneurial, high-growth companies.
However, they are inherently high risk. They are long-term, speculative investments but they give you the chance to get in on the ground floor of fledgling investment opportunities. Tax relief is available up to 30%, meaning a £10,000 investment might cost as little as £7,000."
Investors can put up to £200,000 a year in a VCT and receive income tax relief on the entire amount, although they cannot receive more in rebates than has been paid in income tax. When the holdings are eventually sold, any gains made are free from CGT, providing they have been held for more than five years. Any dividends received are also free from tax.
There are three main types of VCT: limited life, specialist and generalist. Limited life VCTs tend to be lower risk, looking for an exit within, say, five years. Specialist VCTs focus on just one sector, often technology. Generalist VCTs will invest across a variety of businesses.
Performance has been mixed, with some VCTs providing good returns to investors over and above the income tax incentives, and some still losing money in spite of generous reliefs. Cox recommends the Matrix Linked Offer, Downing Income III and Edge Performance H Share for this tax year.
The tax reliefs available on an EIS are even more generous than those on a VCT. EISs invest in similarly small, start-up style companies, so they are also high risk. The tax relief on an initial investment into an EIS is also 30% but investors can put in between £500 and £1 million, potentially getting rid of their entire income tax liability for a year.
There is also the potential to defer capital gains made on a separate investment by reinvesting them into an EIS. The reinvestment has to meet certain criteria - disposal of the original asset has to be less than 12 months before the EIS investment or less than 36 months after it.
In this way, gains can be deferred until a tax year in which you are not using your CGT allowance, or have retired and are paying lower tax rates anyway.
For the EIS investment itself, no CGT is payable if you sell the shares after three years, provided the EIS initial income tax relief was given and not withdrawn on those shares. Any losses on EIS shares can be set against your capital gains or income tax liability in the year of disposal.
Investors can find out about investment opportunities through the Enterprise Investment Scheme Association (eisa.org.uk). IFA Allenbridge also offers analysis of the latest EIS opportunities (tax-shelter-report.co.uk), and there is more useful information on EISs and VCTs on the Clubfinance website (clubfinance.co.uk).
The companies eligible for EISs have to be worth less than £7 million, and individual investors can have up to 30% stake in the business, so these schemes are not for widows and orphans.
However, the tax breaks mitigate some of the risks.
There is a tax-efficient investment for every occasion. The ISA limit may only be £11,280 for this tax year (2012/13) but investors can squirrel far more than that away in other tax-incentivised schemes.
There is a danger, however, of letting the tax tail wag the investment dog, so you need to be clear that the investment proposition suits your needs – and if you're going to look to some of the racier tax-avoidance schemes, you need to ensure that you are prepared for a more volatile ride.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
Venture Capital Trusts were introduced in 1995 to encourage private investments in the small-company sector by offering tax relief in return for a minimum investment commitment of five years. A VCT is a company, run by a fund manager, which invests in other companies with assets of no more than £7m that are unlisted (not quoted on a recognised stock exchange) but may be listed on the Alternative Investment Market (AIM) or plus with the aim of growing the companies and selling them or launching them on the stock market. Investors in new VCTs are offered desirable tax advantages and VCTs themselves are listed on the London Stock Exchange, with strict limits laid down by HM Revenue and Customs on what they can invest in and how much they can invest.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
Enterprise Investment Scheme
A scheme set up to encourage investment into small, unquoted trading companies and give investors tax breaks to compensate for taking risk. Because the companies in the scheme are not listed on a stock exchange they often carry a high risk, so the tax relief is intended to offer some compensation. An EIS company cannot be a subsidiary, must trade wholly in the UK, can’t employ more than 50 people and certain activities (including forestry, farming and hotels) preclude companies from offering EIS relief.
Alternative Investment Market
AIM is the London Stock Exchange’s international market for smaller companies. Since its launch in 1995, 2,200 companies have raised almost £24 billion listing on AIM. The market has a more flexible regulatory system than the main market and can offer tax advantages to investors but its constituents are a riskier investment than bigger companies listed on the main market.