What you need to know about the new Finance Act

As the coalition’s first Finance Act hits the statute books, advisers should be prepared for changes that affect their clients. Here’s a quick guide to the Act’s main features, writes Canada Life's Jeremy Pearson.

The recently published Finance (No 2) Act 2010 embodies into legislation the coalition government’s tax changes for this year. It is a slim volume, 28 pages, but that’s not surprising given that it merely tweaks Labour’s old legislation.

It includes changes to corporation tax, capital gains tax, the VAT rate, insurance premium tax, the pensions excess relief charge and removal of the age 75 retirement age.

THE TAX CHANGES IN A NUTSHELL

Income tax

Current position

• Tax rates of 20%, 40% and 50% apply.
• Personal allowances are reduced if:
• First, the subject is aged over 65 and their income exceeds £22,900
• Thereafter, for any age, if income exceeds £100,000.

Next year

• The personal allowance for the under 65s will be increased by £1,000 to £7,475. Higher-rate taxpayers will not benefit from the increased allowance because the higher rate threshold will be reduced.

Opportunities

1. If there is inequality in the taxable income received by a married couple or registered civil partnership, and one pays a higher rate of tax than the other, diversion of income from one to the other will save tax.

2. This could also be done if one of the couple has their personal allowance reduced and the other does not.

3. Business owners, with control over how corporate earnings are distributed, have various options if their spouse has a lower income, such as employing them in the business or allocating them dividend-bearing shares.

4. Replacing taxable income with return-of-capital bond withdrawals can avoid the personal allowance being reduced.

5. Replacing income producing assets with non-income producing assets or capital gain orientated assets could save tax.

Capital gains tax

Current position

• An annual exemption of £10,100 applies.
• If gains exceed that amount, basic rate taxpayers pay 18% tax and higher rate taxpayers pay 28% tax.
• Entrepreneur’s relief has been increased to £5 million.

Next year

• No changes announced.

Opportunities

1. It is possible for basic rate taxpayers to make such a large gain that part of it is taxed at the higher rate. Management of the other income in that tax year, or making pensions contributions, may allay that.

2. Before the gain is realised, transfers between spouses or registered civil partners living together can enable two annual exemptions to be used and minimise the tax rate applying.

3. By ‘bed and breakfasting’, you can generate just over £20,000 of tax-free gains each year. However, there are restrictions applied nowadays, so it may be a case of using the awkwardly named ‘bed and spouse’, ‘bed and ISA’, ‘bed and Sipp’, and so on, instead.

Inheritance tax

Current position

• No change has been made to Labour’s introduction of a freeze on the nil rate band at £325,000 until 5 April 2015.

Next year

• No changes announced.

Opportunities

1. If the nil rate band is frozen, there is a certain logic in also freezing the value of taxable assets, so the situation does not get worse. This can be done by using a gift and loan trust.

2. A new nil rate band is, in a sense, available every seven years if the subject is making gifts in discretionary trusts. This enables a couple to make gifts to a value of £650,000 every seven years without an entry charge, and more in future if the nil rate band ever increases.

Inheritance tax: the cost of doing nothing

The latest statistics from HM Revenue & Customs (HMRC) show the monthly take from inheritance tax in June was the highest since October 2008.

This is a reflection of the increase in house prices over the past year (+4.9%), equities recovering in value (FTSE 100 + 18.5%, MSCI World exUK Index +17.3%) and a frozen nil rate threshold (+0%).

Inheritance tax (IHT) can be a deadly stealth tax if no action is taken; if nothing else, asset freezing for IHT purposes should be undertaken.

Corporation tax

Current position

• The small companies’ rate is 21%.
• The main rate of corporation tax, for companies with profits of £1,500,000 or more, is 28%.
• The marginal rate relief is effectively 28.75%.

Next year

• The small companies’ rate will reduce to 20% and be renamed the ‘small profits rate’.
• The main rate of corporation tax will be reduced to 27%.
• The main rate will then reduce by 1% annually until it is 24% for the year starting 1 April 2014.

Opportunities

1. Given the high personal income tax rates when compared with relatively low corporate tax rates, some business owners may choose to retain funds in the company.

2. This outlook will be strengthened by the effective 10% capital gains tax (CGT) rate available through entrepreneur’s relief.

3. However, relying on a business as the sole or main means of retirement provision, for example, can be very dangerous given ever-changing economic circumstances.

Trusts

Current position

• Trustees of discretionary trusts pay tax at 50% on income received (42.5% on UK dividend income), although there is a £1,000 standard rate band.
• All types of trusts, except bare trusts, are now subject to tax on capital gains at 28%.
• There is a trustees’ annual CGT exemption of £5,050. This is divided between all the trusts created by the same settlor since 1978, including life insurance trusts, and is subject to a minimum of £1,010 per trust.

Next year

• No changes announced.

Opportunities

1. Discretionary trust trustees may prefer to invest in capital assets, rather than income producing ones, so they pay 28% tax rather than 50%.

2. They could also consider investing in non-income producing assets, such as investment bonds, to defer tax.

3. Another advantage of investment bonds is that when a distribution to a beneficiary is required, it can be facilitated by assignment as opposed to asset encashment and cash transfer. In these circumstances, the beneficiary’s tax rate applies, not the trustees’ 50% rate.

Compulsory annuitisation

Current position

• From 22 June 2010, members of a pension scheme have to buy an annuity or otherwise secure a pension income by age 77.
• The pension commencement lump sum (PCLS) still has to be taken before age 75.
• The alternatively secured pension (ASP) limitations will not apply until the 77th birthday.

Next year

• The proposal is that there will no longer be any specific age by which members have to annuitise or otherwise secure a pension income.
• The PCLS could be taken whenever benefits are crystallised, even if this is after age 75.
• A capped drawdown facility (similar to the current unsecured pension) would be available after age 75.
• There could be an option to have flexible drawdown, whereby unlimited amounts can be taken subject to a minimum income requirement test.
• ASP would be abolished from Apr 2011.
• Lump sum death benefits would be subject to a tax charge of 55%, unless it is in respect of uncrystallised benefits before age 75.

Opportunities

1. The increased flexibility in retirement benefits will increase the appeal of pension saving.

2. The increased tax charge on death benefits will underline the fact that estate planning advice is essential.

Pension contributions

Current position

• The Treasury can repeal the high income excess relief charge by statutory instrument.

Next year

• It is proposed that the pension contribution annual allowance will be reduced from £255,000 to £40,000 and the high income excess tax relief charge be abandoned.
• Any contributions in excess of the annual allowance may not receive any tax relief.
• Possibly, tax relief could be capped at 40%.

Opportunities

1. People who currently earn less than £130,000 could consider maximising their pension savings, if they are happy to contribute more than £40,000 in this tax year.

2. People with relevant earnings of £130,000 or more could take full advantage of the special annual provisions and pay up to £30,000 in ‘infrequent money purchase contributions’.

3. A person with relevant earnings of £130,000 or more might consider paying even more on the basis that while the special annual allowance charge will bring the effective tax relief down to 20%, that will be better than next year when there will be no tax relief on contributions of more than £40,000.

More changes possible

Before the 2011/12 tax year begins, there will be a pre-Budget report in the autumn and a spring Budget next year. So there could be further changes.

If the coalition disintegrates, there could be another general election, which could be followed by more changes to the legislation.

These changes and proposals will affect individuals’ income and future financial security greatly.

One thing that is indisputable about them is that the need for expert independent financial advice is even greater.

Now that the changes have become law, clients and their advisers would be well advised to check their situation.

Tax changes awaiting implementation

Measures announced in the March Budget 2010 or earlier which take effect from April 2011 or later:

• Increase in personal allowance
• Freeze on higher rate threshold
• Freeze on basic rate limit
• Align the national insurance contributions (NICs) primary threshold with personal allowance
• Increase NICs’ primary threshold
• Increase main employee NICs rate by 1%
• Increase additional employee NICs rate by 1%
• Increase employer NICs rate by 1%
• Increase main self-employed NICs rate by 1%
• Increase additional self-employed NICs rate by 1%
• Freeze pensions lifetime and annual allowance for five years
• Pensions tax: restrict tax relief
• Individual savings account: indexation
• Inheritance tax: freeze threshold from 2011-12 to 2014-15
• Venture capital schemes: state aid changes

Jeremy Pearson is technical support manager at Canada Life.