Guide to High Net Worth investment tax mitigation strategies 2020 / 2021
There are many forms of tax mitigation strategies for High Net Worth individuals (HNW). Such as using trusts for reducing Inheritance Tax (IHT). This article will focus on the use of investments and go through the various types. The benefits and disadvantages of each and their suitability to various client circumstances. Since the Retail Distribution Review in 2013 and the Pension Freedom act in 2015. There has been a significant amount of legislation changes that have affected retail based investors. Many people have little or no idea on how this has affected them and the implications.
The economic environment
This has produced a challenging environment for HNWI regarding tax planning and mitigation strategies. Both the UK government and HMRC have become more aggressive and determined to increase the level of tax per HNW capita. This has be further fueled by many global organisations such as Amazon and Google and the associated publicity. There numerous strategies to reduce each type of tax for HNW. Firstly by ensuring that you are effectively and efficiently utilizing all of the UK tax allowances available to them.
Due to historically low interest rates and low levels of return on cash deposit accounts. Many savers have looked for alternative investment. The risk of this is that inflation is running higher than the return on investment. Therefore, that the buying power of the fund is actually decreasing in real terms. However, cash should arguably make up a percentage of a HNW investment portfolio. Also an emergency cash fund should be in place.
Types of investments
The UK government introduced ISA’s on 6th April 1999 replacing the Personal Equity Plan (PEP) and tax-exempt special savings accounts. The maximum annual amount per individual per tax year 2018/19 is £20000 which can made up from a combination of types of ISA. for example you could have £10,000 in a cash ISA and £10,000 in a stock and shares. You can also transfer savings from one ISA type or provider. However if you withdraw funds out from your ISA you will not be able to reinvest that part of your tax-free allowance. For example if you invested £5000 in a cash ISA then withdrew all the funds you would only have £15,000 (£20,000 -£5000 =£15,000) of your ISA allowance remaining (GOV.UK, 2018).
Individual Savings Account (ISA)
The relevant types to HNW are arguably Cash and Stocks and Shares (Equites) and Innovative finance (IFISA). Cash ISAs are essentially cash based accounts, therefore suitable for an emergency cash fund and short-term investment. The disadvantage of these is that the rate of return is lower than the level of inflation. Therefore again the buying power of the money is decreasing in real terms. The advantages are that they are a low risk investment and the there is no CGT or income tax payable. HNW should also utilize their spouses / partner income.
Stocks and Shares ISA
Stocks and Shares ISAs allow investors to purchase shares that are listed on a recognised global stock exchange, units in UK unit trusts and open-ended investment companies (Ken Bicherton et al, 2018, P319-321). They can be used for growth or income investment strategies. However, the investor should have the capacity for loss if the underlying investments fall in value. The Innovative Finance ISA (IFISA) was introduced in April 2016. These allow retail based investors to invest in peer-to-peer (P2P) lending platforms and crowd funding. These lend money to businesses or individuals. The investment is spread over a number of loans to reduce the level of risk. The potential rate of return will typically be higher than a cash ISA and it benefits from tax-free growth.
ISAs are subject to IHT. However by using Business Property Relief (BPR) through investing in the Alternative Investment Market (AIM). it provides IHT exemption and also tax-free income and growth by utilizing all of the benefits of an ISA wrapper. To achieve this the companies need to be BPR qualifying. The shares also need to have being held for a minimum of 2 years and be still held on the death of the investor. Then inherited by their beneficiaries free from any IHT liability. The potential negative for HNW is the maximum of £20,000 per year allowance and that there is income tax relief.
ISA and BPR Case Study
Sarah Jones had been widowed just over two years ago and her husband had always organised their finances. She inherited a substantial investment portfolio. Which provided her with more earnings than she actually required this was generated from pensions, dividends and interest. We performed a fact find and income and expenditure analysis. This highlighted the following assets:
Primary residence £600,000 (Unencumbered)
Farm land £275,000
Cash savings £150,000
AIM Portfolio £375,000
Equities (including ISA £400,000) £1,400,000
Venture Capital Trust £100,000
Sarah’s primary focus was to ensure that her assets were not depleted entirely and IHT planning. After analysing her current position, it was clearly apparent that she had sufficient income and capital. We then focused on IHT planning whilst ensuring that this did not affect her financial security. The farmland would be exempt under the agricultural property relief. Therefore, it would be exempt from IHT. Sarah’s IHT current liability was £920000 (£2.9m – £275000 – £325000 Nil Rate Band x 40%). She had also gifted cash to her grandchildren £43000, after her annual gift allowance of £3000. This caused an additional £16,000 IHT liability (£43,000 – £3000 = £4000 @ 40%).
Her potential IHT liability caused two problems the first was the IHT charge of £936000 which would be payable on her death and the practicality of paying the tax. Also the executors of her estate would not typically be allowed to use her assets to pay the IHT. Therefore, the executors or beneficiaries of the estate may have to use their personal resources or raise capital. For example by means of a bank loan for example. Until the IHT is paid, the estate cannot be settled and distributed. Sarah had taken out a whole of life insurance policy for £300000. Which was placed into a trust and would be available to her children to pay the IHT. We recommended to Sarah that she should take out an additional £636000 whole of life cover policy to cover the gap.
We arranged the policy for Sarah on a regular monthly premium basis at a cost of £300 as she had sufficient monthly surplus income. The life assurance policy was written into trust, by doing this meant that the policy was outside of the estate. All of the money paid out would pass to her children tax-free as the premiums have exemption under the normal expenditure out of regular income rule. This would allow the children to pay the IHT due on the estate.
To reduce the IHT bill further we recommended that Sarah should take advantage of BPR in that ISA’s were now allowed to AIM shares. Although this would increase the risk considerably, the benefit would be that after two years the portfolio would be exempt from IHT. The ISA portfolio was appraised at £400,000. This would result in an IHT saving of £160,000 after two years. Also, if the investment value increased the saving would be greater. The majority of Sarah’s IHT liable assets were in the primary residence and share portfolio. We advised Sarah that it would be ineffective for IHT purposes to gift her primary residence and remain living there rent-free. As this would mean that the house would still have an IHT liability, as Sarah would still have an interest in the property.
Although it would be possible to gift the share portfolio, it would create a capital gains tax CGT problem as it would be a disposal and the gains would create an immediate CGT liability. We recommended establishing a discretionary trust with her children as the beneficiaries and the transfer of share portfolio holdings. This allowed Sarah to claim holdover relief, which transfers the CGT liability on to the trustees.
Creating a discretionary trust during lifetime is deemed as a chargeable lifetime transfer for IHT purposes. This amount would then become a Potentially Exempt Transfer (PET). In addition, after seven years by using taper relief there would be no IHT liability. Sarah could not benefit from the trust, as a non-settlor interests trust holdover relief could be used and avoid a CGT liability. Children under the age of 16 and spouses cannot be beneficiaries, as this would make the trust “settlor interested”.
Taking into consideration the other trusts that were created, the trustees would have an annual exemption allowance of £5850. To offset against any additional gains made which would be subject a tax rate of 20%. This would allow the trustees to utilize holdover relief when distributing capital to the beneficiaries who can then use their own personal CGT annual allowances to reduce or circumvent the tax entirely. Even though the income tax treatment within a Discretionary Trust has several minor disadvantages, the potential CGT and IHT savings significantly outweigh these.
Enterprise Investment Schemes
Enterprise Investment Schemes (EIS) offer tax relief at a rate of 30% the maximum investment is up to £1 million per annum (PA) or £2m if over £1m is invested in knowledge-based companies and retrospective tax relief can be used for the previous year. For example a married couple would therefore have a combined annual allowance of £2m PA. However tax relief is only available up to the amount of the individuals income tax paid e.g. if the HNWI had paid £30000 in income tax then this would be the maximum amount of tax relief available. Therefore based on the amount of £30000 the optimum for tax mitigation purpose would be £100,000 (£100,000 @ 30%).
Another advantage is that for EIS’s is that if they held for three years then there is no Capital Gains Tax (CGT) payable on exit. EIS investments provide 100% exemption from IHT. This is especially relevant to HNW as their estates will be far in excess of the nil rate band pf £325,000. A disadvantage of EIS would be that any money would need to be invested for 3 years to fully utilise the CGT tax advantages. The level of investment risk would be much greater than listed shares (McLaughlin et al. 2018 p594-595). If the EIS shares are sold at a loss then the investor can elect the amount (net of income tax) of the loss and offset against their income in the same tax year. In addition, if the EIS qualify for BPR and if held for more than two years then they are exempt from IHT.
Other potential disadvantages of EIS are it been illiquid, as the capital needs to remain invested for three years, so any potential future changes in investor’s circumstances and tax rules and legislation should be considered.
Seed Enterprise Investment Schemes (SEIS)
SIEs were introduced in April 2012 to stimulate investment in small companies, there are a several differences in the qualifying criteria to EIS such businesses need to employ less than 25 people and have total assets of less than £200,000. SEIS provide start-up capital for new enterprises. The advantages for HNW is that there is a 50% tax relief available on investments up to £100,000 per annum. This is therefore s especially advantageous for additional rate taxpayers. A negative of SEIS is that investors cannot claim tax relief until the company has spent 70% of the money raised through the SEIS. Also, the level of risk is arguably higher and not diversified as the investment is in one company.
EIS and SEIS case study
Adrian is a HNWI and invests approximately £400,000 per year in to an EIS and claiming back £120000 (£400000 @ 30%). He had already exceed his LTA for his pension and was looking for tax efficient investment and was concerned by creating any additional IHT liability. He was currently earning £300000 per annum as an investment banker. His current asset were as follows:
Primary residence £3m (Unencumbered)
Cash savings £500,000
Stocks and Shares ISA £400,000
Venture Capital Trust £200,000
Pension fund £1.1m
We suggested that SEIS would be appropriate; as it would attract even greater income tax relief at 50%, by splitting the total investment into £300000 for the EIS and £100000 for the SEIS, he would gain an additional £20000 potential tax relief (30% of £300000 plus 50% of £100,000) increasing from £120000 to £140000.
He also had a CGT liability at 28% totaling £98000 during the same period therefore he would be able to offset up to £14000 as a 50% CGT exemption( 50% of £100000) against his SEIS and also could potentially can defer up to £84000 (28% of £300,000) against his EIS investment. This would effectively offset all of his CGT liability.
Venture Capital Trusts
Venture Capital Trusts (VCT) have a £200,000 maximum investment PA (Gov.UK, 2018). The majority of investors are aware of the benefits of tax-efficient investing this is most frequently done through a pension or an Individual Savings Account (ISA). However, HNWI with significant levels of capital available to invest over the annual pension allowance of £10k (additional rate taxpayers) and the £20k ISA to invest each tax year. They should consider VCTs and EIS, as both of them offer incentives including the potential for tax-free growth. After 5 years money can be reinvested and attract the 30% income tax relief again. Another benefit of VCT is the tax-free dividend income.
Comparing VCTs and EIS Venture Capital Trust Enterprise Investment Scheme Structure
IS’s are a listed company, which invests in a portfolio of small and medium sized companies, which are not listed the London Stock Exchange (LSE). EIS qualifying companies are usually in the first stage of their lifecycle i.e. start-ups and new enterprises. The UK government policy for increased investment by HNWI in new enterprises is the incentive of income tax relief on the amount invested on EIS and VCT schemes up to £1m for EIS’s and £200,000 for VCTs in any tax year.
The tax relief is available on a qualifying investment retrospective to the prior tax year. VCT and EIS dividends are paid tax-free. VCT Dividends are not included in the £2,000 dividend allowance. Another advantage is that the schemes are free from capital gains tax if the value has increased when the shares are sold subject to them been held for 3 years for EIS and for a VCT it is five years. Both VCTs and EIS have the additional attraction of giving HNWI an up-front income tax relief at the rate of 30% when the investment is completed.
Tax efficiency has become an increasing priority for HNWI’s and business owners. Since the Retail Distribution Review (RDR) there have many pension legislation changes this has restricted the amount of money that can be invested PA for HNWI is who are typically additional rate taxpayers are. Therefore, HNWI should utilise government approved tax-efficient investments. The UK government offers tax benefits for investing in new enterprise funding in VCT, EIS and SEIS. In return for the risk associated in investing in UK small companies, a past success example would be Love Film.
VCT, EIS or pensions
Arguably, neither VCT’s nor an EIS’s should be considered as a total replacement for pension contributions, which are used for saving for and funding retirement. The rationale for this is that VCT, EIS and SEIS although advantageous from both an income tax and CGT perspective are accompanied by significant higher levels of risk. It is therefore essential to view tax-efficient investments as part of a well-diversified investment portfolio.
All investment risk should always be in line with the investor’s attitude to risk and their capacity for loss however Herald et al. 2018 highlights that “In light of the sustained low yield environment, investors have increasingly taken on more risk to meet their return targets”. An advantage of VCT over EIS would be that they are more diversified as they are allowed to invest in more than one company the maximum is 15% of investments per company. Higher risk strategies for people looking to retire in the short term arguably will not be appropriate as the potential for higher losses will be greater and the funds may not recover or achieve the client’s financial objective (Wang and Hanna, 1998).
These case studies are for illustrative purposes only and do not constitute advice.
VCT case study
John Smith is a retired accountant, married and aged 65 and in good health. He has two adult children and several grandchildren. The overall estate had a value £3 million. His current income is produced from a mixture of a regular income from the capital account of his former practice and income producing assets. His income tax liability for the year is £30000. John wanted to reduce his income tax bill and improve Return On Investment (ROI) that he was receiving on his cash accounts. We assessed that John had a balanced attitude to investment risk and that he had ample assets to be capable of tolerating a moderate loss within his investment portfolio, without it affecting his current standard of living.
Our recommended advice was to invest £100,000 into a VCT; he would then receive an income tax rebate of 30%. Therefore, this would his total income tax liability for the current tax year would be effectively eradicated and an investment of £100,000 in a VCT is created. The VCT would then also provide tax-free dividend income of 5% PA. We recommended that John should hold the Investment for a minimum of 5 year to fully utilize the CGT advantages. Then he would be able to sell the investment and repeat the process and attract a further 30% income tax relief (Brookes and Ward, 2011, p261-266).
The UK Government have gradually reduced the maximum annual amount that can be paid in per year which is now £40,000 for 2018/19 and the lifetime allowance (LTA) for pensions . This has been set at £1.03 million since April 6th 2016. For additional rate tax payers earning over £150,000 the allowance reduces at a rate of £1 for every £2 earnt up to £210,000. Therefore, a HNWI earning over £210k PA would only receive £10,000 PA allowance. (£40,000 – (£60,000 ÷ 2) = £10,000).
If a HNWI pension exceeds the lifetime allowance of £1.03 million. When it is drawn down in the form of income benefit. Then tax is charged at a rate of 25% for income and 55% for a cash lump sum. Each time a pension benefit is accessed the test is reapplied, up until the age of 75 .(Moneyadviceservice.org.uk, 2018).Although pensions are an important investment for HNWI. There several drawbacks such as in retirement.
If the HNWI has other income, they may not wish to purchase an annuity to realise a drawdown income facility especially if they are additional rate taxpayer earning in excess of £150k PA and would be paying 45% income tax. Pension schemes pre RDR are set up to purchase an annuity at retirement and a tax-free lump sum of up to 25%, this is frequently referred to as an Uncrystallised Funds Pension Lump Sum (UFPLS)
A solution to this would be to transfer these existing pension schemes on to a platform-based product. The advantage to a HNWI is that this allows them flexibility to draw down income as required and to improve tax efficiently.
Pension case study
Primary residence £3,000,000 (Unencumbered)
Buy to let property portfolio £2,000,000
Cash savings £200,000
Equites (including ISA) £1,500,000
Total net asset value = £7.5m
The property portfolio is Bills only income and generates him £150,000 PA, he has not made any pension contributions within the last 5 years. He considered that this income was to sufficient to fund his retirement.
We carried out a detailed analysis of his income an expenditure and assessed that had a surplus of £5000 per month. The fact find highlighted that Bills pension had a flexi-access drawdown facility. He could take a 25% tax free lump sum of £125,000. After which he would be required to purchase an annuity that he had been quoted at 5% for the remaining £375,000. Which would provide an additional income of £18,750 this added to the £150,000 would income taxed at the additional rate of 45%.
We concluded that this would be extremely inefficient and undesirable. We recommend that Bill move the pension pot over to a new platform based product, since pension freedom commonly known as “A day”. This would allow Bill to flexible drawdown where he could leave the full amount £500000 invested and he could draw down up to the full remaining balance as required this would however be subject to income tax.
As bill had sufficient assets and income to fund his lifestyle. We recommended putting the pension into a trust for his children. This would then fall outside his estate on his death. The ability to carry forward unused allowance from up to three previous tax years. This has given some breathing space to people affected by the tapered annual allowance. We also suggested that bill could utilize his retrospective pension allow for the last 3 years. using the transitional rules from 2015-16.
This means he has an allowance of £40,000 for 2018/19 and using the 3-year retrospective rule he can pay an additional £120,000. With this year’s allowance would total £160,000. This would attract income tax relief at 40% effectively providing an uplift in value of 66.66%.
VCT case study
Hannah has been paying regular premiums into her personal pension scheme since qualifying as a solicitor just over 25 years ago. She had built up a substantial pension fund. The fund value would exceed the pensions LTA of £1.03m,. This would incur a LTA up to 55% on any excess and the 25% tax on income drawn. She required more income than the fund could potentially provide based on forecasts and past growth. She wanted to look at other investments to fund her retirement. To provide a tax efficient income.
Primary residence £1,000,000 (Unencumbered)
Cash savings £250,000
Equites ISA £150000
Total net asset value = £2.2m
She had been using her £20000 ISA allowance by investing in an equity ISA. Based on her risk profile and investment time horizon of over 5 years. She had experience investing in smaller companies. Hannah earning £250000 per annum and therefore could only pay £10000 as she was earning over the £210000 threshold. We suggested investing £200000 into a VCT. This would then attract a 30% tax relief equating to £60000.
This would then receive a tax-free income from the dividends. The investment needs to be held for five years. Then there would be no CGT liability. By using the VCT investment, it would provide tax-free growth and income. In addition, she would be able to sell the investment and simply reinvest every five years.
By a HNW utilizing a tax mitigation strategy though investments. They can effectively they can reduce both their income tax, CGT and IHT liability. However, emergency funds, their capacity for loss and the level of risk should also be considered. Also due to the reduction in the lifetime allowance and annual contributions for pensions in recent years. HNWI additional tax ratepayers due to the reduction, in their annual pension allowance. Should therefore arguably look at using tax efficient investments schemes such as VCT and EIS. Both are higher risk but the income tax and CGT savings offset this. As demonstrated in the case studies by using BPR and Agricultural property relief qualifying investments that are exempt from IHT. This immediately reduce your estate immediately for IHT purposes.
The Financial Conduct Authority do not regulate tax planning and trusts.
The value of investments and the income they produce can fall as well as rise, you may get back less than you invested.
Investors do not pay any personal tax on income or gains, but ISAs do pay unrecoverable tax on income from stocks and shares received by the ISA managers.
Tax treatment varies according to individual circumstances and is subject to change.
Business Property Relief Schemes, EIS’s and VCT’s invest in assets that are high risk and can be difficult to sell such as shares in unlisted companies. The value of the investment and the income from it can fall as well as rise and investors may not get back what they originally invested, even taking into account the tax benefits.