Income or Capital – a game of snakes and ladders?
Until 5 April 2008 both income and capital gains were taxed at the marginal rate, so that the highest rate of tax for each was 40%. However, from 6 April 2008 capital gains tax reduced to 18% and from 6 April 2010 income tax rates go up. Personal allowances will be tapered down to £nil for those with more than £100,000 of income and income above £150,000 will be taxed at 50%, with dividend income being taxed at 42.5%, rather than the current 32.5%.
Consequently, it has become more attractive to plan for capital growth and to look for ways of turning capital into income. Given that this will be even more relevant from next April, this article considers tax planning ideas based on this.
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It will be important to utilise spouses’, and other family members’, lower rate income bands by spreading asset ownership. This could involve inter-spouse transfers of shares or introducing a spouse into partnership, where this is justified.
For the self-employed who have overlap relief brought forward this can be released to reduce profits, either by changing the accounting period or ceasing the trade. Similarly, for those who can wait to incur business expenditure, this should be left until 6 April 2010 so that tax relief is obtained at the higher rate.
Incorporating to take advantage of the lower corporation tax rates can be useful, if the profits do not have to be taken out of the company, thereby avoiding PAYE charges. Similarly, a partnership could consider introducing a corporate partner where the profits could be stored.
Company dividends should be extracted by 5 April 2010 before the dividend tax rate increases.
For those with investment portfolios these can be restructured to plan for investment growth rather than income. The use of tax efficient investments and structured products can assist with this. For example, there are products designed to give capital growth such as the use of zero dividend share portfolios.
Badges of Trade
The courts have established a number of tests, known as the “badges of trade”, to assist in deciding whether an activity is trading or investment. These can help in justifying that an activity is an investment one and that any profit should be taxable as capital gain rather than income. The “Badges” cover a number of areas which include reviewing the “Profit Seeking Motive”, “Number of Transactions” and the “Interval of Time Between Purchase and Sale”. Indicators of investment include the motive, such as holding assets for investment, personal enjoyment and a long period of ownership. A need to fund a sudden emergency would also indicate a non-trading activity.
It is recommended that individuals review their personal position, so they can as far as possible stay below the new income tax limits, whether this means spreading asset ownership or looking at new investment/business strategies. Individuals should also look at ways of generating capital as opposed to income to take advantage of the lower rate of capital gains tax taking professional advice as appropriate.
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