October 2007 - Pre Budget Report Commentary

22nd October 2007

Interestingly, the government's Pre-Budget Report caused a stir primarily because the announcements were made amid cries that the Chancellor had stolen a number of proposals from the Conservative Party´s platforms, and not due to any particular policy surprises contained within it.

Being a Pre-Budget Report, none of the measures announced will become law until the Finance Bill 2008 is passed. Amendments are therefore possible. Nevertheless, in the interests of cutting through the media hype and helping to prepare our clients for potential changes in the landscape, we present here a summary of what we consider to be the most relevant developments. As always, if there are specific issues that you would like to discuss then please contact us and we will be happy to assist.

General Overview

Following the major overhauls of pension legislation and trust taxation in the Finance Bill 2006, 2007 has seen an altogether lighter agenda of change.

The good news is that, overall, we do not expect the measures announced in this year’s Pre-Budget Report to have a significant effect on the Financial Plans of our clients – with one exception. Those who have been contemplating the sale of (or sale of shares in) a business in the near future may be encouraged to take action before the 5th April 2008 following the proposed changes to Capital Gains Tax (more later).

Income Tax

  • Personal allowances and tax thresholds are due to be increased in line with inflation from April 2008.
  • There will be no changes to the National Insurance contribution rates for employers and employees, or to the profit-related contributions paid by the self-employed.

Income Shifting: The Government believes it is unfair that some individuals arrange their affairs by shifting part of their income, from dividends or partnership profits, to another person (e.g. a spouse) who is subject to a lower rate of tax. This tactic has historically been implemented by business owners granting shares to their spouse, which means that part of the dividend paid by the company is taxed as the spouse’s income - thereby making use of a spouse’s allowances and lower marginal tax rate.

A consultation will be launched shortly on draft legislation to prevent such income shifting. It is intended that this legislation will take effect from 2008/09. Against the background of the Government losing an important recent case concerning income shifting, the consultation process is meant to ensure that only arrangements intended to reduce tax, rather than commercial arrangements, are affected by the proposed legislation.

Fensham Howes’ View

For those of you who own a business where other family members own shares we recommend a review of your remuneration arrangements by your accountant. An alternative way of efficiently extracting profits from the business may be for you to revisit your pension contribution arrangements, subject to this being consistent with your overall planning arrangements.

Capital Gains Tax (CGT)

A major reform of capital gains tax for individuals, trustees and personal representatives was announced.

For disposals occurring on and after 6 April 2008, there will be a single rate of CGT of 18%. The annual exemption will be retained. This exemption currently allows an individual to realize gains of up to £9,200 in the tax year without incurring a CGT liability.

This change should result in a more straightforward system of tax, however as a consequence of the proposed simplification there are a number of "knock-on" changes, also effective from 6 April 2008. These are:

  • Taper relief is being withdrawn on business and non-business assets.Currently, after a qualifying business asset has been owned for at least two years, the chargeable gain is reduced by 75%. This means that the current effective rate of tax on gains from such assets for a higher rate taxpayer is now 10%, or 5% for a basic rate taxpayer. The new legislation therefore imposes an increase in CGT for such assets from April 2008.

    Similarly, non-business asset taper relief can currently reduce a chargeable gain by 40% (to an effective 24% rate) after 10 years´ ownership. After the end of the current tax year no such reductions will be available, and the flat rate of 18% will apply, regardless of when the asset was acquired. For a higher rate tax payer, these changes actually imply a reduction from current taxation levels for these types of assets from April 2008.
  • Indexation allowance for assets held prior to April 1998 is being withdrawn. Indexation allowance is a method of upwardly re-valuing the tax basis of assets that have been held prior to April 1998 to take account of the effects of inflation. The concept behind indexation allowance is that any gain on an asset held over a long period is in part due to an increase in the real value of the asset, and in part simply due to inflation.

    Indexation allowance and taper relief both go some way towards addressing this issue by effectively reducing the actual rate of tax payable for assets held for long periods (taper relief directly reduces the rate of tax, whereas indexation allowance reduces the sum to which the tax is applied). The Government has now decided that rather than starting from a high initial rate of tax (40% for higher rate taxpayers) and then reducing it, they will simply do away with all the reduction calculations and just apply a lower rate of tax (18%) in all cases. Going forward this will certainly simplify the capital gains tax regime. However it can create significant issues for clients who have held assets for long periods and who would otherwise have benefitted from significant levels of CGT relief on those assets.
  • From 6 April 2008 the base cost of assets held before 31 March 1982 will be fixed at the 31 March 1982 value. This means that in broad terms, a gain or loss will be calculated using the original acquisition cost of the asset or the value of the asset as at 31 March 1982, whichever is higher. 
  • Following the introduction of taper relief in 1998 a complicated system was introduced to identify which specific shares within a block of shares were being sold so as to determine the right basis for calculating the taxable gain. The current rules broadly apply on a LIFO (last in first out) basis. From 6 April 2008 shares of the same class in the same company will be treated as a single asset which takes us back to the old system of "share pools". However, the rule matching shares disposed of and acquired on the same day and the 30 day "bed and breakfast" rule will remain.

Draft legislation is to be produced later and HMRC will discuss the changes with interested parties.

Fensham Howes’ View

A more straight-forward system of tax is to be welcomed but the implementation of these changes may be somewhat draconian for those who have held assets entitled to taper relief and the indexation allowance which could substantially reduce the amount of gains subject to tax. In particular, those planning to sell shares to provide an ‘income’ in retirement, at which point they might be a basic rather than a higher rate taxpayer may suffer by paying tax at a slightly lower rate but on a much larger gain. However for those who are presently higher rate tax payers and who expect to remain so until retirement, the changes are likely to be positive and may increase the scope to build greater invested wealth in a more tax benign environment.

For those of you contemplating selling shares in your business, a sale before 6 April 2008 could be taxed at the 10% rate of CGT because of taper relief, whereas a sale on or after 6 April 2008 will suffer CGT at 18%. That being said, any sale of shares must be viewed within the context of the overall economic situation which includes sale price, business strategy, etc. We are happy to assist you in any such evaluation if you wish.

The change in rate of CGT and removal of taper relief has important consequences for investors for whom we were considering an offshore investment bond as a home for their capital. For those of you in this situation, we will assess the implications of the CGT changes (and other potential changes concerning the tax classification and treatment offshore funds now being discussed) on an individual basis and will discuss our findings with you at your next review.

Note: The rule changes may also see the introduction of low risk investment vehicles designed to take advantage of the new CGT rules to reduce the tax paid on cash or cash style investments. We will watch these developments with interest and keep you informed.

Inheritance Tax (IHT)

Amid cries that he had stolen the Conservative Party´s proposals for IHT reform, the Chancellor announced a potential doubling of the nil rate band for some married couples and civil partners.

Below we outline the new provisions and analyse their impact.

The proposals

  • The Finance Bill 2008 will allow a claim to be made to transfer any unused nil rate band (NRB) on a person´s death to the estate of their surviving spouse. The definition of "spouse" includes registered civil partners. 
  • The new provisions will apply to anyone who dies on or after 9 October 2007, regardless of when their spouse died (including deaths before 1986 when IHT was introduced).

    The amount of NRB available for transfer will be based on the proportion of unused NRB at the time of death of the first spouse, but at the rate applicable at the time of death of the survivor. A maximum 100% of the NRB will be available. It can be accumulated on more than one occasion, for example if a person dies having survived more than one spouse; but there is an overall limit of 100% so as to avoid multiple “inheritance tax planning” marriages.
  • Claims must be made by the personal representatives of the deceased surviving spouse within 2 years of his or her death (i.e. action only needs to be taken following the second death – there is no need to do anything following the first death).  

Examples

  • On the first death in October 2007 all assets pass to a surviving spouse – no IHT is payable due to the spouse exemption and 100% the nil rate band (£300,000) is unused. When the survivor dies in October 2008, his or her NRB (then £350,000) is increased by 100% to £700,000. 
  • If, on the first death, there was a chargeable transfer of £150,000, i.e. 50% of the NRB, the survivor´s NRB will be increased by 50% of the NRB at the time of the second death, i.e. from £350,000 to £525,000.

There are also provisions to change the IHT rules for alternatively secured pensions (ASP) – but these are beyond the scope of this bulletin and you should contact us directly if you would like to discuss this further.

Fensham Howes’ View

If this sounds complex, it is because it is. Clearly the proposals will make IHT planning much easier for many who are young and recently married, who have been married or in a civil partnership for a long time, or who have been widowed. In particular, the fact that someone leaves all their assets to their spouse will no longer mean that their NRB is wasted. However complexities can arise. For example, those in the baby boom generation who have had several marriages or have been previously widowed and remarried may find things a bit more challenging.

Effective use of the NRB has always been the main feature of IHT planning for married couples. For those who have already implemented a strategy, which includes the use of the NRB on the first death, the proposals make little or no difference.

The proposals do not require any immediate action with regard to IHT planning.

If you have included a discretionary will trust or NRB trust in your Will there is no need to change it – and there may be good practical reasons to have such a trust (see below).

The proposals do absolutely nothing for those who are not married or in a civil partnership or who are divorced. For all such individuals and couples the existing lifetime planning strategies remain as valid as ever.

Do we still recommend the use of trusts in tax efficient Will planning?

In a word, yes. We reiterate that the use of trusts in inheritance tax planning will continue to have valid application for many of our clients. In particular, holding property in trust rather than distributing it outright can help provide meaningful protection in the following areas:

  • The establishment of trusts will provide procedural clarity to enable the tax-efficient passing of assets to your heirs and beneficiaries and avoid the potential complexities of certain situations where calculating the transferable nil rate band capacity may be difficult. For example, trying to follow the proposed rules may entail complex issues of valuation and tracking down gifts made during the lifetime of the first person to die. In addition, a number of problems could limit the availability of transferable nil rate band capacity. 
  • Holding property in trust rather than distributing it outright can help to protect against the potential claims of a beneficiary’s creditors, from a beneficiary’s potential divorce settlement, or from the effects that a surviving spouse’s remarriage or changing opinions can have on the ultimate devolution of assets to beneficiaries. 
  • Holding property in trust rather than distributing it outright can help to ensure the continuation of certain state benefits should the beneficiary become a recipient of means-tested long term care. 
  • Holding property in trust rather than distributing it outright can help to protect the assets of more vulnerable beneficiaries who might otherwise have difficulty in seeking out and following appropriate financial advice. 
  • The use of trusts can be essential in preserving certain inheritance tax benefits arising from the ownership of agricultural property assets or business assets. This can be extremely important for clients who operate in partnerships or own their own business.

    For clients whose estates exceed two times the NRB threshold and expect their value of their assets to grow at a rate faster than the NRB threshold of the inflation rate, planning flexibility and advantages can often be obtained by using trusts (note: the expected long term return of all our structured portfolios exceed the expected inflation rate).

Please contact us if you wish to discuss any of these issues in more detail. At this point however, we can say that the vast majority of clients who have made tax efficient Wills can be confident that they still “work”. It is also likely that despite the changes made on October 9th such Will-planning remains appropriate in most cases where the value of joint estates exceeds the basic £300,000 inheritance tax free nil rate band.

Moreover, planning to reduce the value of the estate assessable to IHT (e.g. by making lifetime gifts and using discretionary trusts to keep life assurance benefits and pension lump sum death benefits outside of the estate) remains an important strategy for those with larger estates.

Fensham Howes’ view

Inheritance tax remains a significant strategic issue for many of our clients. We can help, not only by continuing to keep your planning under review, but also by working with older and younger generations of your family to make sure that wealth is passed as efficiently as possible to younger generations. This approach focuses on continuity and is much more effective than each generation focusing on their own affairs. If you would like us to review your family's multi-generational inheritance tax position and how it may affect your own situation then please let us know.

Residence and Domicile Review

A review of the taxation of non-UK resident and non-UK domiciled persons has been under way since 2003. The announcement by the Conservatives of a proposal to tax non-UK domiciles living in the UK has ignited this area.

The Government has announced proposed measures in their Pre-Budget Report which are very briefly highlighted as follows:

  • Currently UK residents who are not UK “domiciled” only pay UK tax on their overseas income or gains when the money is brought into the UK. This is known as the “remittance basis” of taxation.

    It is proposed that after a “non-domiciled” individual has been resident in the UK for seven years they will only be able to use the remittance basis of taxation if they pay an additional tax charge of £30,000 a year. If an individual decides not to use the remittance basis (and not pay the additional tax charge) then they will be taxed on all their worldwide income and gains, regardless of whether the money is actually brought into the UK. This is known as the “arising basis” of taxation.

    The new rules will come into force on 6 April 2008 and all previous years of residence will count from that day. 
  • Anomalies in the current rules mean that individuals using the remittance basis of taxation can find ways of bringing overseas income and gains into the UK without paying UK tax on them. A number of changes are being made to close these loopholes.

The Government plans to consult on the details of some of these changes.

Fensham Howes' View

For non-domiciled clients with considerable overseas investments and income, the continuance of the remittance basis might still be attractive despite the imposition of the annual charge and the more complex rules. This is particularly true if the £30,000 annual cost and any “tax-gross up” factor is being fully met by an employer.

However, for those who do not have an employer to underwrite the annual charge and all related costs the situation is much less clear. In our view, this is a very complex and profound development for such non-domiciled individuals and we recommend that clients in this situation consult in detail with their tax advisers and pay very close attention to future events. In this regard, we are happy to assist clients in assessing what type of tax help they need.

Summary

We reiterate that whilst tax planning is an important part of a successful and sustainable Financial Plan, it remains the case that the largest contributing factor in achieving your long-term financial goals is to maintain a disciplined and structured investment strategy to harness the power of the capital markets over the long term.

The measures announced in the Pre-Budget Report should be easily accommodated within your Financial Plans.

We would like to thank David Coldrick from Wrigleys Solicitors for his contribution to the inheritance tax and Will related elements of this summary. Wrigleys are well known for their strong tax planning base, expertise in probate and trusts as well as their skills in newer areas, such as personal injury trusts and trusts for the disabled.

Disclaimer

This commentary is not intended to be exhaustive. In the interests of brevity we have focused only on those areas which we believe to be of most relevance to our clients. If there are other aspects of the Budget that you would like to discuss then please contact us.

Every care has been taken in the writing and editing of this document to ensure that the material within it is accurate and up to date, but the contents are not intended to constitute specific advice and no responsibility is accepted for any consequences arising therefrom.