Detailed Taxation Notes for Investment Planning

INTRODUCTION

• Focus on three main taxes affecting investment decisions:

  • Income Tax

  • Capital Gains Tax (CGT)

  • Inheritance Tax (IHT)

• Importance of individual status: resident, ordinarily resident, domiciled.

RESIDENCE

• Residence is determined each tax year.

• An individual's residence status is determined each tax year, and there are specific rules to decide this. Here are the key points:

  • A person is considered a UK resident if they spend 183 days or more in the UK during a tax year. Any day spent in the UK at midnight counts as a day.

  • If someone moves to the UK to live for 3 or more years, they are considered a UK resident from the day they arrive, even if they stay less than 183 days in their first year, as long as they plan to stay long-term.

  • People who frequently visit the UK are also treated as residents. To qualify, visits must meet two conditions:

    • Habitual: The visits must happen for four years in a row.

    • Substantial: The person must spend an average of 91 days or more in the UK over a maximum of four years.

  Because of these rules, it is possible for someone to be a resident in both the UK and another country in the same tax year. In such cases, double-taxation agreements between countries are used to prevent being taxed twice on the same income or gains.

  A person's residence status mainly affects income tax, as UK residents are taxed on their worldwide earnings. It can also affect Capital Gains Tax (CGT) obligations.

• Tests for Residence:

  • Deemed UK resident if present for 183 days or more in a tax year.

  • Each midnight in the UK counts as a day of presence.

  • If living in the UK for 3 years or more = resident from arrival if intended indefinite stay.

  • Habitual and substantial visits considered for residence:

  • Habitual: 4 consecutive tax years.

  • Substantial: Average of 91 days over 4 years.

• Possible dual residency leads to double taxation agreements to prevent unfair taxation.

• Impact on Taxes:

  • Mainly affects income tax and CGT.

ORDINARY RESIDENCE

• Definition of ordinary residence is less clear:

  • Voluntarily come to the UK, settled purpose in UK, habitual presence.

• Residing in the UK for 3+ years grants ordinary residence status.

• The status of "ordinary residence" is not as clearly defined as "residence." You are considered "ordinarily resident" in the UK if:

  1. You moved to the UK voluntarily.

  2. Your stay has a settled purpose.

  3. Living in the UK is a regular part of your life for now.

  Living and working in the UK for three years or more is enough to be considered "ordinarily resident." Essentially, the test for ordinary residence is whether being in the UK is part of your usual lifestyle.

  For example, people who were not previously residents but qualify under the "habitual and substantial" test will be considered ordinarily resident in the UK starting from the fifth tax year. However, if someone planned to make regular visits to the UK from the beginning, they would be considered ordinarily resident right away.

  Ordinary residence status affects income tax and capital gains tax (CGT) responsibilities. For example, leaving the UK for one tax year doesn't automatically avoid UK CGT on assets. If a person:

  • Was UK resident for at least four out of the last seven tax years, AND

  • Becomes non-resident or not ordinarily resident for less than five tax years,

  They may still be liable to UK CGT on any gains made after leaving the country.

• Impact on Taxes:

  • Cannot leave UK for one year to avoid CGT charges on asset disposal.

DOMICILE

• More permanent status than residency; where an individual has their permanent home.

• The status of "domicile" is more permanent than "residence." In simple terms, a person is domiciled in the country where their permanent home is. Even if someone moves abroad, they can still keep their original domicile for life. While a person can have dual nationality or dual residence, they cannot have dual domicile.

  An individual is born with a "domicile of origin," usually that of their father (or mother if the father is absent or deceased). This domicile stays with them until they are 16 years old, at which point they can potentially change it.

  A person can also try to establish a "domicile of choice" by moving to a new country with the intent to live there permanently. There are no strict rules for this, but factors like voting, starting a business, making a local will, and obtaining citizenship are considered.

  A key rule in the UK is the concept of "deemed domicile." HMRC considers a person UK domiciled if they have been a UK resident for 17 out of the last 20 tax years.

  Domicile affects Inheritance Tax (IHT). A UK domiciled or deemed UK domiciled individual is liable for IHT on their worldwide property. A non-UK domiciled person is only liable for IHT on their UK property. This is why HMRC can "deem" someone domiciled in the UK to ensure they are taxed appropriately.

• Individual typically retains domicile for life even when living abroad.

• Domicile of Origin:

  • Domicile determined at birth, typically from the father's domicile.

• Domicile of Choice:

  • Established by intending to live permanently in another country.

• Deemed Domicile:

  • HMRC deems UK domiciled if resident for 17 of the past 20 tax years.

• Impact on Taxes:

  • IHT affects domicile status; UK domiciled = liable for worldwide property IHT; non-UK domiciled = only UK property IHT.

LIABILITIES OF UK RESIDENTS

• UK resident, ordinary resident, and domiciled individuals taxed on worldwide income (arising basis).

• Not ordinarily resident or non-UK domiciled individuals can claim remittance basis:

  • Taxed on UK income, gains remitted to the UK only.

  • Loss of personal tax allowance for most remittance basis claimants.

  • Annual charge of £30,000 for certain individuals.

TYPES OF TAX

n the UK, taxes are classified into two main types:

1. Direct taxes – These are taxes paid directly by individuals or businesses. Examples include:

   • Income tax

   • Capital gains tax

   • Inheritance tax

   • Corporation tax

   • National Insurance

2. Indirect taxes – These are included in the price of goods or services, meaning they are paid indirectly. Examples include:

   • Value added tax (VAT)

   • Stamp duty land tax

   • Stamp duty reserve tax

   • Excise duties

HMRC (Her Majesty's Revenue & Customs) is responsible for making sure the correct taxes are paid at the right time. There are three main ways direct taxes are collected from individuals:

1. Self-assessment – Individuals report their income and calculate the tax they owe.

2. Pay As You Earn (PAYE) – Tax is deducted directly from an individual's salary by their employer before they receive it.

3. Deduction at source on savings and investment income – Tax is taken directly from income earned through savings or investments, often automatically.

SELF-ASSESSMENT

• The self-assessment system for collecting tax was introduced in the UK for the 1996/97 tax year. It's mainly for individuals with more complex tax situations, such as the self-employed, company directors, or those who pay higher-rate tax on investment income. It's not a new tax but a simpler way to handle taxes for people who previously had to fill out multiple tax forms and deal with taxes on different types of income at different times, even in different years.

  Through self-assessment, taxpayers have the option to calculate their own tax payments. It's estimated that just under ten million people are affected by this system.

  The direct taxes collected under self-assessment include:

  • Income tax (on all types of income)

  • Class 4 National Insurance contributions

  • Capital gains tax (on the sale of assets like property or shares)

• Deadlines for filing:

  • Paper: 31 October

  • Online: 31 January 2010/11 example

• Payments:

  • Payments on account made 31 January and 31 July, balancing payment on 31 January.

• Interest & Penalties:

  • Late payments incur interest and surcharges.

PAY AS YOU EARN (PAYE)

• Collected via employers for most employees.

  Most employees in the UK don’t need to complete a self-assessment tax return because their tax is collected through the PAYE (Pay As You Earn) system. This means their employer automatically deducts income tax and National Insurance contributions from their pay and sends the correct amounts to HMRC.

  Each employee is given a PAYE code by HMRC, which helps the employer know how much tax-free income the employee is entitled to. The PAYE code consists of:

  • A number: This shows how much tax-free income the employee gets. To find the full amount, you multiply the number by 10 (since the last digit is usually dropped).

  • A letter: This indicates the type of personal allowance the employee is entitled to. Different letters represent different types of allowances. The most common is the ‘L’ code, which is for employees eligible for the basic personal allowance.

  For example, a PAYE code of 512L means the employee has £5,120 of tax-free income for the year. This amount is spread out monthly, so £427 (one-twelfth of £5,120) will be tax-free each month.

  The PAYE system is used for many types of income, including:

  • Wages and salaries

  • Fees

  • Bonuses and commissions

  • Holiday pay

  • Pensions

  • Profit-sharing scheme payments

  • Statutory Sick Pay (SSP), Statutory Maternity Pay (SMP), Statutory Paternity Pay (SPP), and Statutory Adoption Pay (SAP).

• Employers deduct income tax and National Insurance from pay.

• PAYE Code Components:

  • Number: Tax-free income.

  • Letter: Type of allowances.

DEDUCTION AT SOURCE

• Tax deducted at source from savings/investment income:

  • Interest at 20%.

  • Dividend income net of a 10% tax credit.

INCOME TAX CALCULATION

1. Calculate gross income.

2. Deduct allowable amounts.

3. Deduct personal allowances.

4. Calculate higher-rate relief contributions.

5. Apply tax rates to remaining income.

6. Account for tax paid at source.

CAPITAL GAINS TAX (CGT)

• Tax on gains from disposal of capital assets.

• Disposals include sales, gifting, exchanges, etc.

• Exempt Assets:

  • Principal private residence, motor vehicles, ISAs, etc.

• Calculation Steps:

  1. Determine disposal proceeds.

  2. Deduct acquisition cost.

  3. Deduct purchase/sale/enhancement costs.

  4. Set off losses.

  5. Deduct annual exemption.

  6. Calculate tax (currently 18%).

• EXAMPLES

• Sandra Evans, aged 62, earns £46,000 per year, and 5% of that is deducted by her employer as a pension contribution. She also contributes £200 per month to a personal pension plan.

  She no longer has a company car, but her company provides her with private medical insurance, which has a taxable value of £800.

  In 2009/10 her portfolio is expected to produce £1,800 interest net of tax and £2,700 net dividends.

   

  Step 1: Calculate the gross income

  There are two key Acts that lay down the rules for taxing different types of income:

  • Income Tax (Earnings and Pensions) Act 2003 – the ‘ITEPA 2003’;

  • Income Tax (Trading & Other Income) Act 2005 – the ‘ITTOIA 2005’.

  These effectively replaced the previous system of tax ‘schedules’. Simplistically, most of the types of income that were covered under the old ‘Schedule D’ are now covered by the ITTOIA, with that of the old ‘Schedule E’ being covered by the ITEPA.

  We now need to ‘gross up’ these forms of income and add the result to the individual’s other income.

  Grossing up is a fairly straightforward process. For interest payments, you can gross up by dividing the net payment by 0.8 (ie, reversing the original process where the gross interest would have been multiplied by 0.8 (or 80%) to arrive at the net figure).

  Based on this approach, for dividend payments you can gross up by dividing the net payment by 0.9.

  CASE STUDY

  Sandra had gross earnings of £46,000. In addition she is expecting:

  • Interest of £1,800. £1,800 / 0.8 = £2,250

  • Dividends of £2,700. £2,700 / 0.9 = £3,000

  Sandra’s expected gross income for 2009/10 is therefore £46,000 + £2,250 + £3,000 = £51,250

   

  Step 2: Deduct certain allowable amounts

  HMRC allow certain ‘allowable amounts’ to be deducted from gross income, before tax is applied. Possibly the best known of these, are pension contributions paid under the ‘net pay’ arrangement, for example personal contributions to company schemes.

  To continue the pension theme, contributions to old style Retirement Annuity Contracts (RACs) can also be deducted here. These are still paid gross, mainly due to most pension providers running their RACs on out-dated computer platforms that are hard to convert to the more modern system for an investor to receive basic rate tax relief at source.

  Other examples of ‘allowable amounts’ are:

  • Share purchase and loans to companies, involving loans to small ‘close’ companies or loans to buy shares in them.

  • Partnership investment, where tax relief is available to a partner who pays interest on a loan used to benefit a partnership.

  • Payment of inheritance tax, where interest is allowable if it is paid on a loan used to meet an IHT liability. The relief is restricted to one year from taking out the loan.

  CASE STUDY

  Sandra’s employer deducts 5% as a pension contribution. This equates to:

  • £46,000 x 5% = £2,300

  This is an allowable deduction from Sandra’s gross income of £51,250, to leave £48,950.

  Of this gross income, Sandra’s non-savings income is £43,700 (£46,000 – £2,300). This is significant later.

   

  Step 3: Deduct personal allowances

  All UK residents, regardless of age (yes, this does include a new born baby), are eligible for the basic personal allowance. In 2010/11, this allowance is £6,475. Although we are all entitled to this amount, not all of us have a tax code of 647L, mainly due to enjoying ‘benefits in kind’ which are given a taxable value that is deducted from the standard personal allowance.

  There are other personal allowances that could apply at this stage, such as the Blind Person’s Allowance for those who are registered blind. The most common additional allowance that applies here, however, is the ‘Age Allowance’ for individuals who turn 65 during the tax year.

  For these individuals, their personal allowance is £9,490 in 2010/11 for those aged 65–74, and to £9,640 for those 75 and over. However, the increased amount is reduced by £1 for every £2 of income above a set statutory amount which is £22,900 in 2010/11. This reduction, if applicable, will not reduce the standard personal allowance, just the age allowance addition. It could also reduce the Married Couples

  Allowance (see Step 6).

  For those aged between 65 and 74, this effectively creates an additional tax band at 30% for income between £22,900 and £28,930, and for those aged 75 and over for income between £22,900 and £29,230. As far as possible, this should be avoided by investing in tax efficient investments, such as ISAs or National Savings Certificates, or life assurance bonds where tax on withdrawals can be delayed.

  Similarly, from 2010/11 the standard personal allowance is reduced by £1 for each £2 of income in excess of £100,000, until it is eliminated entirely.

  CASE STUDY

  At age 62, Sandra is entitled to the basic personal allowance of £6,475. However, this will be reduced by £800 to take her taxable benefit-in-kind into account. Her taxable income will therefore be:

  • £48,950 – (£6,475 - £800) = £43,275

  Although this is the correct calculation for the taxable income, a good habit to get into, is to take the personal allowance off the non-savings income first. This is due to the order income is taxed, which is explained more in Step 5.

  Sandra’s non-savings income is £43,700 (the original £46,000 less the pension contribution of £2,300).

  Her revised personal allowance of £5,675 would therefore be taken off this to reach the amount of £38,025. The other income amounts of £2,250 (interest) and £3,000 (dividends) are added to this to arrive at the total taxable income amount of £43,275, as above.

   

  Step 4: Calculate any amounts where higher rate relief is given

  There are two primary situations where this happens, and they work in the same way. The two situations are:

  • contributions to pensions plans, where basic rate tax relief is given at source, and

  • gift aid contributions to charities.

   

  If an individual makes these contributions during a tax year, the amount paid should be grossed up (by dividing by 0.8). The gross amount is then added to the statutory limit where taxable income is taxed at the basic rate (which in 2010/11 is £37,400).

  The effect is that more of the individual’s other income will be taxed at the basic rate rather than the higher rate, therefore effectively providing ‘higher-rate tax relief’.

  CASE STUDY

  Sandra is paying £200 pm to a personal pension plan. This means a gross contribution of £250 (£200/0.8) is being invested on her behalf each month.

  For this stage of the income tax calculation, we can extend the basic-rate tax band for her by:

  • £250 x 12 = £3,000

  Sandra’s basic-rate band will therefore be extended to £40,400.

   

  Step 5: Tax the income

  We’ve finally reached the point where the taxable income is taxed! It is important that the income is taxed in the correct order and at the correct rate.

  The correct order for the tax calculation is always:

  1. earned income, then

  2. savings income, then

  3. dividend income, and finally

  4. chargeable gains on life assurance policies.

   

  * The starting-rate of 10% to savings income only applies if there is insufficient non-savings income for the starting-rate band (£2,440 for tax year 2010/11) not to be exceeded.

  In Step 3 we established that it was a good idea to deduct the personal allowance from the non-savings income. That is because the order in which income is taxed, is also the order in which allowances are deducted (ie, from non-savings income first, then savings income etc).

  CASE STUDY

  We have established that Sandra has an increased basic-rate band of £40,400. This leads to the following computation:

  Type of income                    Amount                 Tax rate                                 Tax due

  Non-savings income                           £38,025 All at 20%                              £7,605.00

  Savings income                    £2,250                    All at 20%                             £450.00

  Dividend income                 £3,000                  £125 at 10%                          £12.50

  £2,875 at 32.5%   £934.37

  Total                                                                                       £43,275                 £9,001.87

  Just to clarify, if Sandra hadn’t been paying the personal pension contributions, she would have had the standard basic-rate band of £37,400. As a result, some of her non-savings income would have been taxed at 40%, as would all of her interest payment. All of her dividend payment would have been taxed at 32.5%. However, her £200 pm personal pension plan contribution translates to a gross annual payment of £3,000 and therefore an increased basic rate band, leaving less income taxed at the higher rate.

   

  Step 6: Give credit for tax paid at source and deduct tax reducers

  The previous steps of the process have established the total tax liability. However, we should take into account the fact that many individuals would have paid tax at source on their savings and dividend income. Therefore, to establish their additional tax liability, we should deduct these amounts.

  We should also consider whether the individual could benefit from any tax reducers. These are simply amounts that can be deducted from the final tax bill. The common examples are:

  • Married couple allowance (MCA)

  • This is now only available if either spouse (or civil partner) was born before 6 April 1935.

  • It provides relief at 10% of a fixed statutory amount that is updated each tax year (£6,965 for 2010/11).

  • For couples married before 5 December 2005, the MCA belongs to the husband, although it can be transferred to the wife.

  • For couples married or registered on or after 5 December 2005, the MCA is allocated to the higher earner. Couples subject to the old rules can elect for these new rules to apply to them.

  • Enterprise Investments Schemes (EIS)

  • An investment in an EIS attracts tax relief at 20% of any contribution paid, up to a limit of £500,000 per tax year.

  • Venture Capital Trusts (VCTs)

  • An investment in a VCT attracts tax relief at 30% of any contribution paid, up to a limit of £200,000 per tax year.

  CASE STUDY

  We have established that £9,001.87 is the expected total tax liability for Sandra. However, that includes tax on interest and dividends where she has already paid some tax at source.

  The amounts paid at source were:

  • Interest: £2,250 x 20% = £450

  • Dividends: £3,000 x 10% = £300

  Therefore, the additional tax Sandra will have to pay is:

  • £9,001.87 - £450 - £300 = £8,251.87

  She is not eligible for any tax reducers.

INHERITANCE TAX (IHT)

• Charged on certain transfers of property/value.

• Domicile impacts:

  • UK domiciled = worldwide property liability.

  • Non-UK domiciled = UK property only.

• Rates and NRB:

  • £0 - £325,000 at 0%, chargeable lifetime transfers at 20%, and transfers before death may incur 40% with taper relief.

• Types of transfers include exempt, potentially exempt, and chargeable lifetime transfers.

TAX PLANNING

• Must consider individual circumstances for effective strategies.

• Helpful tips for Income Tax and CGT include utilizing allowances, segmenting income, realizing losses, and timing disposals to stay within tax bands.

• IHT planning often involves lifetime gifts, joint life insurance policies, and careful structuring of estates.