Investors seek to shift away from tax traps

Wealthy earners are already seeking advice on ways to manage their tax liabilities ahead of next year’s increase in income tax.

From next April, individuals will have to pay 50 per cent tax on earnings over £150,000 and relief for pension contributions will be reduced. Any gains made from fixed-interest investments such as cash and bonds will also be subject to the new higher rate of tax.

As a result, investors with annual earnings above £150,000 are being advised to move into assets that will be liable to capital gains tax (CGT) at 18 per cent, rather than income tax at the new top rate.

Some financial advisers believe such investments will be more tax-efficient than pensions when pension tax relief is reduced to 20 per cent for high earners, effective from April 2011.

Adrian Lowcock, senior investment adviser at Bestinvest, says: “For anyone earning over £150k, pensions are pretty much a turn-off now. You get 20 per cent tax relief on the way in, but, potentially, if you’re a higher earner, you’re paying 50 per cent on the way out and your capital is tied up – which pretty much makes pensions a definite ‘no’ for a lot of people.”

Tax experts expect to see more clients using individual savings accounts (Isas) and growth funds in order to mitigate their tax liabilities. But experts say altering portfolios to reduce taxation can be difficult.

Dominic O’Connell, head of tax at Coutts, takes property as an example: “A rental property is a capital asset and when it is sold the proceeds will be subject to capital gains tax at 18 per cent. Any rent from the property counts as income and will be taxed at 40 per cent.” The tax treatment cannot be swapped around.

This tax distinction extends to losses. Losses incurred on the sale of an asset can be set against gains in future years, but not against income made.

Louise Somerset, tax director at RBC Wealth Management, expects to see clients moving away from alternative investments such as hedge funds, where returns are taxed as income, and towards growth investments, such as unit trusts and open-ended investment companies (Oeics), where returns are taxed as capital gains.

The difference in taxation between the asset classes means funds may also reposition themselves to create capital gains rather than income, she says, by introducing vehicles that wrap around income investments.

But advisers warn that converting income investments is not straightforward. HM Revenue & Customs is alert to the possibility of individuals attempting to avoid taxation. Any solution that looks too clever is unlikely to have a very long shelf-life.

Richard Proctor, tax partner at Grant Thornton, says vehicles that incur capital gains tax rather than income tax have become the holy grail. Proctor advises the self-employed to take less profit from their business as salary and dividends, and instead build up the value of the business. Not only will gains be taxed as capital, but those selling up are eligible for one-off entrepreneurs’ relief on proceeds up to £1m.

However, investors and the self-employed have been advised to think carefully about the lifestyle changes and investment risk they are willing to accept in return for a smaller tax bill.

Although growth investments may incur lower tax, fixed-interest investments that guarantee a return of capital may still be more suitable for many investors in volatile market conditions.