How to (legally) pay 10% tax on a £200k salary

"With corporate tax rates decreasing while tax rates for individuals remain high, and with the income of the UK's highest earners continuing to soar, it's hardly surprising that the debate around tax avoidance has shifted from companies to individuals," says George Bull, a tax expert from accountant Baker Tilly.

The spotlight is on individuals, be they entertainers, footballers or business people. The publicity over Jimmy Carr's tax avoidance is part of a wider expansion of official tax investigations. The government has announced proposals for a General Anti-Abuse Rule (GAAR) to enable HMRC to counteract schemes that work but are perceived as abusive.

Here are a few common methods used to cut the amount that ends up in the taxman's coffers on a £200,000 salary. All legal, and not morally dubious.

If you receive £200,000 in salary, you will pay just over £78,000 in income tax for 2012-13, meaning your net wage is £115,914.75 and your overall income tax rate is 39 per cent.

Source: www.incometaxcalculator.org

Let's start with pensions, on which contributors receive income tax relief. Each tax year investors are allowed to contribute as much as they earn to pensions, up to the annual allowance of £50,000 (2011-12). Employer contributions and the value of benefits built up in final salary schemes count towards this limit. If our high earner makes a £50,000 maximum annual contribution into a pension, that wipes out £25,000 in income tax. But it leaves him with a tax bill of £53,000, an effective income tax rate of 26.5 per cent on the original £200,000 salary.

He then puts £50,000 into a Venture Capital Trust, getting income tax relief at 30 per cent, meaning he wipes out another £15,000 of income tax. He now has a tax bill of £38,000 and an effective income tax rate of 19 per cent.

He then puts £20,000 into Seed Enterprise Investment Scheme qualifying shares. The SEIS income tax relief available is £10,000 (£20,000 at 50 per cent). This leaves him with a total tax bill of £28,000 and an effective income tax rate of 14 per cent on the original salary. He still has take-home pay of £52,000.

The SEIS shares must be held for a period of three years from date of issue for relief to be retained. If they are disposed of within that three-year period, or if any of the qualifying conditions cease to be met during that period, relief will be withdrawn or reduced.

The SEIS scheme is very high risk investment in start-up companies with assets of less than £200,000. There haven't been many SEIS launches as it only started in tax year 2012-13. The ASCEND (Ascension Seedcapital for Creative Enterprise and Digital) Fund from Ascension Ventures is seeking £1.5m through a Seed Enterprise Investment Scheme (SEIS) structure. Alternatively, Oxford Technology has launched a Combined Seed EIS and EIS Fund.

For more information on SEIS: www.seis.co.uk

Alternatively, he may could put his £20,000 into a plain vanilla Enterprise Investment Scheme (EIS), where there is more choice and slightly lower risk but the income tax relief is 30 per cent.

He then gives £20,000 (10 per cent of his full £200,000) as a charitable donation. This wipes out £8,000 in income tax via Gift Aid. So his total tax bill is £20,000 - ie, an effective tax rate of 10 per cent. .

Drawbacks

One big drawback of this tax mitigation strategy is that our high-flyer's net pay will be just £40,000 - a lot less than the £115,914 available if he just paid tax at the normal rates. Much of the rest of his earnings, apart from the charitable donation, are locked up in investments which carry risk. He could lose capital on the investments held within all four tax-wrappers (pension, VCT, EIS or SEIS).

Let's start with pensions. By maxing out his contributions, he could be in danger of exceeding the lifetime limit on his pension pot, which is £1.5m for tax year 2012-13. Another issue is that while pensions may attract tax relief on contributions, the income eventually secured is subject to tax and there are lots of limits and restrictions on how you draw it. (For more on the negative side of pensions read Why pensions are a bad deal.)

There is also a danger that the government could change the VCT, EIS and SEIS rules or that the scheme he subscribes to fails to meet the relevant investment rules, in which case the income tax benefits could be withdrawn retrospectively.

There may also be problems exiting your investment. EIS and SEIS are unlisted vehicles, so if you want to get out you have to wait until the underlying investments are sold via a trade sale or flotation, although there are some instances where the EIS manager will buy back your shares.

VCTs are listed on the stock market, so there is a secondary market. But it is illiquid, partly because VCT shares bought on the secondary market do not qualify for the 30 per cent income tax relief available on a new issue. This means you may have to sell your shares at a discount to their net asset value (NAV). Sometimes managers offer an enhanced buy-back facility where you can sell back your VCT shares at close to NAV and get new shares in the same VCT with a further 30 per cent income tax relief.

VCTs in particular have had mixed results, attracting criticism for poor performance. Over the years the Baronsmead and Northern vehicles have been among the best performing.

Planned-exit VCTs aim to wind up as soon as possible after five years and protect rather than grow capital. These are better for tax planning over a shorter period. Downing offers a good Planned Equity VCT.

Advisers say you should not invest more than 10 per cent of your portfolio into EIS and VCTs because of the volatile nature of the investment. So the tax planning illustrated in this article will not be suitable for most investors.

Still, it illustrates how large chunks of income tax can be avoided or offset using mainstream, government-endorsed schemes for investors with a high salaries and high risk appetites.

VCT vs EIS vs SEIS vs Pension

Source: Investors Chronicle

■ See also: 8 out of 10 cats would avoid paying tax if they could