How your quoted shares are taxed

Income from these investments is taxed at a top rate of 38.1 per cent, while growth is also taxed and quoted shares are probably going to remain the largest contributor of inheritance tax by asset class for the next decade.

However one of the strengths of quoted share investments is their liquidity. Shares can be bought and sold to switch from income to capital growth. Personal cash flows can be manufactured from capital tax efficiently and shares can be settled in trust to respond to the income needs of individual family members.

What's in a share?

Companies may issue different forms of shares, but ordinary shares are by far the most common ones issued to investors in the stock market. It is correct to say that each ordinary share is a unit of ownership that a shareholder has in a company and which gives their rights to income in the form of dividends, capital proceeds on a takeover or winding up and votes at the company’s Annual General Meeting.

There are variants of shares, such as preference shares which may give those shareholders preferential rights to an annual dividend ranking in front of ordinary shareholders. Often the dividend is at a fixed rate. In return for this greater security of income, preference shareholders may have reduced rights to share in capital so that on a company takeover most of the capital gain may accrue to ordinary shareholders.

Quoted shares and securities probably stand out as the most liquid investment of all. By signing up to an online trading platform and with the benefit of online banking an individual can these days buy and sell a listed investment within around 120 seconds, often from the comfort of a sofa in the local coffee shop on a mobile phone.

The basic valuation of a company’s share is derived from investors’ expectations of its projected future cashflows. This is their belief in its ability to maintain or grow profits and pay out dividends discounted by inflation and adjusted for the particular risks to which its’ business is exposed. These risks can be specific to the company, or more generic such as the wider economy, wars or merely the unpredictability of the weather which may affect companies who engage in primary food production.

With quoted shares, an individual investor can obtain historic copies of the company’s accounts, research investor news and attend company presentations to guesstimate future earnings. Alternatively there is a whole army of city analysts whose job is to value a company share in light of all available information that may affect it. Analysts will individually arrive at different conclusions and may indicate through the full range of media whether a stock price is fully valued or has room for growth because the current price does not take into account the top range of earnings, or the potential size of the market for its goods or services, for example. It is up to individual investors, armed with whatever advice is available from professional advisers to press insights, combined with their own life experiences, to decide if a particular share is good value for the income it currently produces or has scope to grow in value by producing even more income.

Income tax

Dividends paid from companies are taxed on UK resident investors at special dividend rates. Until 5 April 2016, investors received a 10 per cent tax credit to offset their tax bill. In order to simplify Self-Assessment, the credit was abolished from that date and new dividend rates were introduced, raising an extra £2bn for the Treasury.

Dividends are generally treated as forming the highest tranche of an individual’s income taxed at the rates applicable in Table 1. For 2017/18 there is a £5,000 tax-exempt Dividend Allowance. A proposal that from 6 April 2018 this would reduce to £2,000 has been put on hold.

Ways in which investors seek to minimise their annual income tax bill on listed share dividends include the following;

■ Investing through an Individual Savings Account where possible. Dividends received in an ISA are not taxable. The ISA annual investment allowance for 2017/18 is £20,000 but there is no cap on the annual level of tax-free dividends.

■ Investing in ‘growth stocks’ that is to say companies or investment trusts that reinvest annual profits in longer term projects, such as those in the tech sector. These are often the ‘rising stars’ of the stock market. Increased dividends may be paid one day, when the company’s products and services are selling in the market, but in anticipation of that day the share value may rise and an investor might sell and take a capital gain where the tax rate may be less.

■ Transferring investments between spouses or civil partners to use lower dividend tax bands, the tax-free Dividend Allowance or even an unused Personal Allowance in the case of a non-working spouse. Dividends from shares held jointly are always taxed 50/50, but if spouses or civil partners formally vary their interests to reduce their tax bill they can elect on HMRC Form 17 to be taxed in that beneficial way.

■ Investing via a Venture Capital Trust which is a listed investment that can provide a tax-free dividend. These are considered more risky because they invest mainly in small unquoted trading companies often with no track record. Following a subscription for new VCT shares, an investor can receive an income tax rebate of 30% capped to £60,000. This tax sweetener is not available if existing VCT shares are bought in the market, only on new issues. HMRC will claw it back if a subscriber for new shares sells them within the first five years.

■ Manufacturing an income from capital by selling some shares each year. The profit is taxed at the lower capital gains tax rate of 20 per cent for those shareholders whose total income exceeds £45,000. Income tax does not apply on capital gains. This is set out in Table 2 and discussed further below.

Investors who are resident overseas do not generally pay income tax on UK listed investments. They may however pay foreign income tax in their country of residence. A UK national who therefore lives overseas for an extended period may stay reinvested in UK currency and pay no income tax.

Trustees of family discretionary trusts pay income tax on dividends at 38.1 per cent. However, when the trust income is distributed to beneficiaries they may be entitled to a refund of some or all of this tax. Grandparents and parents who wish to help younger family members may therefore achieve income tax savings by passing quoted shares into a family trust. This legitimately converts non-recoverable income tax otherwise paid by the donor into potentially recoverable income tax in the hands of the younger family member. This will not work if a parent gifts shares to benefit a minor child however. In that situation a parent will be taxed on their child’s dividends if they exceed £100 per annum.

Capital gains tax

With a maximum rate of 20 per cent, capital gains tax is at one of its lowest rates on quoted shares since 1965.

The first £11,300 of an individual’s aggregate annual capital gains on all assets is free of capital gains tax. This is the annual CGT exemption. Capital gains above this level are first reduced by any unused capital losses brought forward from earlier years. Any excess capital gain on shares is then taxed at 20 per cent. The gain has to be realised, that is to say the shares have to have been sold before the tax applies. A mere rise in the value of investments is not taxed because until the shares are sold no cash profit has been made.

In some cases, such as a gift of shares into a trust or to younger family members, a taxable gain is deemed to be made even though no cash is paid. The annual exemption may be available, but if not the tax rate on the deemed profit is also 20 per cent.

Many investors will use their capital gains each year to raise £20,000 from share sales to reinvest the proceeds back into their ISA allowance. This is smart and providing the original cost price of the shares sold was no less than £8,700 no taxable gain will be made. Taxable shares worth £20,000 are turned into future tax-free investments every year. This is how ISA-millionaires are made, given time.

Some investors will save and build a portfolio of shares during their working life to use as an alternative to a traditional pension scheme. They may then draw down on that portfolio each year from both real income and capital growth to produce what we call a ‘manufactured income’. This can be very tax efficient. The best way to demonstrate this is by an example (see Table 2).

Case study: A tax-efficient plan for investing and spending

Having saved all her life into a Self-Invested Personal Pension (SIPP) managed by her investment adviser, Emma is comfortable with the ‘spark’ of the stock market. She has recently inherited £500,000 from the sale of her late father’s house, her children have flown the nest and she now wishes to supplement her other income for some ‘fun spending’ including a bit of foreign travel and hobbies. Emma is quite happy to dip into half of her capital over her estimated remaining twenty year life expectancy to age 75, leaving around £250,000 in reserve for old age care or for her children to inherit.

Conscious that she can always draw from both income and capital returns, Emma has no desire to invest purely for income and with the help of her investment manager is invested mainly for capital growth. The portfolio mandate is for approximately 1% income and 5% capital growth, producing a real total return of a little over 6 per cent per annum. These figures are projected in blue in Table 2. Due to the fact that Emma has other income that fully uses up her income tax Personal Allowance, her Dividend Allowance and her basic rate band, her dividends from this portfolio are taxed at 32.5 per cent. This tax is set aside together with capital gains tax at 20 per cent on investment gains that exceed her annual CGT exemption. These tax reserves are shown in red and deducted from the performance of the portfolio.

Working across each row in turn we can see that Emma’s adviser has produced a tax efficient plan that allows her to draw a reasonable amount for spending each year over 20 years (Column F). Under these investment and tax assumptions that sum starts at £22,000 in 2017 increasing each year by 5 per cent to cover the rising cost of Emma’s expensive hobbies and holidays.

The summary at the foot of Table 2 shows where all the money has gone. This also shows that total tax has been paid of £65,873 on combined capital and income returns of £545,220 which is an effective tax rate of 12.1 per cent. This has been achieved through the benefit of using her annual CGT exemption and the 20 per cent CGT rate against investment gains.

This table is of course highly theoretical. It assumes regular linear capital growth and inflation of 5 per cent on Emma’s spending. The reality is the stock market does not work that way and in some years growth will be up and in other years down. However, provided Emma’s investment manager and her tax adviser review her position annually, they can respond to economic and tax changes, ‘flex’ her drawdown plan and keep her on target.

Inheritance tax

About £4.8bn is collected annually from deceased estates in the UK. There are many tax reliefs that prevent inheritance tax at the 40 per cent standard rate from applying on business interests, agricultural land and woodlands. Every individual has the standard Nil Rate Band worth £325,000 which together with the new Main Residence Nil Rate Band worth £175,000 from April 2020 will go some way to removing the majority of estates from the tax. HMRC’s last complete review, carried out in relation to 2013/14, showed only 1 in 4 deceased estates paid the tax.

On the other hand, it is a tax that can be expected to grow with house-prices and worldwide stock markets generally on the rise. In the five years to 31 March 2017, inheritance tax receipts have grown on average by around 11 per cent per annum.

Of those estates exposed to inheritance tax, shares contributed 41 per cent of total revenue, followed by houses at 30 per cent.

An investor wishing to mitigate inheritance tax might want to consider the following approaches;

1.Making outright gifts of shares to younger family members. Capital gains tax may be payable on a gift to individuals so tax advice may be needed first.

2.Transferring shares to a family trust. It is possibly to postpone the payment of capital gains tax when a gift into a trust is made but there are limits on what may be gifted in this way, typically £325,000 every seven years. Cash can be paid to family members on a flexible basis, but the donor and spouse or civil partner must not receive any benefit while alive, even accidentally. If carried out correctly, the value of a family trust fund is not within the main 40 per cent regime. Instead it pays the tax at 6 per cent every 10 years and many trusts simply save for this tax at the rate of 0.6 per cent per annum.

3.Investing in shares quoted on the AIM or ‘Alternative Investment Market’. One of the largest reliefs from inheritance tax is Business Property Relief. This applies on most forms of trading business interests, but tax law requires the shares to be ‘unquoted’. For these purposes AIM listed shares are unquoted because that market is not a ‘recognised stock exchange’. There is a trap however, because only those AIM companies who mainly trade will qualify. Companies with the majority of their balance sheet holding investments or whose profits come from investments will not qualify. However, the range of companies is diverse from software developers, to food producers and pub chains. Many specialist fund managers provide tailored IHT portfolios designed to preserve wealth and protect it from the 40% tax charge. These providers will also appraise the companies from an investment and tax viewpoint and make sure the inheritance tax rules are complied with.

SIZE OF MARKET According to the Office for National Statistics, as at 31 December 2014 the entire value of quoted shares in UK registered companies was £1.7 trillion with approximately 80 per cent of that value in the top 100 companies.

Growth in market: On 17 May 2012 the FTSE 100 Index stood at 5,338 and closed at a near all-time high of 7,503 as at 17 May 2017. This represents an annual average compound rise of just over 7 per cent. This is the collective capital growth of the stock market and does not take into account the dividend returns to shareholders over that five year period.