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Minding the tax gap

PORTFOLIO: The wide disparity between income and capital gains tax means many tax experts have been working on ways to turn income into capital gains
September 22, 2009

Converting income into capital gains has become the tax planner's favourite strategy for high earners with the top rate of income tax set to rise to 50 per cent in April 2010. But some experts are warning that capital gains tax may also be set to rise, and investors who can crystallise gains now should do so.

Investors who take capital gains, rather than income, can take advantage of the more generous 18 per cent capital gains tax rate that was introduced in April 2008, and the £10,100 tax-free capital gains allowance. In contrast, income tax is much higher, with a top rate of 40 per cent, rising to 50 per cent next year, and the annual tax-free income allowance is smaller at just £6,475 for under 65s, rising to £9,490 for those aged 65-74 and to £9,640 for anyone aged 75 and over.

People earning over £150,000 a year will see tax rise to 50 per cent from April 2010. From 2010-2011 the basic personal allowance for income tax will be gradually reduced to nil for individuals with 'adjusted net incomes' above £100,000 a year.

In the light of a shifting fiscal climate, investors should consider whether it is more advantageous from a tax perspective to position their portfolios to capture capital gains or income. Jane Sydenham, investment director at Rathbone Investment Management, says: "The increasingly wide gap between the top income tax rate and capital gains tax rate has been influencing our investment thinking, encouraging us to generate capital growth rather than income."

This is simply good tax planning. David Austin, managing director head of financial planning at Cazenove Capital, says: "I haven't heard anything specifically that HM Revenue takes a dim view of turning income into capital gains."

However, wealth managers warn that the disparity between income tax and capital gains tax rates may not last long. Prior to April 2008, CGT was 40 per cent and some experts think it could swiftly rise back to this level.

Ms Sydenham says: "Speculating on a number is very difficult but the gap between the top rate of income tax at 50 per cent and capital gains tax at 18 per cent is enormous. It seems like an anomalous gap given that government is keen to cut spending and raise taxes.

"We are of the view that the gap is probably too wide and seems likely to be reduced, given the vast levels of government debt and reduced tax receipts, as capital gains tax is an easier target for governments looking to raise revenue than income tax.

"CGT doesn't raise an awful lot of money but seems vulnerable."

Mr Austin says: "The slight concern is: does one believe the dislocation of rates is sustainable? It simply encourages people to issue products for the CGT regime.

"However, if CGT went up to 40-50 per cent it would catch the natural entrepreneur which presumably the government wants to avoid. The previous CGT regime - with business asset taper relief - was quite a good system."

Meanwhile, Ms Sydenham warns that recent tax changes have often been introduced retrospectively and investors need to consider that risk. "It may be worthwhile thinking about taking some capital gains early, if appropriate on investment grounds. A rate of 18 per cent is still pretty attractive by historical standards.”

How to take advantage

Here are some products that have been attracting the attention of tax planners seeking to restructure portfolios for capital gains rather than income. However, financial advisers generally caution against allowing the tax tail to wag the investment dog.

Ucits III funds:

The implementation of Ucits III fund rules allows onshore funds to use derivatives, which enable them to take short positions. These funds can use absolute return hedge fund strategies and can apply a range of techniques to provide the absolute return hedge fund strategy exposure. They are taxed to capital but the older style of offshore hedge fund (with non-distributor status) had gains and income taxed at the investor's rate of income tax.

Structured products:

Structured products incorporate some form of capital protection combined with defined returns calculated by reference to the change in an underlying asset, for example the FTSE 100 Index. Structured products are normally created so as to ensure the proceeds returned at maturity are categorized as capital gains rather than income. It is important to note that tax treatment is subject to change, however, and cannot be guaranteed to remain the same during the term of the product.

Zero-dividend preference shares:

High earners are buying into the new zero-dividend preference shares being issued by investment trusts as they seek more tax-efficient ways to generate lump sums for future needs. Much of this demand is being driven by zeros' increased tax advantages, following the announcement of higher income tax for high earners. Zeros pay no income, but return a defined capital sum provided it can be fully covered by the trust's assets. As a result, holders of zeros are liable only to capital gains tax at 18 per cent, rather than income tax, which rises to 50 per cent for those earning £150,000 or more from April 2010.

Qualifying life policies:

The rules for a policy to be qualifying are complex, but require the policy to be run for a minimum time and to include a certain amount of life-assurance cover. The advantage of qualifying life policies is that you do not pay any income or capital gains tax when they mature. Mr Austin says: "It's an older style product and has typically been a high commission product with large penalties for early encashment. But we're talking to providers to try to change this."

Offshore investment bonds:

The bond's income and gains can be tax-free if the life assurance company is based overseas. The key tax benefit is that investors can withdraw up to 5 per cent of their initial capital from the bond each year without triggering a tax liability.

Individual savings accounts:

Any capital gains within an Isa wrapper are free of tax. However, Mr Austin says: "Lots of people forget that the income from an Isa is tax free too."