UK: Family Wealth Management - Autumn 2012

Last Updated: 25 September 2012
Article by Smith & Williamson

TOUGH CHOICES FOR INVESTORS

The sporting glories of the summer provided a welcome distraction from the deep-seated problems of the global economy. But now attention is firmly focused back on the high levels of government and consumer debt, deflationary forces and large unsustainable fiscal deficits.

The lack of a political solution to the eurozone crisis is affecting economic confidence in other parts of the world. Added to all this uncertainty, the outcome of the US presidential election in November is likely to have global ramifications. The two contenders in the race for the White House have very different plans for the economy, so in this issue of Family wealth management we look at how the result might affect the world's markets.

In times like this caution prevails, with investors facing tough decisions. Many will be looking for quality stocks to provide some stability. We consider the characteristics of the new generation of 'nifty fifty' companies. This is a set of nimble companies with robust business models – global brands with sustainable growth that stand out from the rest of the pack.

For pension investors within ten years of retirement, this is a critical time to be looking at how funds are invested and to consider moving some assets to safeguard gains. We also remind readers to review their pensions regularly to make sure they avoid any potential tax traps.

The Government has introduced a new annual charge for high-value houses owned through companies. We consider the details of this measure, which is designed to deal with the perceived avoidance of stamp duty land tax.

Also in this issue, we look at the proposals for a legal definition of UK tax residence and at the attractions of the proposed changes to business investment relief, which would allow non-UK domiciled individuals to invest in UK businesses without triggering a tax charge.

THE RACE FOR THE WHITE HOUSE

How will the US presidential election affect the markets?

With US election day looming on 6 November, we look at the likely impact of the election on the US economy and the markets.

The economy will be a central issue in the forthcoming election race between President Barack Obama and Republican nominee Mitt Romney and is one of the key dividing lines between the candidates.

Key issues

Broadly speaking, Obama believes in the power of big government, while Romney thinks a smaller state empowers individuals. When it comes to closing the deficit, this means that Obama favours tax increases alongside spending cuts, whereas Romney believes in deeper cuts and lower taxation.

Obama now owns the economic situation, and the election may be determined, to a large extent, by how Americans feel about the recovery on Election Day. Particularly important are the unemployment rate and the price of gasoline, and more specifically the direction these are travelling come November. The election may be won or lost for Obama four days before polling day with the release of the October employment figures. The one unknown is the risk of a major geopolitical event that could dramatically change the dynamics of the election.

What happens next?

As well as the presidential election, the whole of the House and a third of the Senate is up for election. The smart money is on the Republicans holding the House and winning control of the Senate from the Democrats. Therefore the most likely outcome is divided Government, with a Democrat in the White House and the Republicans in charge of Congress.

Whoever wins, before Inauguration Day, Obama and the incumbent Congress will have seven weeks to deal with the socalled 'fiscal cliff'. Unless the two sides can agree on corrective action, on 1 January 2013 massive but largely arbitrary tax increases and spending cuts will be automatically implemented. This could knock anything up to 4% off 2013 GDP.

After the inauguration, if Obama wins the hope is that he and the Republican Congress will cooperate and tackle the big fiscal issues facing the country in a measured way. However, the lesson of the past four years is that compromise is a dirty word in Washington. If Romney wins, and assuming the Republicans also win the House and Senate, he will have a much freer hand. Policy will clearly have a more right-wing flavour, and spending reductions and tax cuts will be the order of the day.

Impact on investors

Academic research suggests that no party is 'better' for investors. However, the historical impact of the presidential cycle on the markets suggests that the second half of presidential terms is generally much better for equities than the first. The average return of the S&P 500 in the first year of presidential terms is 5.9%, versus 17.5% in the third (source: Global Financial Data, Inc). 2008, which saw the collapse of Lehman Brothers and the height of the global banking crisis, is an exception to the general rule that the fourth year of presidential terms tend to be good ones for the stock market.

Tackling the deficit

The best case scenario is that the politicians show a bit of courage and seek to tackle the problem of the country's debt – and the other issues facing the country – without the usual petty point scoring.

The worst case scenario is that nothing really changes and the gridlock continues. In that case, it may be that only a big external shock, such as the meltdown of the eurozone, or panic in the bond markets, will finally focus minds.

The huge current and future debt burdens mean that very serious decisions on fiscal priorities are needed, but the politicians have proved wholly incapable of making these under the current system.

INVESTMENT OUTLOOK

Hopes of an autumn resolution

Bond yields in Spain and Italy have fallen from the highs seen in mid-July due to speculation that the European Central Bank (ECB) is ready to step up its efforts and intervene once more in bond markets. Minutes of the recent Federal Open Market Committee (FOMC) meeting hinted at further quantitative easing (QE) in the US as the Federal Reserve keeps one eye on next year's looming 'fiscal cliff'.

As we enter an important few months that may settle the fate of the eurozone, we remain cautious in the near term, given the risk that policymakers will again fail to deliver. While many equity markets look attractively valued on a relative basis, our long-term focus remains on good quality companies with robust business models, global franchises and high and sustainable dividend yields. We are also focusing on a suitably diversified mix of index-linked, conventional and good quality investment-grade corporate bonds. Our stance is designed to combine a measure of insurance against further deflationary pressures with reasonable exposure to the assets most likely to generate sustainable positive returns in a fragile economic environment.

UK equity market surprisingly resilient

The upward revision to the second quarter GDP figure from -0.7% to -0.5% does little to change the bleak outlook for the UK economy and failed to provoke a positive reaction from financial markets. The UK economy remains a big underperformer among the major developed economies. According to the official statistics, GDP is still more than 4% below its precrisis peak, although employment has shown a surprising degree of resilience.

The Bank of England downgraded its growth forecasts from 1.3%, to closer to zero by the end of the year, with growth of around 2% expected in 2013. The Government and the Bank of England are pinning a lot of hopes on the funding for lending scheme (FLS) that was launched on 13 July, designed to stimulate more bank lending. Further QE and/ or another interest rate cut are likely to be delayed until the impact of the scheme becomes clearer. Although inflation picked up marginally in July, this looks to be the result of temporary factors. Consumer price inflation is expected to drop below the Bank of England's 2% target by the end of the year and provides further scope for a more dovish approach by the Bank's monetary policy committee.

Despite a backdrop of poor economic growth and an uncertain outlook for the eurozone, the UK equity market has remained surprisingly resilient. Seven of the ten major sectors have performed well year-to-date and the UK remains home to many good quality, nifty fifty companies with robust business models and global franchises (see the next article for more on the nifty fifty). However, given the continuing slowdown in China, the UK market's large weighting in mining companies will continue to be a drag on performance in the short term. A return to growth in many of the Far East's larger countries, should that materialise, would have a positive impact on the sector and the overall market.

US economy paints mixed picture

US equity markets hit four-year highs during August but continue to listen with anticipation to the Federal Reserve for hints that a response to the mixed economic data and potential fallout from the eurozone is just around the corner. The continuing fall in consumer price inflation to 1.4% in July remains well below the Federal Reserve's 2% target and certainly provides scope for further stimulus. However, while market expectations of further monetary stimulus are clearly high, for the Federal Reserve to act so close to the presidential elections in November would be politically contentious (see the previous article for more on the election). In addition to this, the real question remains whether the US needs further QE. There is little evidence to suggest that the previous two rounds of QE have had any lasting beneficial impact on the real economy. While equity markets have received a temporary boost, the impact has clearly been diminishing. With the S&P 500 and NASDAQ indices among the world's best performers this year, we expect the most certain ground for further monetary stimulus to come in response to a seismic shock from the eurozone, should this occur in the coming months.

Recent data releases continue to paint a mixed picture for the economy's progress. Unemployment and the housing market both now appear to have bottomed out, but look to be on different trajectories. The labour market continues to limp along with the unemployment level still a concern. This reflects a lack of confidence in the corporate sector, with companies unwilling to commit to large, labourintensive investment projects given the prevailing uncertainty. The outlook for the housing market, however, remains brighter and looks to be gaining significant traction. New home sales have increased around 36% since the trough in February 2011. With mortgage rates likely to remain low for the foreseeable future and a shrinking supply of housing, this could provide a genuine boost to the US economy.

Europe enters crucial period

Despite a continued equity market rally and optimism among investors that the ECB stands ready to react, second quarter GDP figures continue to show a deteriorating economic environment. Spanish and Italian equity markets have both rallied on the back of ECB president Mario Draghi's comments that the central bank will do "whatever it takes" to save the single currency. The future path of European equities remains closely linked to future decisions by the ECB and Europe's political leaders. A backdrop of deepening recession, rising unemployment and a lack of competitiveness across southern Europe is making it harder for policymakers to put together a credible plan for resolving the ongoing eurozone crisis. The divergence in performance between the troubled peripheral nations and stronger countries in the north, which is at the root of the eurozone's problems, continues to widen. The eurozone as a whole looks set to fall further into recession by the end of the year.

Some of this deteriorating outlook appears to have been priced into markets already. We are entering a potentially crucial period for the region with a Greek exit back on the agenda if an agreement to revise the terms of its bailout package cannot be reached at the next planned summit in October.

The German Constitutional Court dismissed complaints against the ratification of the European stability mechanism. It did, however, impose an EU190bn cap on Germany's liability, which cannot be increased without further legislative approval.

THE NEW 'NIFTY FIFTY'

Investing in global companies

A new group of marketleading global companies may offer investors some stability in turbulent times. What makes them stand out?

Five years on from the last global financial crisis, the global economy now faces new challenges and headwinds. Today's problems are debatably more deep rooted, with government and consumer debt at high levels, deflationary forces and large, unsustainable fiscal deficits all causing uncertainty about the economic outlook and presenting tough choices for investors.

In the 'risk on, risk off' environment we have experienced over the last few years, where negative real interest rates at the bank and bond yields on socalled safe haven sovereign bonds have fallen to all-time lows, investors are seeing little in the way of real return.

Focus on quality

With so much uncertainty out there it has never been more important to focus on quality. In particular, focusing on stocks with the characteristics that make them more likely to perform well in a lower nominal growth world may help to restore faith in a traditional buy-and-hold strategy.

During an eight-year period in the mid- 1960s and early 1970s we saw the emergence of a 'nifty fifty' group of US large cap stocks – household names such as Coca-Cola, General Electric and McDonald's – which outperformed the S&P 500 by 189% (around 15% per annum). They were widely credited for the equity bull market of the early 1970s due to their solid earnings growth, global brands and comparative advantage in their sector.

Many of these companies are still solid performers today. The current low-growth environment in the US and Europe is paving the way for a new group of market-leading global companies, with sustainable growth and exposure to emerging markets, to outperform.

Key characteristics to look for

So what kind of stocks should investors focus on? There are several characteristics that make the new nifty fifty stand out from the pack. The lower-growth environment in the developed world has meant companies with high exposure to emerging markets and global brands are well placed to take advantage of highergrowth economies, especially where there is a growing consumer sector.

Companies such as Apple, BMW and LVMH have continued to perform well because strong demand in countries such as China has helped offset weakening demand domestically. Another important attribute in today's environment of record low interest rates and bond yields is income. Many global companies have consistently been able to generate high and sustainable dividend yields due to high profitability, low net debt to equity ratios and large amounts of cash on their balance sheets.

The price of quality

In many cases income from these stocks does not come at a large premium. For example, global companies with prospective dividend yields of around 4% and solid dividend growth prospects over the next three years currently trade at a discount to their historic price/earnings ratios. Such companies include WPP, GlaxoSmithKline and British American Tobacco.

Given their comparatively positive earnings growth outlook over the next three years, this is a small price to pay for quality. Although risks clearly remain, focusing on the new nifty fifty, a set of nimble companies with robust business models, global brands and consistent and sustainable organic growth levels, combined with a suitably diverse portfolio, may help provide some stability in an increasingly choppy economic climate.

PENSIONS – A WAKE-UP CALL

Regular review is a must to avoid tax traps

Check your pension regularly to make sure it's on target to meet your needs in retirement.

Pensions have long been an integral part of people's financial planning. Their primary attraction has been the range of tax breaks available, compared to other forms of saving or investment.

However, people are increasingly likely to find they have unwelcome tax liabilities when they fill out their annual tax returns or come to take their benefits. Here's an overview of the advantages and tax traps of paying into a pension scheme. It highlights the importance of reviewing your pension arrangements regularly.

Tax advantages

  • Income tax relief on contributions up to the highest marginal rate of income tax paid.
  • Tax-advantageous investment growth within the pension fund.
  • The ability to take lump sums free of income tax at retirement.
  • On death, the ability to pass funds to named beneficiaries in an income tax and inheritance tax-effective manner.

Tax traps

  • Contribution limits – If pension contributions exceed the maximum allowable in a tax year, any excess contributions will be taxed as additional income and subject to income tax at the highest marginal rate. The annual allowance fell from £255,000 to £50,000 last tax year and this could mean some taxpayers find they have an unexpected tax bill when completing their annual tax returns.
  • Allowance limits – The current maximum lifetime allowance is £1.5m. If a pension scheme provides more benefits than the lifetime allowance the excess will be liable to a tax charge of 55%.
  • It is therefore possible that some individuals, or their employers, are making payments into what are supposed to be tax-effective investments only to find a proportion of the contribution is subject to income tax of 50% and that the benefits bought by this contribution are subject to a 55% tax recovery charge. Not the tax-effective savings vehicle they had been expecting!

The importance of regular review

It is clearly important to assess the likely tax treatment of employer and personal pension contributions before they are made, rather than wait until a large unexpected tax demand arrives. Other issues to consider are as follows.

  • Investment performance – Many people's pension funds are their largest asset and yet they have left their pension pots in poorly performing funds for years. As people get older and their circumstances change, are the funds still appropriate?
  • How benefits are taken – It has not been a requirement to buy an annuity with your pension fund for many years, yet many plans don't make investors aware of the possible alternatives to annuity purchase if benefits are taken with them.
  • Falling annuity rates – Is your pension going to provide the benefits you expected? Annuity rates have plummeted over the past 20 years. According to Prudential, the current maximum lifetime allowance of £1.5m will now only buy a married couple aged 60 an index-linked pension of £28,703pa* assuming no lump sum is taken.
  • Legislative change – There has been a torrent of pension changes recently. Can your pension still provide what you want? Are there new opportunities you are unaware of? In summary, in an increasingly complex pension environment, regular review is vital to ensure you're on target to meet your income requirements.

* Rates accurate as at 12/07/2012. Pension is payable monthly and reduces by a third on first death.

SAFEGUARD YOUR PENSION POT

Make sure the default 'lifestyle' option doesn't erode your hard-earned pension gains

Pension investors, especially those within ten years of retirement, should check how their pension funds are invested and consider whether moving some assets would help to safeguard gains.

Many employer-sponsored pension plans offer a default 'lifestyle' option for how contributions are invested. People often opt for this default option because it is simple, but this means that they could find themselves invested in inappropriate funds that don't match their particular needs. There are two key factors behind this, given the current volatile state of the markets.

First, the lifestyle option typically means that your money is initially put into a 'balanced' fund. This can mean that as much as 80% of your pension savings are invested in equities which, while offering the potential for growth, can also bring a great deal of uncertainty.

Secondly, anyone in their mid-50s or older is likely to have their lifestyle pension fund moved automatically by their pension provider out of equities and into bonds and cash as they approach retirement age. The timing of this transfer is pre-determined and takes no account of investment conditions at the time the transfers are made.

The importance of timing

Market fluctuations can have a major impact on your pension investments. For example, the FTSE 100 has been around the 5,800 mark for most of the summer; five years ago it was around 6,450, but a year later had fallen by almost a third to around 4,440. If your investments are switched when the market is relatively low, you can lose out substantially. If the market bounces back even just a day later, you lose out on that recovery if your funds are transferred on a 'bad' day. If you're approaching retirement, you may not have time to make up such a loss. Given the current state of the eurozone, equity markets could continue to be volatile for some time; if you're at a critical age and your funds are transferred at an unfavourable time, this could be very damaging to your retirement savings. These lifestyle transfers are generally made at predetermined dates according to an individual's age, rather than the state of the markets. For example, many pension providers assume that if a person expects to retire at 65, their 55th and 60th birthdays can act as key trigger dates for them to be moved out of equities and into bonds and cash.

Members' responsibilities

This issue has been exacerbated by the shift towards group personal pension plans in which members are responsible for their own investment decisions. As a result, people tend to take the default option of investing in lifestyle funds. In the 'good old days', by contrast, pension schemes were overseen by trustee boards, who were generally more aware of these issues.

However, individuals are not obliged to take the lifestyle option for their pension investments. People can take control by choosing the funds in which they are invested and vary the asset allocation accordingly.

Be vigilant

It's advisable to keep a watchful eye on your pension value. If things have gone well for a while and you are a few years away from retirement, consider whether it would be appropriate for you to move some of your investments into cash and bonds with a view to minimising the downside; the idea is to crystallise your gains, not your losses. Try not to be tempted to wait for the market to reach the top, as no-one knows when that will be.

At the same time, you might consider the appropriateness of making regular monthly investments into the stock markets so you remain exposed to this asset class which, historically, has performed well. While everyone's needs and attitude to risk are different, it's very important to safeguard your gains.

In short, it's a question of being alert to the value of your pension and the effects of movements in the FTSE and other markets, depending on how you are invested. Of course, a professional can help you. If you do seek professional advice, the most important times are when you set up your pension and in the five to ten years prior to retirement, to ensure that you protect and maximise your investment.

RESIDENTIAL PROPERTY TRANSACTIONS UNDER SCRUTINY

New annual charge for high-value houses owned through companies

The Government is introducing new measures designed to deal with the perceived avoidance of stamp duty land tax by owners of high-value homes.

The Treasury has set out proposals for an annual charge for high-value residential property – residential dwellings with a value of more than £2m – owned by 'non-natural persons'. Capital gains tax (CGT) will also be extended to gains made on such property by certain non-resident, non-natural persons. The Government has indicated that the new rules – expected to take effect in April 2013 – will target perceived avoidance of stamp duty land tax (SDLT) by owners of expensive residential property and are designed to discourage the use of corporate envelopes by non-UK residents.

The annual charge and CGT charge for non-resident, nonnatural persons, will not apply to non-residential or commercial property, any type of property valued at less than £2m, or any property held directly by a non-resident individual.

Annual charge

The annual charge will be self-assessed and the tax will be payable by 15 April each year (subject to transitional rules). Where the property was owned at 1 April 2012 the value at that date will be used to calculate the charge payable in April 2013. The valuation will be based on CGT market-value rules. Properties will have to be revalued every five years, so for a property held at 1 April 2012 the next valuation date will be April 2017.

The annual charge will apply to UK and non-UK resident owners of high-value residential property who are corporates, partnerships with a corporate member or collective investment schemes. Exclusions from the charge are currently limited to certain property developers, trustees and charities.

The charge will operate in bands and will be indexed in April each year (commencing 1 April 2014) – in line with the consumer prices index (CPI) in September of the previous year.

CGT charge

The CGT proposals are expected to use the same high-value residential property definition as for the annual charge and will apply to the whole gain accruing on a disposal (not just the gain arising from April 2013). The definition of non-natural persons for this purpose is likely to be wider than for the annual charge and will include:

  • companies and other corporate bodies
  • trustees (with some exceptions) and collective investment Vehicles
  • personal representatives
  • clubs and associations
  • entities existing in other jurisdictions permitting property to be held indirectly.

This list does not include non-resident individuals.

The charge will apply to direct and indirect property disposals, including shares in a property-owning company where more than 50% of the value of assets is derived from UK residential property (understood to be high-value residential property as defined). There will be restrictions on the use of losses.

Action required?

Where a high-value property is owned by a non-natural person, early action will be required to review property values, and to consider whether the existing structure is still appropriate.

PERFECT STORM CONTINUES FOR 'LINKERS'

Opportunities that really are gilt-edged

An examination of the main attractions of index-linked gilts.

Index-linked gilts, known as 'linkers', offer investors full inflation protection since the value of the bond is indexed to the retail price index (RPI). When the bonds are redeemed, they return the original capital multiplied by the uplift in the RPI index over their lifetime.

So, if RPI grows by 50% between the issue date of the bond and redemption, investors would receive £1.50 for every £1 invested in capital at redemption. The bonds also return a modest coupon, which is also linked to the evolution of RPI, with coupons on the earlier issues generally 2.5% per annum of the uplift in RPI in that year. Investors receive the uplift in the value of the bond tax-free.

Attractive returns

Since they were first issued in 1981, index-linked gilts have offered very attractive returns to investors, and at least matched other asset classes, like equities, or conventional gilts, which are not guaranteed to appreciate in value in line with any nominal index, like RPI.

They also have fixed maturity dates and known duration. For example, the UK index-linked gilt 2.5% of 2020, first issued in 1983, has appreciated from an issue price of 100 in October 1983 to a current price of 370 with relatively low volatility; e.g. a 270% price appreciation over 29 years. This exceeds the appreciation in RPI since issue, because the price of the bond discounts future inflation of approximately 3% per annum, between now and maturity in 2020.

Inflation expectations

Valuations for linkers diverge from the evolution of RPI according to investors' inflation expectations – the price of the bonds is not mechanically tied to the evolution of RPI during the lifespan of the asset. If investors expect a period of higher inflation between now and maturity, prices may be driven to a significant premium relative to RPI uplift to date.

The index-linked 2.5% gilt of 2020, standing at a price of 370, would stand at 291, if it was priced exactly in line with RPI accrual since 1983, which means the bond discounts an extra 27% of RPI accrual between now and 2020 when it matures, e.g. about 3% RPI accrual per annum.

Clearly, the amount of future inflation discounted in current prices will also depend on the time value of money and cash interest rates, and the size of the coupon stream, since investors are buying a stream of discounted future coupons in the current cash price. So linkers with higher coupons, like the 4.125% gilt of 2030, discount more future inflation in the current price. Prices are lower, like all bonds, when cash interest rates are higher, since the value of future dividends and the principal at maturity is reduced. Current economic conditions of stagnant growth and very low cash rates, plus inflation accruals of about 3% per annum, are very attractive for linkers.

Deflation

UK index linkers do not have a floor at 100, unlike other indexlinked government bonds (like US TIPS, Australian or Canadian linkers). This has not been a problem because they were issued in the early 1980s, since when inflation has always been positive year on year.

However, for investors who seek protection against outright deflation, new US TIPS, issued at par, offer that protection. The main attraction of index-linked gilts is as a tax-efficient, capital protection vehicle with no credit or default risk, since they are government-guaranteed, with known maturity dates.

The value of investments in bonds can fall as well as rise and if you do not hold these investments until maturity you may not get back the original amount invested. Investments in bond funds may not behave like direct investments in the underlying bonds themselves. By investing in bond funds the certainty of a fixed income for a fixed period with a fixed return of capital are lost.

SOWING THE SEED FOR GROWTH

The attractions of the new SEIS

SEIS is the Treasury's new scheme designed to persuade investors to back the UK's fledgling businesses by offering generous tax breaks.

Venture Capital Trusts (VCT) and Enterprise Investment Schemes (EIS) already provide a way for individuals to invest in small unquoted companies. Now the Treasury has launched a new tax-incentivised method for putting money into even smaller companies – the Seed Enterprise Investment Scheme (SEIS).

SEIS has been put in place to assist very early stage enterprises, which would normally find it difficult to raise finance through traditional means. As the name suggests, SEIS is designed to complement the existing EIS legislation and the Treasury anticipates that participating companies may subsequently use the EIS to raise further funding.

Tax relief

Individuals who subscribe for qualifying SEIS shares can claim income tax relief at 50% up to a maximum annual subscription of £100,000 – in other words, the actual cost of investment after tax relief would be £50,000. While investors do not need to be UK residents they must have a UK tax liability, but the tax relief available is not reliant upon their marginal rate of tax. For example, a higher rate taxpayer who is subject to 40% tax would still receive tax relief at 50% of any SEIS subscription, but relief can only be claimed until an individual's tax liability is reduced to zero.

Just like an EIS, any shares within SEIS must be held for a period of three years to continue to benefit from income tax relief. On disposal, the SEIS shares are exempt from CGT.

A reinvestment relief is available for the tax year 2012/13 only. Where all or part of a capital gain arising in that year is reinvested into SEIS shares, the amount reinvested will be exempt from CGT. The £100,000 investment limit which applies for income tax relief also applies for reinvestment relief. The investment in SEIS shares can take place before disposal of the asset, providing that both disposal and investment take place in 2012/13.

The company

For investors to claim and retain SEIS tax relief, the company which issues shares must meet a number of requirements. It must have carried out the trade for which shares are issued for no longer than two years, must be unquoted, have gross assets of no more than £200,000 and less than 25 employees.

The amount a company can raise under SEIS is restricted to £150,000 in any three-year period and it cannot have received an investment from a VCT or EIS in the past. The company must spend all the SEIS money for the purposes of a qualifying business activity within three years.

The opportunity

These investments will be higher risk than VCT or EIS, which in themselves are already considered high risk, given the size and nature of the investee company. VCT and EIS providers may offer these schemes when they come across potential investments that are too small for the much larger tax-efficient offerings.

The attractive levels of tax relief might make these schemes of interest to those individuals who have maximised or are no longer able to make pension contributions, have fully utilised ISA allowances and considered other tax-efficient investments such as VCTs and EIS. However, given the high risk to capital invested, it is likely that they will be of most interest to those wishing to take advantage of the initial tax relief, combined with the potential of washing out a CGT liability arising in the current tax year. There is also the added possibility of setting any ultimate loss made against income tax. This cocktail of tax benefits means that, while there is still a high risk of capital loss from such schemes, such losses could be mitigated.

Seek advice

These types of investments are high risk and therefore not suitable or appropriate for everyone. Investments of this nature, while aiming to mitigate tax, can carry a significant risk to capital and you should not invest unless you can afford the loss of capital. Specialist advice is therefore essential.

CONTEMPLATING A BRUSH WITH THE ART MARKET?

Is the time right to invest in works of art?

Harry Smith of valuers and fine art consultants, Gurr Johns, explains the opportunities and pitfalls of the art market.

There is a common perception at the moment that the art market is doing very well. There have certainly been some exceptional sale prices recently and the major auction houses (and some dealers) are unlikely to paint anything but a rosy picture.

What is the reality? Firstly, it's important to remember that the art market is not a single market but many, all of which behave differently and have different interest groups and supporters. There is a big distinction, for example, between the market for contemporary art and the market for old masters.

Contemporary art vs old masters

Contemporary art is generally collected by a young and financially successful group with a relatively robust approach to risk. Old masters, however, tend to be bought by an older generation who are usually more cautious. On the other hand, the supply of top-quality old masters is limited, so the sudden appearance of such a work creates a sense of now or never among potential purchasers. By contrast, contemporary artists are often still working, so supply is often less of an issue.

The common factor in all art markets, however, is quality. In any market the number of top-quality items is a fraction of the market as a whole, but it's here that demand is strongest and prices highest. Although every collector accepts that the search for quality is important, it is very difficult for the non-expert to recognise it. All too often the collector finds himself outbid at what he may consider to be an excessive price, yet it is those rare items of high quality that not only maintain their value in the long term, but also appreciate faster than the market as a whole.

Opportunities for the sharp-eyed

The art market also has elements of a lottery. Every month there are wrongly catalogued lots, which for the sharp-eyed can present opportunities. Experienced dealers are constantly on the hunt for these 'sleepers' as they are known. It would be wrong to assume that these all crop up in minor sales, however, as probably the most lucrative opportunities have occurred at major auctions like Sotheby's and Christie's. Some years ago I bought a painting at Christie's for a client (lucky man) for £26,000, which we subsequently sold to the National Gallery of Washington for nearly $2m. Christie's recently sold a rare painting by the Dutch artist Pieter Saenredam for £3.7m, which had initially been catalogued as a copy and put up for sale for less than £5,000! Only when more than 20 telephone lines were booked when the painting went to auction was it withdrawn and checked thoroughly – a very near miss.

We learned this important lesson when we found an important item of furniture in Australia catalogued by Sotheby's as a copy – booking a telephone line for the auction alerted them to the interest of a professional and we had to buy the item at 15 times its original estimate.

The art market can provide the collector/investor with opportunities for great returns – but this is still an illiquid market, with the associated risks. Sound advice from a trusted professional could help to mitigate some of these risks. Be warned: it is no safer for the enthusiastic amateur, who buys on the basis that he 'knows what he likes' than is, say, the bloodstock market.

BOOST FOR NON-DOMS INVESTING IN THE UK

Changes to business investment relief

We examine the Government's legislation to allow non-UK domiciled individuals to put money into UK businesses without triggering a tax charge.

The opportunity

The Government has introduced, from 6 April 2012, a business investment relief for remitted foreign income and gains. The relief applies to UK resident non-domiciled persons and allows them to remit overseas income and capital gains to the UK taxfree for the purposes of a business investment which satisfies certain conditions. These include the following.

  • Money must be put into a private limited company that is either an eligible trading company, stakeholder company or holding company.
  • An eligible trading company must be carrying on at least one trade, or preparing to do so within the next two years.
  • Funding must be in the form of shares or loans.
  • The investment must be made within 45 days of the income or gains being remitted to the UK.

The dangers

Any remuneration or benefit received directly or indirectly and related to making the investment must not be excessive. An excessive benefit or extraction of value results in loss of the relief unless remedial action is taken. Such a benefit might be in the form of money, capital, property or goods and services.

When considering whether an individual has received such a benefit it will be necessary to take account of any benefit received by a relevant person – their spouse or civil partner, minor children or grandchildren, certain close companies and trustees.

If the remitted cash is not invested in a qualifying company within 45 days, the cash should be taken back offshore, otherwise it will be treated as a taxable remittance. In the event that shares are sold or a loan repaid this will be a chargeable event and the amount originally invested should be taken offshore or reinvested in a further qualifying company within 45 days.

If the chargeable event arises because of anything other than a disposal, such as an extraction of value by excessive remuneration or benefit, the investor has 90 days to make a disposal and 45 days to take the amount of the investment offshore.

However, if the chargeable event is a transaction that results in a CGT liability, the investor will be able to acquire a certificate of tax deposit out of the proceeds of sale to discharge the UK tax and need not reinvest that amount or transfer it offshore.

A welcome relief

Overall, this looks to be a welcome relief allowing offshore resources to be deployed. The type of trading activity permitted will include commercial and residential letting and it is understood that this will include cases where a company owns just a single property, provided there is a profit motive. The investment might well attract other tax-efficient reliefs such as EIS, VCT, CGT entrepreneurs' relief and inheritance tax business property relief.

RESIDENCE TEST WILL BRING CLARITY

Proposals for a legal definition of UK tax residence

The introduction of a statutory residence test aims to provide greater clarity and objectivity in tax legislation.

A cause of great uncertainty for some taxpayers should finally be cleared up with the Government's proposals to introduce a legal definition of tax residence. The move, which should come into effect from 6 April, 2013, should provide simple, transparent and objective legislation. At the same time, the concept of ordinary residence will be abolished.

The proposed residency tests

There will be a three-stage test to determine residency.

1. Automatic overseas test – if any of the following conditions are met, non-resident status is guaranteed: the individual goes abroad to work full-time, or is in the UK less than 46 days in the tax year having been not resident in any of the previous three years, or is in the UK less than 16 days if resident in any of the previous three years.

2. Automatic UK test – a person will be UK resident if they spend 183 days or more in the UK, or their only home is in the UK or they work full-time in the UK.

3. Sufficient UK ties test – for those with more complex circumstances, residence status is determined by taking into account the number of days in the UK and connecting ties with the UK. The potential ties are family residence, available accommodation, working in the UK for at least 40 days and having spent more than 90 days in the UK in either of the previous two years. The fewer days spent in the UK in the tax year, the greater the number of ties permitted before becoming UK resident. This means that if someone spends less than 91 days in the UK they may be able to retain a home in the UK without becoming resident, subject to their own personal circumstances.

Other key points

A tax year can be split into periods of residence and non-residence if an individual's status changes. This is permitted when caused by engaging in full-time employment or a change in housing situation, but not as a result of loss of residence because of variations in the number of ties with the UK.

In the case of severe illness or a national emergency, individuals will be permitted to stay in the UK for up to 60 days without it affecting their day count.

Level playing field

In general, the introduction of a statutory residence test is to be welcomed and the proposed tests should bring greater certainty for individuals who are either leaving or arriving in the UK. However, the system remains complex in parts so it is advisable to keep detailed records of location each day and of hours worked, where appropriate. Some aspects are still under consultation and final draft legislation is expected in December.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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