Financial & Tax Planning - The Budget And Beyond, Spring 2007

In this issue, aside from some of the more interesting changes in the Budget, there’s plenty to explore. We look at tax relief on pensions, HMRC’s policy on ASPs, news about ISAs, the maze of hedge funds and the advantages of offshore bonds.

In recent years there has been a dramatic increase in the number of UK residents purchasing property overseas for either holiday or retirement use. Many people have acquired the offshore property by purchasing shares in a company that, in turn, owned the property. The main reason for this arrangement was to avoid the impact of ‘enforced heirship’ succession laws in those countries or else to minimise local taxes.

For example, in France the succession laws state that children are automatically entitled to a share of any property left on death. In the US purchasers are recommended to use a Limited Liability Corporation to protect against claims from visitors to the property who may hurt themselves and subsequently sue for damages. One of the latest boom areas for property development is Bulgaria where non-residents cannot own land. So again, it is customary for the purchaser to buy shares in a Bulgarian company that owns the land.

Unfortunately, this type of arrangement resulted in a potential UK tax charge on the basis that the individual was acting either as a director or shadow director, and the company was making a property available to them by virtue of their ‘employment’. The resulting benefit-in-kind had to be calculated by reference to the market rental of the property and could lead to a significant tax charge.

To solve the problem, legislation will be introduced in 2008 to exempt cases where the property fits certain criteria. Namely, the property must be:

• owned by a company which, in turn, is owned by individuals

• the only or main asset held by the company

• not funded directly or indirectly by a connected company.

In addition, the owning company’s only activities should be incidental to its ownership of the property. In the meantime, HM Revenue & Customs (HMRC) will not pursue associated tax liabilities. It is also understood that, once the new legislation is passed, people should be able to reclaim tax paid in previous years.

There was one small area of simplification for individuals who receive dividends from non-UK resident companies, as they will now be entitled to a dividend tax credit from 2008. However, this tax credit will only apply where the person owns less than a 10% shareholding in the distributing non-UK resident company and receives less than £5,000 of dividends a year from non-UK resident companies.

Another helpful relaxation in the rules concerned the pre-owned assets income tax charge. This complicated tax, which took effect from 6 April 2005, applies where assets have been given away and now fall outside the donor’s estate for inheritance tax (IHT) purposes, even though the donor continues to benefit from the asset (for example, where someone had given their home to children before the commencement of IHT, but the individual continues to live in the property). If people wish to avoid the annual income tax charge, donors can elect for the asset to remain within their estate for IHT purposes.

Where the conditions were met at 6 April 2005, an election to stay within IHT should have been made by 31 January 2007. However, many people failed to lodge an election by that date. The 2007 Finance Bill will include draft legislation allowing HMRC to accept elections that missed the deadline and to extend deadlines for future tax years.

Many people are unaware that pension contributions can be paid for minors or non-working spouses up to £3,600 per annum and as they attract tax relief, the net cost is just £2,808.

The competitively priced savings environment of a stakeholder pension can be used for such investments. Charges are restricted to a maximum of 1.5% per annum of the fund value for the first ten years and 1% thereafter, with no initial charges.

The benefits of this tax subsidy and the favourable treatment of the underlying pension fund makes this an attractive way of building up long-term pension funds for non-taxpayers.

For example, many grandparents have taken advantage of these provisions to finance pension contributions for their grandchildren by making gifts within their annual allowance for IHT.

Also, parents have used the plans to fund savings for their children, as they are not taxed on the income or gains arising from the pension fund. HMRC’s view is that, because the underlying investment is tied up for a longer term, it is a valuable savings discipline.

With this in mind, you might want to consider whether this little-used tax efficient savings plan could be valuable to you or your family. If so, we’d be happy to help you find an appropriate provider.

The best fixed and variable deposit rates currently available exceed 6% per annum gross. It’s an attractive headline rate, but it must be remembered that for higher rate taxpayers this equates to a net return of 3.6% after tax.

With this in mind, higher rate taxpayers should be aware that it is currently possible to invest in cash deposits and get much better net returns.

For example, offshore bonds from life assurance companies allow investments in a wide range of cash deposits at more competitive rates. Whilst many people perceive the charging structures of these products as prohibitive, offshore bonds can offer distinct tax advantages which, in appropriate circumstances, increase equivalent gross returns to more than 8% for higher rate taxpayers.

Generally, only investments in excess of £500,000 will suit these particular deposits.

If you would like to explore these opportunities further, please contact us.

Until 5 April 2006, it was mandatory for individuals to purchase an annuity with their accumulated pension funds when they reached 75. This ruling committed pension policyholders to make decisions about spouses’ pensions, escalations and guarantees that might not be required.

If the policyholder died shortly after purchasing the annuity, the whole of their fund would be absorbed into the annuity pool, which is used to provide benefits for annuitants.

A breath of fresh air
Then, on 6 April 2006, the Alternatively Secured Pension (ASP) was introduced. It was a great idea that enabled individuals to take their tax-free cash at age 75 and leave the balance of their pension fund invested to provide an income up to approximately 70% of a single life level annuity.

On the pensioner’s death, it was mandatory for the fund to be used to provide similar benefits for their dependants. If there were no existing dependants (or upon the death of the dependants) the remaining fund could either be left to a charity in full, or be allocated to other members of the same pension scheme-subject to IHT. Alternatively, the fund would form a windfall profit for the pension provider.

Suspect device
However, there were rumblings that schemes such as the ASP were seen as intricate tax-planning devices. And so it was announced in December 2006 and confirmed in the March 2007 Budget that fund transfers to allocated members of the same pension scheme would suffer punitive income tax charges of 70% of the value of the fund, with the balance subject to IHT at 40%. This leaves just 18% for the allocated members.

Whilst the full value of the fund can still be passed on to charities, which can now also be nominated by the pension providers, the barrier to worthwhile pension investment has again gone up. The remaining pension savings for those who do not need to provide or have elected not to provide for dependants seem doomed to dissolve into the ether.

The elusive incentive
The government has been wrestling with ways to encourage individuals to save for retirement for many years. It’s quite clear that they have never really understood the reasons why many investors have been reticent to commit resources to an investment that could evaporate into nothing.

The enforcement of annuity purchase by age 75 has always been cited as a reason for investors not wanting to put money into a pension plan to look after them in retirement.

People are concerned that a death shortly after the purchase of an annuity would mean that their fund could end up in an annuity pool that doesn’t provide any benefit to the investor or to their family with years of saving gone to waste.

Passing down the benefit
Advisers, investors and pension providers breathed a sigh of relief when it was announced that a modified form of unsecured income (ASP) would, on the death of the pensioner and their spouse, allow any remaining pension fund to be passed on to other members of the same pension scheme-after a charge to IHT.

Whilst it is understood that this change was made primarily to help members of a religious sect who objected to annuity pooling since they cannot benefit from the death of others, its extension to all investors seemed sensible and pragmatic.

Pension investments could now be passed down the generations to allow individuals to accumulate more in their funds. This would, presumably, reduce the future pensions burden on the state. Investors were encouraged by the prospect of their children and grandchildren being able to benefit from their savings. Pensions saving suddenly looked a whole lot fairer.

Spoiling it for everyone else
However, it seems that a few people have spoilt the party for the majority by advertising this excellent annuity vehicle as a terribly good way of avoiding IHT – which is incorrect in both theory and in practice.

Under ASP as it was originally envisaged, there would have been no loss of tax relative to the alternatives. There is no doubt that a very small minority would be able to pass on 60% of an unused pension fund to their children. But surely these individuals can still quite easily make potentially exempt transfers or find other ways to pass on assets, perhaps by funding pension contributions for the family, to achieve the same end as they would have done within their own pension scheme?

In legitimate cases, and over a period of time, ASP would have started to help to plug the pensions gap as more and more people had their schemes kick-started. The lifetime allowance would still be there to police excessive provision, but HMRC does not seem to view it this way.

Harshly applied penalty
The suspicion that investors’ pension funds will dissolve is an unwelcome psychological factor. It could deter people who might otherwise have been prepared to invest through a pension scheme for their own and their family’s future.

The tax charges (82% in total) will still mean that a small amount of a policyholder’s pension savings can reach the next generation – but was it really necessary to take such punitive steps?

What exactly was HMRC worried about? Was it investors taking transfer values from their unfunded civil sector final salary schemes to generate lump sum death benefits that were not otherwise available? If so, had HMRC identified the real cost? Surely this eventuality could have been corrected in isolation without penalising the majority of investors?

Whatever the reason for the U-turn on ASPs, it seems to be counter-intuitive. Hopefully, good sense will eventually prevail, so that everyone will be given the choice to pass on their hard-earned savings – even if they are subject to the normal rules for IHT.

As at April 2006, there was £111bn invested in Cash ISAs and £70bn invested in Stocks and Shares ISAs.

The government is keen to encourage further saving and, in his pre-Budget report in December, the Chancellor announced that Individual Savings Accounts (ISAs) will become permanent.

These changes were confirmed in the March 2007 Budget when further rule modifications were announced. These will take effect as of 6 April 2008.

This is good news, as ISAs were originally planned to cease in 2010. The proposed changes are also designed to make ISAs less complicated, which is again good news. We’ll take a look at each of these new proposals and see how they’re going to be achieved.

New investment limits, with no distinctions
Mini and Maxi ISAs will cease and be replaced by the more appropriately named ‘Cash’ and ‘Stocks and Shares’ ISAs. Investors will be able to invest in one or both of these ISA components each year, with either a different or the same provider. A limit of £3,600 will be placed on the Cash component whilst any remaining amount (up to the new £7,200 annual limit) can be invested into the Stocks and Shares component.

For example, an individual could invest £1,500 into a Cash ISA with one provider and £5,700 into a Stocks and Shares ISA with either the same or another provider.

PEPs come within the ISA wrapper
Personal Equity Plans (PEPs) were replaced by ISAs in 1999 but many investors still have considerable funds invested in them. The new reforms will simplify things, bringing the more restrictive PEP investment rules into line with the ISA rules. At the same time, the PEP name will cease to exist as the investments will automatically become Stocks and Shares ISAs.

Again, it’s good news, as the reform will simplify administration for investors and providers. And, whilst providers will not be required to amalgamate their clients’ accounts, it is clearly an option for them.

Transfers from Cash ISAs to Stocks and Shares
Individuals who have funds invested in Cash ISAs will be able to transfer some or all of these funds into Stocks and Shares without affecting the ISA status of the funds or their annual investment limit. This will allow much greater investment flexibility and may be useful as people’s circumstances change.

Child Trust Funds roll over into ISAs
The first of the Child Trust Fund accounts will mature in 2020 and these funds will be allowed to roll over into ISAs. This measure aims to encourage young adults to continue to save.

Consolidation of PEPs and ISAs
There are many individuals who have substantial funds invested in PEPs and ISAs across a large number of different providers. As a consequence, they are difficult to manage effectively as it is hard to create a sensible asset allocation. This has, in some cases, created a barrier to any meaningful annual review of portfolios. However, it will now be possible to consolidate the PEP and ISA holdings with a single provider, keeping holdings in their tax-advantaged wrappers, simplifying the administration and allowing a unified investment strategy to be applied to the holdings.

If better investment options are available, it will be possible to sell the holdings within a Stocks and Shares PEP or ISA and then transfer the funds, in cash, to another provider. Alternatively, most underlying funds can be re-registered with another provider to facilitate flexibility. The decision to transfer will be triggered by a desire to see the PEP and ISA investments managed more effectively and it is important to choose the new home for them with care.

Two investment options
There are two main types of investment options available: the share portfolio and the unit trusts and open-ended investment company (OEIC) portfolio.

Share portfolio
An investment manager manages a portfolio of directly invested shares, all held within PEP and ISA wrappers. This is an attractive route for individuals who already have a portfolio managed in this way, or for those who have substantial PEP and ISA holdings, as both can be managed as a single holding by the same investment manager, with the advantage of continuous review.

Unit trusts and OEIC portfolio
There are approximately 2,000 UK funds, most of which have their own risk profile and specialise in a particular asset class and/or geographical location.

Internet-based fund platforms can access a huge range of these unit trusts, all within a single PEP or ISA account. Most advisory firms will offer advice on the initial selection of funds and will then monitor and review their performance.

New certainties, simpler management
The new ISA reforms will create investment assurance and allow greater freedom. We know that ISAs will continue, and that they will be simpler to administer – and it’s a welcome development for the investment industry.

ABSOLUTELY FABULOUS?

An exploration through the maze of hedge funds, and the intricate art of investing for absolute return.

Even though equity markets have doubled over the past four years, most investors have not forgotten the bear market that began in 2000 and the pain caused to portfolios invested for relative performance, which were all the rage after the 12-year bull market for equities.

Growing hedges
Though investing for absolute return is not a new discipline, the area is now largely populated by hedge funds, the number of which has grown exponentially since 2000. Given that there are now approximately 10,000 hedge funds worldwide, managing over US$1.5trn across an array of strategies, it is important to understand how these might fit into an investment portfolio.

The most widely used definition of a hedge fund is a fund where the objective is to produce an absolute return regardless of market direction. For this reason, hedge funds should be regarded as an investment discipline rather than an asset class such as bonds, equities or commodities. Though hedge funds may invest in all these asset classes, they typically specialise in one asset class, depending on the manager’s area of expertise.

In order to preserve capital, hedge fund managers get greater flexibility than the managers of relative ‘long-only’ funds. They have a far wider remit to use financial tools such as shorting or buying pure options, which allows them to reduce or ‘hedge out’ any unwanted risks at any given time. However, is it wrong to believe that hedge funds will make money in every market condition. When you invest in a hedge fund, you are investing in the manager’s skills and they won’t be right 100% of the time – nobody ever is.

Individual hedge funds tend to focus on specific strategies determined by the manager’s area of expertise. Over 40% of hedge funds employ equity-related strategies, known as ‘equity long/short’, where managers can profit from flat and falling markets.

Other common strategies include Convertible Bond Arbitrage, Event Driven and Global Macro. There are many other exotic varieties and the expected return between funds and strategies varies a great deal, so that two funds following the same strategy can have very different risk profiles.

Time to invest?
So is now the time to be looking at absolute rather than relative returns? Trying to time market moves is never easy. The only certainty is that markets have gone up a lot in the last few years. Whether they will continue to do so in the future is entirely unpredictable. For some investors the profile of the lower volatility return that absolute return investing can give is attractive in itself. But all investors can benefit from diversifying their portfolios away from relative return into other uncorrelated asset classes such as hedge funds, and there is no doubt that investing for absolute returns is back and here to stay.

Having said this, any decision must be balanced against the leveraging undertaken by some hedge funds, which can potentially expose them to much more risk.

Smith & Williamson runs a number of absolute return strategies for clients, including The Nucleus Enterprise Fund, a UK long/short equity fund.

Confidence stalled
An unexpected sell-off in the Shanghai stock market triggered significantly greater falls in other speculative asset classes, such as emerging market equities and commodities. Volatility spiked, as leveraged investors scrambled to reduce their risk exposure, with widespread substantial losses. The catalyst for the fall was the rumour that China might introduce a capital gains tax to clamp down on speculation. Foreign investors read this as a prediction of an economic slowdown, with the likelihood that emerging market risk had suddenly increased. In addition to these factors, the publicity given to Alan Greenspan’s comment about the significant risk of recession in the US, and the collapse of the sub-prime mortgage market rattled investors.

Market imbalance, not deterioration
In our view, the recent turbulence reflects market imbalance rather than deteriorating fundamentals. It is clear that the US economy is slowing as a result of the weakness in the housing market and in manufacturing. There are also concerns that the problems of the sub-prime lenders might spread to the broader financial market. However, the US economy seems unlikely to plunge into recession given the recovery in consumer spending power. Several indicators that historically have been predictive of recession may be flashing red, but a proactive Federal Reserve under Bernanke’s governance would mitigate any perceived downturn, probably by cutting rates.

Is expansion slowing?
There is little sign that economic growth in the rest of the world is slowing – forecasts have been steadily revised up in the Eurozone, and we still expect growth in China to approach double digits this year and next. Only Japan, where wage growth remains negligible, seems to be lagging. Furthermore, global expansion is taking place against a background of subdued inflation that suggests that interest rates will remain on hold until the summer. In short, we believe that global economies are still at their mid-cycle phase, and that corporate profits are less vulnerable to a cyclical downturn, although their growth could slow to pedestrian levels, especially in the US.

Predicting rates of growth
On valuation grounds, there seems to be limited downside risk given the recent fall in bond yields, together with the increasing possibility of rate cuts later this year. While the long-term growth of real US corporate profits has been well above trend since 2005, a more subdued growth rate need not lead to weaker performance while the gap between earnings yield and cost of capital remains close to record highs. However, this does suggest that markets will be increasingly sustained by mergers and acquisitions activity, with increasing sensitivity to the health of the US housing market. Taking in all of these factors, it’s clear that stock picking will become ever - more important this year.

Investors in the stock market tend to use direct equities, unit trust funds or open-ended investment companies (OEICs) as tax-efficient vehicles for income and IHT planning.

Any capital gains that they make are liable to capital gains tax, subject to taper relief and their annual exemption. If the assets are transferred to anyone other than their spouse or a trust, the capital gains are crystallised immediately and tax may become payable. Having said this, capital gains tax vanishes at death, leaving only IHT to pay.

Dividends received from such investments are subject to tax at the individual’s marginal rate, although credit is given for withholding taxes.

Another way ahead
Offshore bonds are non-qualifying policies of insurance, and are provided by insurers in a number of jurisdictions, notably the Isle of Man, Luxemburg and Dublin. Unlike assets that are subject to capital gains tax, offshore bonds have their own unique income tax treatment that can, in some circumstances, provide advantages in tax planning.

The underlying investments are made into the stock market using unit trusts and OEICs or funds that mirror them, and many offshore bonds offer the widest selection possible. UK investors cannot hold offshore bonds that invest in single stocks and shares, otherwise they will expose any gains to punitive tax charges.

The offshore advantage
Offshore bonds are non-income producing assets, so any growth and income on the investments are not subject to any form of tax. Furthermore, as long as annual withdrawals from the bond do not exceed 5% of the original capital invested (on a cumulative basis), there is no tax to pay on any underlying growth at that time.

However, if this 5% allowance is exceeded, or the bond is fully encashed, an income tax charge at both basic and higher rate tax might apply, subject to top-slicing relief. It is possible to manage this income tax liability by transferring the offshore bond to someone else. Unlike assets that are subject to capital gains, tax assignments do not crystallise gains. Any underlying tax liabilities are assumed by the bond assignee, who may be subject to tax at a lower rate than the bond assignor.

Offshore bonds are tax efficient for individuals who have already used their pensions allowance, as encashments can be planned to coincide with a time when either their own or their spouse’s tax rate is lower. As assignments of offshore bonds do not crystallise tax liabilities, these investments are also efficient in IHT planning, as they can be passed on to the next generation at any time without crystallising tax liabilities on gains on the underlying investments.

A flexible way to manage funds
Offshore bonds also offer a lot of investment flexibility. For example, if investors want their discretionary fund manager to manage the investments within the bond, they can do this either by using funds or by establishing a specific fund, depending on the amounts invested. Finally, many trustees are now turning to offshore bonds to reduce both the administration within the trust and its tax liabilities. Assignments of offshore bonds or their segments to beneficiaries is an effective way of keeping tax liabilities to a minimum.

If you are interested in learning more about offshore bonds, their uses in tax planning and the risks involved, please contact us.

From the tax years 2005/06 onwards, individuals who are not domiciled in the UK (or aren’t ordinarily UK resident) can choose on a year-by-year basis whether they wish to be assessed on their relevant foreign income (RFI) on either an arising or a remittance basis.

A specific claim must be made if the taxpayer wishes to choose the remittance basis, but HMRC has confirmed that the claim will be treated as made if the nonresidence pages and page F2 of the foreign pages of the self-assessment tax return have been completed.

Where no remittances have been made in the year in question, the claim can be indicated by an entry in the ‘additional information’ box.

This leads onto the question of what action should be taken where a non-domiciled individual has income arising outside of the UK, but has no income arising within the – UK and, consequently, hasn’t received a self assessment return.

If non-domiciled individuals do not file a specific claim under Section 831 ITTOIA 2005, will they be regarded as assessable on the whole of the income that arises? HMRC confirmed that, in these circumstances, the individual will need to consider notifying chargeability. However, if the individual is able to make a claim under S831 and there have been no remittances of RFI, then there will be no need to notify.

If HMRC subsequently enquires into the individual’s affairs, there will only be an issue if the individual’s circumstances does not entitle them to claim the remittance basis, or if it transpires that there were remittances of RFI that hadn’t been notified.

Section 831(1) says: "A person may make a claim for a tax year for the person’s relevant foreign income to be charged for that year in accordance with Section 832."

No deadline is stated for submitting a claim and so it appears that the claim can be made at any time up to the fifth anniversary of 31 January, following the tax year to which it relates (Section 43(1) TMA 1970.)

Discounted gift schemes
Where an individual invests in a discounted gift trust, there is usually an immediate reduction in their estate for IHT purposes, with a further reduction dependent on the individual surviving for seven years after the date of the investment.

Until recently, HMRC has agreed immediate reductions in estates for individuals aged up to 100. However, it is understood that HMRC is now denying any discount for individuals aged 90 or over on the establishment of these schemes. It is likely that the matter will be tested through the courts in due course.

Banks must provide client details to HMRC
The Special Commissioners have ordered four high street banks to disclose details of their clients’ offshore bank accounts to HMRC. This follows a similar order in April 2006 made against Barclays Bank. It is understood that HMRC officers are looking for information on individuals who are both resident and domiciled in the UK, who may not have declared income from their offshore bank accounts.

To provide a clearer distinction between its services, Smith & Williamson Pension Consultancy Limited has changed its name and reorganised its departments.

We are pleased to announce that, as of 12 March 2007, Smith & Williamson Pension Consultancy Limited changed its name to Smith & Williamson Financial Services Limited.

Smith & Williamson Financial Services Limited’s operations will be divided into three distinct departments: Personal Financial Planning, Employee Benefits and Advisory Investment Services.

We hope that these changes clarify the distinct services that we offer and will help you to identify the specific team that you need to speak to.

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.