Tax Talk: Tax-Efficient Investments

Tax Talk is a regular series written by FSL’s tax expert, Alex Ranahan. Alex has nearly ten years’ experience as a tax adviser and analyst. He is accredited by The Association of Taxation Technicians. Alex’s Tax Talks are on general topics and are not tax or financial advice. If you are unsure of the tax treatment of a transaction, we encourage you to seek the appropriate tax advice. 

Welcome to the first edition of Tax Talk. To ease in to the series, this month we will take a general look at some of the common tax-efficient investments out there.

This is only a brief summary of each topic. We have included a quick and easy reference table as far too many conditions exist for us to cover them in a blog post. All information is correct as of January 2022. All information is aimed at UK residents and UK-domiciled individual investors.

Individual Savings Accounts

Let’s begin by looking at Individual Savings Accounts, commonly referred to as ISAs.

Although ISA investment has probably the lowest maximum investment amount per annum of any of the investments discussed – with the exception of pension contributions where the annual allowance is abated – it is a useful place to begin.

A stocks and shares ISA is one where the holder adds their money into the account – up to a maximum of £20,000 across all ISAs the individual holds – and the account provider invests the money into stocks and shares on their behalf. Any dividends paid on the shares, any movements within the portfolio, any gains and losses made by the account provider, are all incurred free of tax for the investor if they are held within the ISA wrapper.

A withdrawal from the stocks and shares ISA is always a cash withdrawal. You cannot transfer assets out of the ISA wrapper, making it less flexible than other options. Withdrawal requires the provider to sell the stocks and shares to receive cash proceeds. Of course, once cash has been withdrawn, it is no longer exempt from tax. Any further investment made with that cash will be subject to the usual tax rules unless that is also in a tax-efficient investment.

Pensions

Next, we need to consider pensions.

The most well-known type of tax-efficient investment, yet usually not thought of as such. I certainly think of it as more of a bank account I hope to access in mumble-mumble years’ time, rather than a wise strategy for keeping my financial affairs tax efficient, but it is worth remembering the tax benefits all the same.

Pensions in the UK receive tax relief when you contribute to them, as opposed to some countries where tax relief is given on withdrawals from the pension. Using a mechanism similar to the Gift Aid scheme on donations to charity, a simple contribution to a personal pension pot will be topped up by the Government, treating the contribution as net of 20% tax. This is known as a ‘relief at source’ arrangement.

The typical maximum amount you can contribute to your pension with tax relief is the annual allowance of £40,000 per year. However, for those individuals whose ‘adjusted income’ is over £240,000 and ‘threshold income’ is over £200,000, the annual allowance is diminished by £1 for every £2 in excess of £200,000, to a minimum annual allowance of £4,000.

Share investment schemes

But what if you want to look at investing more directly in a business? Then let’s look at some of the share investment schemes that have been approved by HMRC. The purpose of these schemes is to encourage investment in small, new companies to give them the opportunity to grow quickly using injections of capital.

Since these companies tend to be more risky investments than, say, buying units in a fund that tracks the FTSE 100, the Government wants to encourage wealthy investors to plump for small businesses by giving tax breaks to both the investor and the business. I’ll focus wholly on these share schemes in a future post, but here is a general summary to whet your appetite:

Enterprise Investment Scheme

First up is the Enterprise Investment Scheme (EIS).  A common yet attractive relief where 30% of the amount subscribed for shares is taken off your Income Tax bill for that year or the previous year.

If you are lucky enough that your shares rise in value, then after three years of ownership you may sell the shares and pay no tax on the capital gain. Alternatively, if the business falters, then any loss on selling the shares may be offset against other capital gains. An unusual tax break that applies to EIS shares is that if you still have a capital loss from the EIS sale after offsetting it against capital gains, you can offset it against income for the year of sale or the previous year. This is a very valuable relief.

It is worth noting that the current scheme is due to end for share issues after 5 April 2025, but this would not affect any investments made before then.

Seed Enterprise Investment Schemes and VCTs

A similar scheme is the Seed Enterprise Investment Scheme.  The principle behind it is the same: to get capital into small companies.  The difference here is just that the target businesses are even smaller. The tax reliefs available for SEIS are, in essence, at higher rates than EIS reliefs but for lower amounts.

Finally, there are Venture Capital Trusts. These are listed companies that use the funds raised from shareholders in the VCT and invest them into small, unlisted, new companies – where have we heard that before?

Some investors prefer buying VCT shares as the VCT is invested in several businesses, spreading the risk. The tax reliefs available for VCT investment includes the tax reducer on income tax in the year of investment and capital gains on sales of VCT shares are exempt five years after purchase.  However, VCT losses cannot be offset against income in the way that EIS and SEIS losses can.

Tax-efficient investments at a glance