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Tax-efficient investments could essentially be defined as investment opportunities that are backed up with valuable tax benefits.
The tax benefits of these types of investments effectively reduce the downside risk and therefore can encourage investment by more risk-averse investors.
When looking at making investments, investors need to weigh up the risks they are willing to take based on their own personal circumstances and potential returns.
One common misconception is that some tax efficient investments are only available to very high net worth investors. This means that whilst investors will require money behind them there are opportunities for many different types of investors.
For example, the maximum annual investment in the EIS is £1,000,000. However, according to figures published by HMRC, in 2017-18, 82% of EIS investors made a claim for tax relief in respect of an investment of £50,000 or less.
New investment is going to be a very important factor as the UK finally leaves the Brexit transitional period and starts to rebuild the economy once the coronavirus pandemic is under control.
We have listed below some of the most common tax efficient investments available in the UK, starting with the most straightforward.
Individual Savings Accounts
An Individual Savings Account (ISA) account is free of all Income Tax and CGT. Eligible holdings include cash, national savings products, life insurance products, stocks and shares. Account-holders may make withdrawals at any time without the loss of tax relief.
The list of investments that can be held in a tax-advantaged ISA also includes:
- securities (including retail bonds) and shares issued by housing associations and other co-operative societies or community benefit societies (registered societies - formerly known as industrial and provident societies);
- a broader range of securities issued by companies, including those admitted to trading on certain Small and Medium Size Enterprise (SME) market;
- shares in a wider range of investment trusts.
The maximum amount that can be invested in an ISA in 2020-21 tax year is £20,000.
Junior ISAs can be opened for children. Investments are available in cash or stocks and shares and a child can have one or both types of Junior ISA. Junior ISAs automatically turn into an adult ISA when the child turns 18. The annual subscription limit for investment in a Junior ISA is currently £9,000.
The income and gains which arise as part of pension savings are generally exempt from Income Tax and CGT. Tax relief for contributions to pension schemes is given at a taxpayer’s marginal rate of Income Tax subject to the annual and lifetime allowances. This means that a qualifying £100 contribution would cost a basic rate taxpayer £80. For higher earners it is even more beneficial, higher-rate taxpayers only need to contribute £60 in order to boost their pension fund by £100, and additional-rate taxpayers only need to contribute £55, subject to the overriding limits.
The annual allowance for tax relief on pensions has been fixed at £40,000 since 2014. The annual allowance is further reduced for high earners. Since 6 April 2020, the tapered annual allowance increased from £150,000 to £240,000. Those earning over £240,000 will begin to see their £40,000 annual allowance tapered.
There is also a pensions lifetime allowance, the limit is currently (as at 2020-21) set at £1,073,100. The lifetime allowance is the maximum amount of pension and/or lump sum that benefits from tax relief.
There is a three year carry forward rule that allows taxpayers to carry forward unused annual allowance from the last three tax years if they have made pension savings in those years.
Venture Capital Schemes
The purpose of the venture capital schemes is to provide funding for mainly new and growing companies. These investments are aimed mainly at experienced investors and proper due diligence is required.
Enterprise Investment Scheme
The Enterprise Investment Scheme (EIS) is designed to help smaller higher-risk trading companies to raise finance by offering a range of tax reliefs to investors who purchase new shares in those companies.
The amount of Income Tax relief for individual investors in the EIS is 30% and the maximum annual amount that an individual can invest through the EIS is £1 million. The limit is further increased to £2 million if at least £1 million of that is invested in knowledge-intensive companies. Tax relief is limited to the amount which reduces the individual’s Income Tax liability for the year to nil.
The tax advantages of the EIS also includes CGT exemption on qualifying gains on shares held for 3 years, CGT deferral relief and income tax relief for any losses made on the shares bought.
The generous tax allowances are in some way meant to off-set the fact that making investments in these types of companies can carry a high-risk.
Seed Enterprise Investment Scheme
The SEIS provides for extensive Income Tax and CGT breaks for investors and this greatly encourages much-needed seed capital in new businesses. The SEIS is most valuable for taxpayers who can fully benefit from the tax reliefs on offer.
For investors the main benefits of the scheme are as follows:
- Income Tax relief worth 50% of the amount invested to qualifying individual investors on a maximum annual investment of £100,000.
- A 50% exemption from CGT on gains reinvested within the scope of the SEIS. The maximum gain to be relieved is capped at £100,000 and the relief will be withdrawn if the SEIS relief is ultimately withdrawn.
- There is a 100% exemption from CGT on the sale of shares more than three years after the date on which they were issued.
- An SEIS investment will normally qualify for 100% relief from Inheritance Tax where the usual conditions are met.
Under certain circumstances, small business owners can also use the scheme to invest in their own businesses. Of course, investors must consider the importance of picking a good company to invest in and carry out proper due diligence.
Venture Capital Trusts
The Venture Capital Trusts (VCT) scheme has been designed to encourage individuals to invest in small, usually high-risk trading companies. The VCT scheme is similar to the EIS which also offers tax breaks for investors.
The VCT scheme offers investor’s Income Tax relief of 30% on new subscriptions for ordinary shares in VCTs. The maximum amount qualifying for relief is £200,000 in each tax year. Dividends received from VCTs are exempt from Income Tax, provided the shares acquired (by subscription or purchase) are within the annual limit of £200,000 and held for 5 years. Shares in VCTs acquired within the annual limit are also exempt from CGT on disposal at any time, but losses on disposal are not allowable as capital losses.
Social Investment Tax Relief
The Social Investment Tax Relief (SITR) scheme was launched in 2014 and is a tax relief scheme to encourage individuals to support social enterprises and to assist social enterprises access new sources of finance.
Individuals making an eligible investment in an SITR can deduct 30% of the cost of their investment from their Income Tax liability for the relevant later year in which the investment is made or the previous tax year. Individuals can also defer their CGT liability and benefit from capital gains disposal relief.
A Social enterprise must be a community interest company, a community benefit society, with an asset lock or a charity. In order for their investors to claim SITR, eligible social impact bond contractors need to be accredited by the Cabinet Office.
The SITR is currently due to come to an end on 5 April 2021.