Less familiar tax traps can catch out the uninformed. Ceri Jones outlines 10 to be aware of.
One of HM Revenue & Customs’ favourite sayings at this time of year is that “tax doesn’t have to be taxing”, but with the UK tax code 10 times longer than the complete works of Shakespeare, there are countless tricks and traps to navigate.
1) Capital gains tax on main residence
A common misconception is that the sale of your main home is exempt from capital gains tax (CGT), but this is not always the case.
If a property has not been your main residence all the time you have owned it, the ownership is apportioned into exempt and non-exempt periods. The last 18 months is regarded as exempt even if the property was unoccupied during this time. However, this final qualifying period will be reduced to nine months from April 2020, so if you are planning to move out before renovating and selling a property, you may want to time it accordingly.
People who work from home and claim business expenses for rent, heating or lighting will also lose the CGT exemption for that portion of the house, because it is not covered by the private residence relief. This means that when you sell your house, you will probably face a CGT bill on this element of the total value. This liability can be reduced, however, if the home office returns to non-business use outside office hours.
2) IHT and reservation of benefit
You cannot give away an asset – for instance a house – and continue to use it, hoping the gift will be ignored for inheritance tax (IHT) purposes. The common example involves a parent giving their house to their children but continuing to live in it rent-free.
Such gifts are known as gifts with a reservation of benefit (shortened variously to GWR, GROB and GWROB) and are chargeable to IHT. The government netted £128 million from gifted assets in the 2017/18 tax year alone.
Furthermore, when your children sell the property, they will pay CGT on the increase in value from the date of the gift, not the date of your death. In addition, assets given away with the intention of avoiding contributions to nursing home costs will be regarded as a ‘deliberate deprivation of assets’, and the value will still be assessable in working out your care cost contribution.
The tried and trusted way around the reservation of benefit rules is for the parent to pay market rent to live in the home – but the rent must be regularly reviewed, because if it drops below market rate at any stage, the GWR provisions kick back in. The gift will then avoid IHT on your death, provided you live for another seven years.
This solution works well if the older generation is income-rich and the younger generation is income-poor, but bear in mind that the children may have to pay income tax on the rent they receive.
3) UK residents with offshore income and gains
If you are a UK resident and you receive offshore income and capital gains, these must be reported on your tax return. This is often overlooked, especially when someone holds a small overseas bank account generating interest, or receives rental income from an overseas property. The UK tax can be reduced if the income is already subject to tax in the country where it arises and a tax treaty is in place between the UK and that country.
The exception is if you are taxed on the remittance basis available to individuals who are resident but do not live permanently in the UK, and you do not bring your foreign income and gains into the UK. In that situation, tax should not be an issue.
4) Offshore funds and excess reportable income (ERI)
Many offshore funds, including exchange traded funds such as iShares, make profits that they don’t distribute to their investors, but their investors have a duty to report this in their tax returns. For the highest rate taxpayers, this so-called Excess Reportable Income (ERI) can attract income tax at as much as 45% for bond funds and 38.1% for equity funds.
Information on ERI is not easy to find, however. First, the rule is applicable to only so-called reporting funds, which follow a particular tax regime, and not to non-reporting funds, which are taxed differently. To find out if your fund is a reporting fund, you need to check the manager’s website, or the list of such funds on HMRC’s website (hmrc.gov.uk/cisc/offshore-funds.htm).
Any fund not domiciled in the UK is an offshore fund; for example, many popular funds registered in Dublin are reporting funds. Reporting status applies at unit/share class level, so a fund may have one share class with reporting status and another without.
Where the fund holds more than 60% of its investments in bonds and debt securities, the distribution is treated as interest, and where the fund holds less than 60% in bonds or debt, the distribution is treated as a dividend. Both should be recorded on HMRC’s SA106 form as part of your tax return. ERI falls within HMRC’s new Requirement to Correct regime of fines for failure to disclose.
Investors in reporting funds are more favourably taxed than those in non-reporting funds, as although they pay income tax on income generated by the fund, ultimately they pay CGT at the sweeter rates of 18% or 28% on the remaining profit on disposal. In contrast, the entire proceeds of non-reporting funds are subject to income tax, and there is no chance to use your CGT allowance and reliefs.
5) Pre-owned tax assets
People who gave away their assets in the past could also face a little-known annual income tax charge called preowned assets tax (POAT). This was introduced in April 2005 to catch people who had engineered IHT planning exercises as long ago as 1986 that were legitimate at the time. The aim is to tax the yearly benefit from the continued use of the gift.
You do not need to pay POAT on any assets that will in any event be caught by IHT and the GWR rules; POAT applies only if you would otherwise avoid them, such as if you occupy a home, or use a car or boat, having gifted them (between March 1986 and April 2005). If you do not declare POAT, you may be hit with penalties and interest for late payment.
Large cash transfers from parents to children, which are then used within seven years to buy assets benefiting the parent, may also be caught.
6) Tax on investment bonds
“People are often attracted to investment bonds because they think they can take a 5% income ‘tax-free’ every year, whereas in fact this is a deferral, not an exemption,” says James Quarmby, partner at Stephenson Harwood.
These 5% withdrawals can be carried over from one year to the next, which may be helpful to higher-rate taxpayers who want to delay payment until they fall into a lower tax band, most obviously when they reach retirement.
All gains and income earned within an investment bond are taxed at 20%, which is automatically deducted internally. Then, at maturity or encashment, all gains are treated as income; as 20% tax has already been deducted, basic-rate taxpayers pay nothing more. However, there will be additional income tax to pay if your gains push your income over the higher or additional-rate tax threshold that year.
You might be able to avoid this by ‘top-slicing’, which evens out the tax charge over the years by dividing the profit paid since the bond start date (including withdrawals) by the number of years it has been held. If the top-sliced profits, when added to your other income for the tax year, are below the higher-rate tax threshold, there is no extra tax to pay, but if the sum pushes you over the higher-rate threshold, then additional tax must be paid on the entire gain.
7) Employing family members
Many small businesses pay salaries to family members for office work and cleaning, but be realistic. The dangers have been highlighted by an ongoing case in which the former chief executive of a small mutual insurer transferred £200,000 to his wife for her administration support – around four times more than any other person working for the company – and is now appealing bans from the Financial Conduct Authority and the Prudential Regulation Authority.
Small businesses typically pay modest salaries to family members who help out informally, but the reward should match their contribution. The question to ask is what the business would have paid a third party for the same services.
• The work must be genuine.
• Family members must be paid commercially viable wages.
• Payments must actually be made and records kept.
• Both you and they must pay national insurance if they earn over £166 a week.
• Adhere to child employment law for those between 13 and 16 years old.
8) Income tax on eBay sales
“Many people wrongly assume that income falls outside the tax net just because it is generated informally from something that isn’t your day job,” says Jeremy Cape, tax and public policy partner at Squire Patton Boggs.
But if you regularly make a profit selling or reselling items online, or let out your home from time to time on Airbnb, then you should be careful. If you are selling unwanted personal items on an ad hoc basis, such as old clothes or your child’s outgrown bike, you won’t usually need to pay income tax. However, HMRC gets interested if you are systematically selling items, and particularly if you are buying or modifying items to re-sell at a profit, as this looks like trading. Cape adds that he’d be concerned if such receipts occurred once a fortnight.
9) Higher-rate pensions tax relief
If you are a higher-rate or additional-rate taxpayer saving into a pension, you may need to claim additional tax relief in your self-assessment tax return. Around 15% of higher-rate taxpayers have no idea whether they’re getting 40% pension tax relief, and hundreds of millions of pounds of tax relief are left behind with HMRC by people who forget to claim.
“If you have a trust-based workplace scheme or one which offers salary sacrifice, higher-rate taxpayers get 40% tax relief automatically,” says Romi Savova, chief executive at PensionsBee. “But elsewhere, you’re probably getting tax relief at 20%, so you need to reclaim the difference on your tax return. The best thing to do is ask your HR department.
“When you’re claiming extra tax relief on a pension, make sure you’re entering the gross value of contributions – in other words, the total of everything you paid in, plus tax relief at 20%.”
10) The Money Purchase Annual Allowance
If you are over 55 and planning to withdraw more than the 25% tax-free cash from your pension, you will trigger the money purchase annual allowance, which will restrict your pension contributions to £4,000 a year.
If you plan to contribute more than £4,000 a year to your pension, you may wish to consider fully withdrawing any ‘trivial’ pension pots you hold that are worth less than £10,000, rather than exceeding the tax-free cash allowance on your main pension, to avoid triggering the money purchase annual allowance.
UK tax code is more than 17,000 pages long
Source: Dominic Frisby Edinburgh Fringe Show
Really useful tips here