The View from No 50
K P Bonney & Co
Chartered Accountants and
Chartered Tax Advisers
Ilkley LS29 6JA
Tel: 01943 870933
Fax: 01943 870925
TAX CREDITS – GIVING AWAY MONEY WITH YOUR NAME ON IT!
When tax credits were first introduced, the message used in order to encourage take up was ‘money with your name on it’. Following a recent change in the way tax credits are calculated the message to taxpayers is ‘giving away money (to others) with your name on it’.
The purpose of tax credits is to deliver money to those families who need it most. Nothing wrong with that, so long as it doesn’t foster a culture of dependency.
But the fundamental problem with the system is it pays current year benefits based on previous year income. Thus
Income in year 1 - £20,000.
Income in year 2 - £30,000.
The actual outcome for year 2 is not known and is not reported until some time after the end of year 2.
During year 2 the family receives tax credits on the basis that its income for year 2 will be £20,000 – the same level as year 1. When it later turns out that income is £10,000 higher, the family has to repay the ‘overpaid’ tax credits. In this example the amount of money repayable will be something in the region of £3,700. How many families will have set the money aside just in case it might have to be repaid? Not many. Right now lots of families are struggling to repay debts they didn’t even realise they were accumulating.
The Chancellor has yet to go on record with his apology for this poorly thought out system.
Privately, the Chancellor might recognise the problem is that the system is designed badly (current year benefits based on previous year income). But tax credits are one of his flagship policies. To admit the system is flawed would be just plain embarrassing. To construct a new workable system which delivers the right benefits at the right time would be difficult and take time. So for the Chancellor the problem is not so much to fix the system but to fix the symptoms.
Enter government adviser with a cunning plan.
If income in year 2 is no more than £25,000 higher than income in year 1 then any overpayment of tax credits in year 2 will be disregarded.
The £25,000 income increase disregard is introduced with effect from April 2006, so expect the overpayment problem (the symptoms) to have been cleared up by this time next year. Then the Chancellor will report that overpayments for 2006/07 have fallen to a miniscule number. The system is working!
Er, well, no actually. All we have done is pay over millions of pounds of taxpayers’ money to families who don’t need it! What a shameful piece of deception and a scandalous waste of money.
But that is not all. And this is where we have a moral dilemma. Maybe you do too.
The change has a consequence which our government adviser didn’t foresee.
Income for tax credit purposes is calculated in pretty much the same way as it is for tax purposes.
Under the new ‘simplified’ pension rules you can pay a pension contribution and deduct it from your earnings for tax and for tax credit purposes.
Suppose your income is £23,000 per annum. Suppose you pay a pension contribution of £10,000 (gross) during 2006/07. That reduces your income to £13,000 for tax and tax credit purposes. You receive an extra £3,700 in tax credits.
You don’t repeat the pension contribution in 2007/08. Your income is £23,000 but you have been paid tax credits on the basis your income would be only £13,000. Do you have to repay £3,700 of tax credits? No, you don’t because the income increase is less than the disregard figure of £25,000. You get to keep the extra £3,700 you have been paid for 2007/08.
In 2008/09 you repeat the process by paying a further pension premium.
Other measures can have similar results. It has been shown in a recent article in the professional press that a self employed businessman can effectively buy a van for his business and not only does it cost him nothing, but he also effectively gets cash back. The conclusion of the piece is that he cannot afford not to buy a new van. So the general body of taxpayers ends up funding the purchase of the van and more!
The tactic for those who are so inclined is to ensure their income fluctuates – one year low, next year high. So long as the increases are kept below £25,000, tax credits are set by reference to income of the lower year.
A crazy system has just been made crazier.
Our Advice – The basic advice remains as it always has been. Whether or not you think you will ultimately be entitled to tax credits, always make a claim. In order to secure an unrestricted claim for the year 2006/07, do this before 6 July as claims can only be backdated by three months.
The new point to be aware of is that legitimate manipulation of your income can secure disproportionate entitlement to tax credits.
Do you have a moral dilemma with that?
INHERITANCE TAX PLANNING
As observed in previous newsletters, more and more families are finding themselves caught in the inheritance tax net. The main reason for this is the value of houses has risen more quickly than the value of the inheritance tax nil rate band.
The essentials of inheritance tax planning for all affected families are to ensure tax efficient wills are written and to make use of the available exemptions.
What else can be done to reduce any potential liability?
One strategy which is increasing in popularity is to invest in business assets of a kind which are eligible for a relief called ‘business property relief’. For some types of business assets the rate of relief is 50% and for others it is 100%. If you invest in assets which qualify for the 100% rate, these assets are effectively treated for inheritance tax purposes as having a value of nil. The assets which qualify for the 100% rate of relief are
· Business interests – the amount invested in a business by a sole trader or partner.
· Shares – the value of shares in an unquoted trading company. The company can be a family company at one extreme or a company quoted on the Alternative Investment Market (AIM) at the other.
The 100% rate of relief is attained once the assets have been owned for a period of two years.
In recent years a number of stockbrokers and fund managers have established AIM portfolio management services. They clearly foresee investor demand for these services.
Interestingly, the two year ownership period mentioned above is not as restrictive as might be thought. It is not necessary to hold a particular share for a continuous period of two years. It is only necessary to hold qualifying shares for a period of two years. Thus a portfolio can be actively managed without losing the benefits of the relief.
Further, it is only necessary to hold qualifying shares for two years out of the five years immediately preceding death. This allows the manager to exit from the market if he sees difficult times ahead. It is important to understand, however, that business property relief will only be secured to the extent the portfolio is invested in qualifying shares at the time of death. To the extent the portfolio is held in cash or other investments it will not benefit from the relief.
The big advantage of this strategy is that you do not have to give anything away. Hopefully your investment will produce an income which will help you to maintain your standard of living. Your investment might even grow in value!
Our advice: When carrying out inheritance tax planning, give serious consideration to investing in assets which qualify for business property relief. We do not ourselves give investment advice but we can direct you towards advisers who do and who can help you to construct a tax efficient portfolio.
THE CHAIRMAN AND THE COACH
The club chairman visited the team coach who was sick in hospital. ‘Gordon,’ he said, ‘the board decided to send you a ‘Get Well’ card and I’m sure you will be pleased to hear it was a majority decision.’
Copyright: K P Bonney & Co LLP 2006. All rights reserved. No part of this publication may be produced, stored in a retrieval system, or transmitted in any form or by any means, electronic mechanical, photocopying, recording or otherwise without prior written permission of the publishers. Disclaimer: The publishers have taken all due care in the preparation of this publication. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the authors or the publisher.
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