Tax Talk – Tax-efficient investments

Tax Talk is a series of articles brought to you by FSL’s own Tax specialist, Alex Ranahan.

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, and at the bottom, 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, UK domiciled individual investors.  And please remember, this is not financial or tax advice.  Please consult a qualified adviser in both areas.

Let’s begin by looking at Individual Savings Accounts, commonly referred to by their acronym 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  Of course, once cash has been withdrawn, it is no longer exempt from tax.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.

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.  I’ll just point you to HMRC’s guidance on this as it actually does a good job of explaining what you need to know.

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 FTSE100, the Government wants to encourage wealthy investors to plump for small businesses by giving tax breaks to both the investor and the business.  I’ve linked here to the Government guidance on these schemes, which goes into more detail.

I’ll focus wholly on these share schemes in a future blog post, but here is a general summary to whet your appetite.

First up is the Enterprise Investment Scheme.  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.

This just gives you an idea of the tax incentives that exist. There are more reliefs, which are summarised in the table at the bottom of this article.  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.

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.

Well, that’s my time.  I hope that this first article has provided you with some insight into tax efficient investments.  If you would like to propose any themes for future articles then please send suggestions to:

See you next month!

Type of Tax Relief:Income TaxCapital Gains TaxMaximum Investment per yearWithdrawal of Relief
ISAInterest and dividends paid on ISA investments free of tax. Withdrawals from ISA pot are tax free at point of withdrawal.Any gains made by ISA provider free of tax. Growth in value of ISA free of tax.£20,000N/A
PensionIncrease to Basic Rate Band and Higher Rate Band by gross amount of pension contribution.Any gains made by pension provider free of tax. Growth in value of pension free of tax.£40,000 subject to high threshold income abatement.If contributions exceed annual allowance.
EIS30% of invested amount deducted from overall liability for tax year of investment and previous year.Gain on sale of EIS shares after 3 years is exempt from tax. Defer gain on asset if proceeds are reinvested in EIS shares. Losses allowable against gains. Remaining losses offset against income in year of disposal or previous year.£1m, or £2m in knowledge-intensive companies.If shares are sold within 3 years of issue.
SEIS50% of invested amount deducted from overall liability for tax year of investment and previous year.Gain on sale of SEIS shares after 3 years is exempt from tax. Defer 50% of gain on asset if proceeds are reinvested in SEIS shares. Losses allowable against gains. Remaining losses offset against income in year of disposal or previous year.£100,000If shares are sold within 3 years of issue.
VCT30% of invested amount deducted from overall liability for tax year of investment. Dividends from qualifying shares exempt from tax.Gain on sale of VCT shares is exempt.£200,000If shares are sold within 5 years of issue.