A Guide to Tax Rules on Investments
As is the case with any endeavour that involves, hopefully, earning a profit, it is important that investors understand the tax rules around their investments. Making sure tax is paid where due is crucial to keeping one’s financial affairs in good order and avoiding unnecessary stress and complications down the line. Tax also has a bearing on how profitable a successful investment might be so it is important to understand tax rules when making a decision on a particular investment or asset class is.
The importance of being aware of different tax relief opportunities around investments should also not be underestimated. With the UK government keen to encourage pension and general savings as well as stimulate the economy in focused ways, there are some very generous tax relief incentives that can be taken advantage of and really boost the appeal of certain investments.
In this article, we’ll cover the main asset classes open to retail investors in the UK and the general tax rules around each. We’ll also cover ISAs and SIPPs, the two main tax-efficient investment wrappers the UK government has provided to help encourage general and pension savings. While not exhaustive, the majority of investments made by retail investors in the UK will fall under the tax rules of the asset classes covered below.
Tax Efficient Investment Wrappers
ISAs and SIPPs are the two ‘wrappers’ that different kinds of investments can be held in, with the first an incentive to general savings and the latter specific to pension savings. Cash and investments held within ISA and SIPP wrappers come under different a different taxation regime to what they would normally if held outside of these special accounts. As such, it generally makes sense for investors to make as much use of ISAs and SIPPs as possible and only hold investments that go beyond their annual allowance outside of these wrappers.
ISAs (Individual Savings Accounts) were first introduced as far back as 1999 and have been happily taken advantage of by UK-based investors since. The wrapper allows savings and investments up to an annual value ceiling, currently £20,000, to be sheltered from the usual application of Income and Capital Gains Tax. ISAs can be considered as a nod to the fact that as many individuals as possible having a good level of savings as a financial buffer, or to make bigger purchases such as property or starting a business, brings significant advantages to the overall health of the nation.
ISAs are basically like a tax-sheltered savings account but as well as cash, investments such as company shares, funds and bonds can also be held in them. Last year the Innovative Finance ISA, for P2P loan investments, was introduced and this year the Lifetime ISA, for long term savings or a property deposit, was added, providing additional flexibility to the kind of investments able to take advantage of the special ISA tax rules.
The annual £20,000 allowance for cash and investments placed into an ISA wrapper does not carry forward so any unused part of the allowance is forfeited at the end of a tax year. The £20,000 annual allowance can be split between different kinds of ISA as preferred but each ISA held does not come with a new £20,000 allowance. The exception is the Lifetime ISA which, because of additional tax relief advantages we will cover, has a £4000 annual allowance. However, the remaining £16,000 can still be used up through other forms of ISA.
Cash ISAs shelter interest earned on cash savings from counting towards taxable income.
Investment ISAs, or Stocks and Shares ISAs as they are also known, shelter income from dividends or bonds from counting towards taxable income. Any profits realised by selling individual company shares, exchange traded bonds or funds are also not subject to the usual Capital Gains Tax if held in an ISA. Shares, ETFs, unit trusts and investment funds, corporate and government bonds can all be held within an Investment ISA.
One downside to holding investments in an Investment ISA is that while profits are not taxed any losses sustained on investments held within the ISA cannot be used to offset Capital Gains Tax due on non-ISA investments.
Innovative Finance ISAs shelter interest earned from P2P lending from counting towards taxable income. Again, however, any loss sustained would not be eligible to be used to offset gains on other non-ISA investments that Capital Gains Tax is applicable to.
Lifetime ISAs come in cash, investment or a mix of cash and investments forms but don’t cover P2P lending investments. Lifetime ISAs offer the same tax-shelter advantages as the other ISA formats covered here with the additional bonus that the UK government adds a 25% top-up to contributions up to the £4000 annual LISA allowance. This means that if £4000 is invested into the LISA in cash form, or as investments, an additional £1000 cash top-up is added.
The restriction that comes with this extra government top-up is that LISA savings can only be used to make a deposit on a first home or be used for retirement, accessible from the age of 50.
Tax rules on ISA inheritance
As of 2015, an additional tax advantage that applies to savings and investments held in an ISA is that their tax-sheltered status is maintained if inherited by a spouse or civil partner. In the unfortunate circumstance of an ISA holder passing away, the surviving partner can apply for an ‘Additional Permitted Subscription’ allowance. This essentially means that a one-off added ISA allowance equal to the value of the deceased’s ISA-held assets is granted that allows the surviving partner to transfer all holdings into a new ISA in their name and retain all tax advantages.
Unfortunately, should an ISA holder wish to pass their ISA-wrapped assets on to a beneficiary who is not a spouse or civil partner they will no longer retain their tax-sheltered status.
SIPP (Self Invested Personal Pension) wrappers have several similarities to ISAs but offer even better tax breaks for investors and are also more flexible in terms of the variety of asset classes that can be held in them. As well as all of the asset classes that can be held within an ISA, many kinds alternative investment can also be held in a SIPP, including commercial property, though residential property cannot. Different SIPP providers have different rules on what asset classes can be held in their SIPP wrappers. However, the more flexible wrappers are usually more expensive in terms of annual fees.
The annual allowance for the tax breaks offered by a SIPP is also higher, at £40,000. Unused allowance from the previous three tax years can also be carried over. However, as is generally the way of the world, the heightened tax relief advantages of holding investments within a SIPP mean that they come with more restrictions.
The main restriction that applies to investments held within a SIPP is that, because they are classified as pension savings, they are locked in until the holder has reached the age of 55.
Otherwise, in the same way as covered in the previous ISA section, interest or cash returns generated from cash, equities, funds, bonds and P2P lending are sheltered from being counted towards the holder’s taxable income. Profit realised between the purchase and sales price is also exempt from Capital Gains Tax.
And now the big tax advantage that holding investments in a SIPP provides: income tax already paid at source is returned by the government in the form of a top-up to the value of SIPP-held investments. For the basic rate income tax band, this means an automatic 20% top up to the value of all investments held in a SIPP and 40% or 40% for higher and additional rate income tax payers.
Tax Rules on SIPP inheritance
SIPPs can be inherited by any beneficiary the holder chooses in the event of their death. If the holder passes away before the age of 75 then SIPP holdings are inherited tax free. If the holder is older than 75 then standard inheritance tax rules apply and are charged against the value of the SIPP-wrapped assets.
Tax Due on Non-ISA/SIPP Investments
While the tax sheltering qualities of ISAs and SIPPs mean that it makes sense to put all eligible investments up to the annual allowance into this kind of wrapper, those blessed with a high annual income may make addition investments beyond those allowances. There are also some popular investment choices that are not eligible to be placed within an ISA or SIPP wrapper, such as CFDs trading, Spread Betting and buy-to-let residential property investments.
Returns on equities, or company shares, come in two different forms, both taxed in a different way. Some companies, usually bigger blue-chips particularly from industries such as utilities, infrastructure and finance, though not only, pay part of their profits back to shareholders in the form of dividends. These dividends are considered as income by HMRC in the same way a salary is. This means that after allowances, dividends earned are counted when income tax is applied, though at a lower rate than salary income.
Currently, the first £5000 investors might earn in dividends does not count towards taxable income, however this will be reduced to £2000 from April 2018. After this allowance dividends or distributions paid on fund investments are taxed at:
- 7.5% (for basic rate taxpayers)
- 32.5% (for higher rate taxpayers)
- 38.1% (for additional rate taxpayers)
Capital Gains Tax is applied to profits realised by selling equities at a higher price than that at which they were purchased, in the case their value has risen on the stock exchange. However, UK tax payers have a personal allowance of £11,100 on which Capital Gains Tax is exempt so tax will only be paid on profits beyond this allowance. How much Capital Gains Tax is paid beyond this depends upon the holder’s income tax band. For those in the basic income tax band Capital Gains Tax on profit that does not take the holder into a higher income tax bracket is charged at 10%. For any portion of profits that takes the holder into a higher tax band the rate is 20%.
For taxation purposes investment funds, unit trusts, ETFs and OEICs are treated in the same way as individual equities with regard to both Income Tax and Capital Gains Tax.
Equity investments, either directly or via funds, involve acquiring shares in a company. Bonds on the other hand are debt investments. A bond holder is basically lending their money to the issuer for a fixed period of time against interest. While dividends paid out by companies to shareholders are discretionary and vary, bonds pay holders a ‘fixed annual coupon’, which is really the rate of interest. If held outside an ISA or SIPP this income is taxed in the same way, with the same personal allowance rules, as dividends from equities.
An exception to this rule is UK Government-issued bonds, or gilts. Income derived from the coupon on UK gilts is tax free.
While the difference between trading CFDs and Spread Betting is largely technical rather than practical in terms of how they are traded, they are treated differently by HMRC. CFDs are classified as a financial instrument and as such Capital Gains Tax is applied to profits made beyond the personal allowance. However, any losses incurred can also be used to offset tax.
Spread Betting is considered as gambling by HMRC and is therefore exempt from Capital Gains Tax. However, any losses can also not be used to offset tax due from other sources of income. If it is deemed that a spread better is living from the proceeds of spread betting then the activity is deemed to be a ‘trade’ and income tax then due on the proceeds.
Long a favoured investment in the UK, buy-to-let residential property investments until recently took advantage of attractive tax breaks on rental income earned, with mortgage interest wholly deductible. Recent concerns that the popularity of buy-to-let investment was a major factor in inflating UK house prices have led to many of the historical tax breaks that applied to buy-to-let have now been revoked in an effort to reduce the appeal of the asset class.
So, as a buy-to-let investor in 2017, what is the tax situation?
Up until this year, landlords were able to fully offset mortgage interest against profits, substantially reducing tax liability. As of the 2017/18 tax year 75% of mortgage interest can be offset, falling to 50% next year, 25% the following and zero by 2020/21.
Rental income on a buy-to-let property counts fully as income, minus whatever mortgage interest can be offset up until 2020/21. This means someone earning £38,000 a year in a salary and gross rental income of £11,400 from a buy-to -let property would be considered as having a £49,400 annual taxable income, minus a new 20% tax relief on mortgage interest.
Source: The Telegraph/Plan Money
Capital Gains Tax if a property is sold for a profit on its purchase price is also applied to buy-to-let property investments. The first £11,100 of any gain is exempt as the annual individual Capital Gains Tax allowance each individual takes advantage of. After that, 18% Capital Gains Tax is due by basic rate income tax payers and 28% for higher rate payers. If the profit from the property sale pushes a basic rate income tax payer into the higher rate for that tax year then 28% Capital Gains Tax will be due on the section of the profit that falls within the higher rate.
Interest earned on P2P lending conducted outside of an ISA or SIPP counts towards taxable income. However, it has been included within the Personal Savings Allowance along with interest earned on cash savings so only bigger lenders earning over £1000, or £500 in the case of those in the higher income tax band, will be liable.
For interest earned from P2P lending above the Personal Savings Allowance, and outside of a tax-efficient wrapper, income tax is charged at normal income tax band rates. A basic rate income tax payer earning £2000 from P2P lending will pay 20% tax on the second £1000. A higher rate income tax band earner would pay 40% on £1500.
Capital Gains Tax is applied to P2P lending only in rare circumstances. Some P2P lending platforms allow the trade of loans that have already commenced. If a £1000 loan were to be sold for £1100, in theory Capital Gains Tax would be due on the £100 profit but only if the holder had used up their £11,100 allowance across all investments that year.