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This article was first published in the July 2009 edition of Accounting and Business magazine
Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.
Younger readers will probably be shocked at the thought that the Government might ask anybody to pay income tax at a rate above 40%. Yet when Harold Wilson was prime minister in the 1960s, a 60% higher rate of tax was the norm, while it was reputedly possible to pay a 98% rate on investment income and, in the right (or possibly wrong) circumstances, a rate in excess of 100%.
Even so, people who have been used to a top rate of 40% are still waking up to the reality that the chancellor’s 45% rate to be introduced in 2011-12 has suddenly become 50% from next April.
As if that were not bad enough, at the same time Alistair Darling cut the rate of income tax relief on pension contributions for those earning over £180,000 per year to 20%, starting in two years’ time. In reality, though, thanks to transitional forestalling rules, this will have an immediate effect for those making substantial one-off contributions.
All of this comes on top of increases to national insurance contribution (NIC) rates announced in the pre-Budget report last December. These come into effect in 2011-12, by which time the combined marginal tax rate for those in employment will be 51.5% at the highest level.
Compared with these changes, the future loss of personal allowances for those earning above £115,000 might either seem not all that significant, or the straw that breaks the camel’s back. It should also be noted that the marginal rate of tax for those earning between £100,000 and £115,000 will be 60%, as their personal allowance disappears.
Ironically, those who are not domiciled or ordinarily resident in the UK and choose to be treated on a remittance basis might have the last laugh, since they are not entitled to personal allowances anyway.
It can reasonably be said that Alastair Darling has launched an attack on the well-off. It is inevitable that many of these individuals will be asking advisors to help them mitigate some of the effects of these changes, with the focus on income tax.
Few are likely to be willing to take any drastic steps to save an increase in NICs from 1% to 1.5%, even when this is coupled with an increase in employer’s contributions from 12.8% to 13.3%.
Most of the measures suggested below will work equally well to reduce taxable income below £100,000 and therefore save personal allowances or help those in the 50% bracket.
The simplest measure is to accelerate the payment of salaries or bonuses from tax year 2010-11 into the current period. For example, if a company normally pays annual bonuses every September, by paying an interim bonus half-way through the year in March 2010 it guarantees a 40% tax rate instead of 50%.
Paying a higher salary this year and a lower one next year has the same effect. In reality, though, it is unlikely that anyone apart from an owner or manager of a business would do this, since the commercial risks might outweigh any benefits.
Advancing payments need not cause cashflow problems, as it is possible to trigger a tax liability without actually paying the bonus or additional salary. An example is voting the payment to a director. However, PAYE and NICs still have to be funded.
Back in the bad old days, there was an income tax rate of typically 60% and a capital gains tax (CGT) rate of 30%. That fuelled a vigorous tax avoidance industry geared towards converting income into capital gains. But such activities could once again come to the fore when the income tax rate is 50% and the CGT rate is 18%, or 10% if entrepreneurs’ relief is applicable.
Shady operators will no doubt suggest ways to convert what most of us would see as salary into capital gains. However, there may well be legitimate routes that could achieve similar goals.
The idea of rewarding employees with shares rather than cash will seem more attractive now than it has done over the last few years. This results from more than just a change in tax rates.
If employees receive shares by reason of their employment, income tax (and sometimes NICs) will be payable based on the difference between the market value when shares are acquired and the amount paid by the employee to acquire them.
Since share values are currently at almost unprecedented lows, the amount of income tax payable on shares offered today will often be half of that a year ago. That makes this route extremely attractive for all concerned at the moment, and it seems reasonable to assume that any recovery will still be, at best, taking off next April when the 50% tax regime comes into force.
There is also the prospect of combining share acquisition with salary sacrifice at that time, effectively halving the cost of the shares.
Even better, in most cases corporation tax relief will be available based on the market value at the time when the option is exercised, less any amount paid to acquire them.
The disadvantage of taking this step is that it will accelerate the tax liability, which might need to be funded if the shares are not going to be, or cannot be, sold immediately.
Some serious planning might be required in connection with share options. Income tax and NICs (where applicable) become payable at the time of exercise using the tax rates in force at that time if options are unapproved. The tax due is once again calculated on the difference between the market value when shares are acquired and the amount paid by the employee to acquire them.
Clearly, if highly paid employees can exercise options on 5 April 2010 rather than a day later, there will be a straight 20% reduction in the tax bill; in other words, 40% rather than 50%. For example, a gain of £200,000 would cost £80,000 rather than £100,000. This will also not lead to any reduction in the corporation tax relief available.
Commercial imperatives may be an issue, but it would be advisable to review all share schemes to see whether changes can be made to allow employees to exercise their options in this way.
The position might be even better where companies can utilise Enterprise Management Incentives. Tax will not be payable when an option is granted, and even on exercise is only due on the difference between market value at grant and the exercise price, which are frequently the same.
When employees subsequently sell their shares, they pay CGT on any increase over the value at grant. This is even more attractive with a 32% gulf between the highest rate of income tax and CGT.
Where options have been granted with an exercise price below market value, exercising while the 40% rate is in place would be advantageous.
Employers are still able to take advantage of a mismatch between the income tax paid by their staff, often zero, and the corporation tax relief they are entitled to offset.
On Budget day, HM Revenue and Customs issued new guidance. Tax relief on pension contributions will be restricted for those with income in excess of £150,000, so that for those with income over £180,000 it will be reduced to 20% in two years’ time.
Transitional rules operate between 22 April 2009 and 5 April 2011. This is complex legislation, which may be subject to change before Royal Assent and professional advice should be sought urgently by those who may be caught by these rules. After Royal Assent, while opportunities might be limited, the position should be reviewed as planning might be beneficial.
There are often opportunities for employees to sacrifice an element of salary to take advantage of a benefit that is not taxable; for example, shares as referred to above.
This will become even more attractive, as the effective relief will be at a rate of 50% rather than 40%. However, most of these schemes – for example, childcare vouchers at £55 per week – have been on a relatively small scale. People already earning at least £150,000 per year may not be interested in going to considerable trouble to save what are considered relatively paltry amounts.
However, where the benefit could be of great value is when an employee is seconded to the UK from overseas. In these circumstances, provided that the secondment is no more than two years, they are entitled to receive travel and subsistence, including accommodation, tax free.
If an employer can pay for the accommodation and other costs, then this is a very attractive prospect for the employee, even if it means a reduced headline salary.
In future, where employees earn something close to £115,000, there will be advantages in scheduling their payments either side of 5 April in successive years. This could result (assuming a 2011-12 personal allowance of £7,500) in a pattern where employees alternately earn £100,000 and £130,000 in succeeding years rather than £115,000 in each.
This simple measure would save up to £9,000 in year one, but two-thirds of the saving would be paid in year two, resulting in a net saving of £3,000.
There is no doubt that high-powered tax planners will come up with numerous other schemes that will help taxpayers avoid the higher rates that will be payable in future.
The only certain way to avoid paying tax at more than 40% is to keep salaries below the threshold of £150,000. However, expressed in a different way, many people – myself included – would no doubt be happy to pay 50% tax on as much income as possible. I certainly would.
Philip Fisher heads the employment tax and rewards team at PKF (UK) LLP and is the author of Employee Share Schemes.
Last updated: 1 Jul 2013