Income, capital gains and how to beat the 50% top tax rate

Thursday, November 19, 2009 | Posted by: Sue Knight
Categories: Protecting your wealth | Tags: tax planning, HMRC, CGT, Sue Knight, income, capital gains, taxpayers, discretionary cash bonus schemes, conversion, employee incentive plans, cash balances, equity reward plans

Avoiding the new 50% income tax rate by converting income into capital is likely to be a top dinner party discussion for the wealthy right now. From 6 April 2010, individuals with income above £150,000 will be taxable at 50%. By contrast, as noted in 10 strategies for tax planning in 2009 , the capital gains tax (CGT) rate looks very attractive at 18%.

This stark contrast is driving taxpayers to look for ways in which to convert their income, taxable at up to 50%, into capital gains, taxable at 18%. If achieved, the ‘conversion’ creates a tax saving of up to 32%.

How can income convert into capital gains?
A receipt is either income or capital in nature. Income receipts are subject to income tax and receipts from capital profit are subject to CGT. A receipt of income will always remain income, so strictly speaking there is no ability to ‘convert’ income into capital.

Except…

An individual could benefit from a ‘conversion’ of sorts by organising their activities in such a way that what is received is capital in nature and not income. Specialist advice needs to be sought as to whether a receipt is income or capital in nature, as this is covered both by tax legislation and case law.

If you are able to organise your affairs so that a receipt is capital, you may benefit from the 18% rate, or possibly reduce this even further down to 10% rate with Entrepreneurs’ Relief. 

Examples of ‘conversion’ tax planning opportunities

• A number of banks are offering investments where the return is structured as capital and subject to capital gains tax rather than as income-bearing investments such as cash deposits.
• A shareholder looking to extract significant cash balances from his company, say £30m or more, may be able to achieve this at a maximum tax cost of 18%, or even lower, depending on the base cost of the shares.
• It may also be possible to replace traditional equity reward plans and discretionary cash bonus schemes with employee incentive plans that provide tax-efficient arrangements which align employee reward to the commercial objectives of the business. In addition to the potential tax saving this also gives a possible national insurance saving.

Significant tax savings – for now
The disparity in rates means that taxpayers should consider whether their economic activities might be organised so receipts can benefit from the 18%/10% rates. This may mean making choices:

• Should savings be invested for capital growth over income?
• Should a transaction be structured so that the economic return creates a capital receipt (as in the examples noted above).

If the disparity continues, more tax planning strategies will arise. While this may attract the attention of HMRC, such planning strategies can provide significant tax savings and will therefore be attractive to higher and additional rate taxpayers. However, watch out for the forthcoming Pre Budget report on 9th December which may well contain further anti-avoidance legislation in this area.

Image (adapted): © Mike Licht/Notions Capital

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