How your quoted shares are taxed

How your quoted shares are taxed Blick Rothenberg partner Frank Nash explains how to be tax-efficient when it comes to shareholdings. Individuals who invest in quoted companies and investment trusts gain access to the profits of a diverse cross section of the global economy. Ultimately, a share is an investment in all the day-to-day goods and services that consumers and businesses buy, so that as economies grow so do dividends and share value. Quoted shares are a long-term investment and stock markets in the short term can be volatile. Income from these investments is taxed at a top rate of 38.1%, while growth is also taxed and quoted shares are probably going to remain the largest contributor of inheritance tax ( IHT ) by asset class for the next decade. However, one of the strengths of quoted share investments is their liquidity. Shares can be bought and sold to switch from income to capital growth. Personal cash flows can be manufactured from capital tax-efficiently and shares can be settled in trust to respond to the income needs of individual family members. What s in a share? Companies may issue different forms of shares, but ordinary shares are by far the most common ones issued to investors in the stock market. It is correct to say that each ordinary share is a unit of ownership that a shareholder has in a company, and which gives them rights to income in the form of dividends, capital proceeds on a takeover or windingup, and votes at the company s annual general meeting. There are variants of shares, such as preference shares, which may give those shareholders preferential rights to an annual dividend ranking in front of ordinary shareholders. Often the dividend is at a fixed rate. In return for this greater security of income, preference shareholders may have reduced rights to share in capital, so that on a company takeover most of the capital gain may accrue to ordinary shareholders. Quoted shares and securities probably stand out as the most liquid investment of all. By signing up to an online trading platform and with the benefit of online banking, an individual can these days buy and sell a listed investment within around 120 seconds, often from the comfort of a sofa in the local coffee shop on a mobile phone. The basic valuation of a company s shares is derived from investors expectations of its projected future cash flows. This is their belief in its ability to maintain or grow profits and pay out dividends discounted by inflation and adjusted for the particular risks to which its business is exposed. These risks can be specific to the company, or more generic such as the wider economy, wars, or merely the unpredictability of the weather, which may affect companies that engage in primary food production. With quoted shares, an individual investor can obtain historic copies of the company s accounts, research investor news and attend company presentations to guesstimate future earnings. Alternatively, there is a whole army of city analysts whose job it is to value a company share in light of all available information that may affect it. Analysts will individually arrive at different conclusions and may indicate through the full range of media whether a stock price is fully valued or has room for growth because the current price does not take into account the top range of earnings, or the potential size of the 20K Annual ISA Investment Allowance for 2017-18

market for its goods or services, for example. It is up to individual investors and investment managers, armed with whatever advice is available from analysts and press insights, combined with their own life experiences, to decide if a particular share is good value for the income it currently produces, or has scope to grow in value by producing even more income. Income tax Dividends paid from companies are taxed on UK resident investors at special dividend rates. Until 5 April 2016, investors received a 10% tax credit to offset their tax bill. In order to simplify self-assessment, the credit was abolished from that date and new dividend rates were introduced, raising an extra 2bn for the Treasury. Dividends are generally treated as forming the highest tranche of an individual s income, taxed at the rates applicable in Table 1 (see below). For 2017-18 there is a 5,000 taxexempt dividend allowance. A proposal that from 6 April 2018 this would reduce to 2,000 has been put on hold. Table 1: Income rate on dividends 2017-18 Income Dividend tax rate Dividend allowance Specific exemption 5,000 Nil Then add dividends to other income to see in which band they fall; Personal allowance Tax-free for all income First 11,500 Nil Basic rate band Dividend income between Next 33,500 7.5% 11,501 and 45,000 Higher rate band Dividend income between Next 105,000 32.5% 45,001 and 150,000 Top rate tax Dividend income above 150,000 Excess income 38.1% Ways in which investors seek to minimise their annual income tax bill on listed share dividends include the following: Investing through an individual savings account ( ISA ) where possible. Dividends received in an ISA are not taxable. The ISA annual investment allowance for 2017-18 is 20,000, but there is no cap on the annual level of taxfree dividends. Investing in growth stocks, that is to say companies or investment trusts that reinvest annual profits in longer-term projects, such as those in the tech sector. These are often the rising stars of the stock market. Increased dividends may be paid one day, when the company s products and services are selling in the market, but in anticipation of that day the share value may rise and an investor might sell and take a capital gain where the tax rate may be less. Transferring investments between spouses or civil partners to use lower dividend tax bands, the tax-free dividend allowance or even an unused personal allowance in the case of a non-working spouse. Dividends from shares held jointly are always taxed 50/50, but if spouses or civil partners formally vary their interests to reduce their tax bill they can elect on HMRC Form 17 to be taxed in that beneficial way. Investing via a venture capital trust ( VCT ), which is a listed investment that can provide a tax-free dividend. These are considered more risky because they invest mainly in small unquoted trading companies, often with no track record. Following a subscription for new VCT shares, an investor can receive an income tax rebate of 30%, capped to 60,000. This tax sweetener is not available if existing VCT shares are bought in the market, only on new issues. HMRC will claw it back if a subscriber for new shares sells them within the first five years. Manufacturing an income from capital by selling some shares each year. The profit is taxed at the lower capital gains tax ( CGT ) rate of 20%. Income tax does not apply on capital gains. This is set out in Table 2 and discussed further below. Investors who are resident overseas do not generally pay income tax on UK-listed investments. They may, however, pay foreign income tax in their country of residence. A UK national who therefore lives overseas for an extended period may stay reinvested in UK currency and pay no income tax. Trustees of family discretionary trusts pay income tax on dividends at 38.1%. However, when the trust income is distributed to beneficiaries they may be entitled to a refund of some or all of this tax.

Grandparents and parents who wish to help younger family members may therefore achieve income tax savings by passing quoted shares into a family trust. This legitimately converts non-recoverable income tax otherwise paid by the donor into potentially recoverable income tax in the hands of the younger family member. This will not work if a parent gifts shares to benefit a minor child however. In that situation, a parent will be taxed on their child s dividends if they exceed 100 a year. Case study: A tax-efficient plan for investing and spending Having saved for most of her life into a self-invested personal pension managed by her investment adviser, Emma is comfortable with the stock market. She has recently inherited 500,000 from the sale of her late father s house, her children have left home and she now wishes to supplement her other income with some fun spending, including foreign travel and hobbies. Emma is happy to dip into half of her capital over her estimated remaining 20-year life expectancy to age 75, leaving around 250,000 in reserve for old-age care or for her children to inherit. Conscious that she can always draw from both income and capital returns, Emma has no desire to invest purely for income and with the help of her investment manager is invested mainly for capital growth. The portfolio mandate is for approximately 1% income and 5% capital growth, producing a real total return of a little over 6% a year. These figures are projected in blue in Table 2. Due to the fact that Emma has other income that fully uses up her income tax personal allowance, her dividend allowance and her basic rate band, her dividends from this portfolio are taxed at 32.5%. This tax is set aside, together with CGT at 20% on investment gains that exceed her annual CGT exemption. These tax reserves are shown in red and deducted from the performance of the portfolio. Working across each row in turn we can see that Emma s adviser has produced a tax-efficient plan that allows her to draw a reasonable amount for spending each year over 20 years (Column F). Under these investment and tax assumptions, that sum starts at 22,000 in 2017 increasing each year by 5% to cover the rising cost of Emma s hobbies and holidays. The summary at the foot of Table 2 shows where all the money has gone. It also shows that total tax has been paid of 65,873 on combined capital and income returns of 545,220, an effective tax rate of 12.1%. This has been achieved through using her annual CGT exemption and the 20% CGT rate against investment gains. This table is highly theoretical. It assumes regular linear capital growth and inflation of 5% on Emma s spending. The reality is that the stock market does not work that way and in some years growth will be up and in other years down. However, provided Emma s investment manager and her tax adviser review her position annually, they can respond to economic and tax changes, flex her drawdown plan and keep her on target. Table 2: Emma s manufactured income (Effective tax rate on capital drawdown over 20 years) Year A B C D E F G Opening fund ( ) Income at 1% Reserve for IT at 32.5% Growth at 5% Annual CGT Reserve for CGT at 20% Portfolio with net returns Annual draw down for spending Closing fund ( ) 1 2017 500,000 5,000 (1,625) 25,000 11,300 (2,740) 525,635 (22,000) 503,635 2 2018 503,635 5,036 (1,637) 25,182 11,526 (2,731) 529,485 (23,100) 506,385 3 2019 506,385 5,064 (1,646) 25,319 11,757 (2,713) 532,410 (24,255) 508,155 4 2020 508,155 5,082 (1,652) 25,408 11,992 (2,683) 534,310 (25,468) 508,842 5 2021 508,842 5,088 (1,654) 25,442 12,231 (2,642) 535,076 (26,741) 508,335 6 2022 508,335 5,083 (1,652) 25,417 12,476 (2,588) 535,076 (28,078) 506,517 7 2023 506,517 5,065 (1,646) 25,326 12,726 (2,520) 532,742 (29,482) 503,260 8 2024 503,260 5,033 (1,636) 25,163 12,980 (2,437) 529,383 (30,956) 498,427 9 2025 498,427 4,984 (1,620) 24,921 13,240 (2,336) 524,376 (32,504) 491,872 10 2026 491,872 4,919 (1,599) 24,594 13,505 (2,218) 517,568 (34,129) 483,439 11 2027 483,439 4,834 (1,571) 24,172 13,775 (2,079) 508,795 (35,836) 472,959 12 2028 472,959 4,730 (1,537) 23,648 14,050 (1,920) 497,880 (37,627) 460,252 13 2029 460,252 4,603 (1,496) 23,013 14,331 (1,736) 484,635 (39,509) 445,127 14 2030 445,127 4,451 (1,447) 22,256 14,618 (1,528) 468,860 (41,484) 427,376 15 2031 427,376 4,274 (1,389) 21,369 14,910 (1,292) 450,337 (43,558) 406,779 16 2032 406,779 4,068 (1,322) 20,339 15,208 (1,026) 428,837 (45,736) 383,101 17 2033 383,101 3,831 (1,245) 19,155 15,512 (729) 404,113 (48,023) 356,090 18 2034 356,090 3,561 (1,157) 17,805 15,823 (396) 375,902 (50,424) 325,478 19 2035 325,478 3,255 (1,058) 16,274 16,139 (27) 343,922 (52,946) 290,976 20 2036 290,976 2,910 (946) 14,549 16,462 0 307,489 (55,593) 251,896 90,870 (29,533) 454,350 (36,341) (727,451)

Reconciliation A Opening fund 500,000 B Add: Gross income 90,970 D Capital growth 454,350 Combined incoome and growth 545,220 C Less: Income tax (29,533) E Capital gains tax (36,341) Combined taxes (65,873) 979,347 F Less: Total of annual drawdowns on the fund (727,451) G Closing fund at 2036 251,896 Effective overall tax rate: = Total taxation 65,873 12.1% Combined income tax growth 545,220 1. The table is a theoretical illustration based on consistent linear capital growth. In practice stock markets do not work that way. 2. Income and capital gains tax at current rates which will probably change. 3. It is assumed the annual CGT exemption will rise by 2% per annum and will be used each year against share sales. 4. The dividend allowance is assumed to be used elsewhere, but if available would reduce the income tax. Capital gains tax With a maximum rate of 20%, CGT is at one of its lowest rates on quoted shares since 1965. The first 11,300 of an individual s aggregate annual capital gains on all assets is free of CGT. This is the annual CGT exemption. Capital gains above this level are first reduced......by any unused capital losses brought......forward from earlier years. Any excess......capital 11% gain on shares is then taxed...at Average annual 20%. The gain has to be realised,...that growth in IHT is to say the shares have to...... have been sold before the tax... receipts in the...applies. A mere rise in the value......of five years to 31 investments is not taxed because.....until March 2017 the shares are sold no cash......profit has been made. In some cases, such as a gift of shares into a trust or to younger family members, a taxable gain is deemed to be made even though no cash is paid. The annual exemption may be available, but if not the tax rate on the deemed profit is also 20%. Inheritance tax About 4.8bn is collected annually from deceased estates in the UK. There are many tax reliefs that prevent IHT at the 40% standard rate from applying on business interests, agricultural land and woodlands. Every individual has the standard nil-rate band worth 325,000, which together with the new main residence nil-rate band worth 175,000 from April 2020 will go some way to removing the majority of estates from the tax net. HMRC s last complete review, carried out in relation to 2013-14, showed only one in four deceased estates paid the tax. On the other hand, it is a tax that can be expected to grow with house prices and worldwide stock markets generally on the rise. In the five years to 31 March 2017, IHT receipts have grown on average by around 11% a year. Of those estates exposed to IHT, shares contributed 41% of total revenue, followed by houses at 30%. Many investors will use their CGT exemption each year to raise 20,000 from share sales to reinvest the proceeds back into their Isa allowance. This is smart and, providing the original cost price of the shares sold was no less than 8,700, no taxable gain will be made. Taxable shares worth 20,000 are turned into future tax-free investments every year. This is how ISA millionaires are made, given time. Some investors will save and build a portfolio of shares during their working life to use as an alternative to a traditional pension scheme. They may then draw down on that portfolio each year from both real income and capital growth to produce what we call a manufactured income. This can be very tax-efficient. The best way to demonstrate this is by an example (see Table 2).

An investor wishing to mitigate IHT might want to consider the following approaches: 1. Making outright gifts of shares to younger family members...cgt may be payable on a gift to individuals so tax advice may be needed first. 2. Transferring shares to a family trust. It is possible to postpone the payment of CGT when a gift into a trust is made, but there are limits on what may be gifted in this way, typically 325,000 every seven years. Cash can be paid to family members on a flexible basis, but the donor and spouse or civil partner must not receive any benefit while alive, even accidentally. If carried out correctly, the value of a family trust fund is not within the main 40% regime. Instead it pays the tax at 6% every ten years and many trusts simply save for this tax at the rate of 0.6% a year. 3..Investing in shares quoted on the Alternative Investment Market (AIM). One of the largest reliefs from IHT is business property relief. This applies on most forms of trading business interests, but tax law requires the shares to be unquoted. For these purposes, AIM-traded shares are unquoted because that market is not a recognised stock exchange. There is a trap, however, because only those AIM companies that mainly trade will qualify. Companies with the majority of their balance sheet holding investments or whose profits come from investments will not qualify. However, the range of companies is diverse, from software developers, to food producers and pub chains. Many specialist fund managers provide tailored IHT portfolios designed to preserve wealth and protect it from the 40% tax charge. These providers will Frank Nash Partner +44 (0)20 7544 8930 frank.nash@blickrothenberg.com Blick Rothenberg 16 Great Queen Street Covent Garden London WC2B 5AH +44 (0)20 7486 0111 email@blickrothenberg.com also appraise the companies from an investment and tax viewpoint and make sure the IHT rules are complied with. The residential nil rate band and business property relief play key roles in helping families avoid IHT. Size of market According to the Office for National Statistics, as at 31 December 2014 the entire value of quotes shares in the UK registered companies was 1.7 trillion, with approximately 80% of that value in the top 100 companies. Growth in market On 17 May 2012 the FTSE 100 Index stood at 5338 and closed at a near all-time high of 7503 as at 17 May 2017. This represents an annual average compound rise of just over 7%. This is the collective capital growth of the stock market and does not take into account the dividend returns to shareholders over that five year period. First written for Investor s Chronicle. January 2018. Blick Rothenberg Limited. All rights reserved. While we have taken every care to ensure that the information in this publication is correct, it has been prepared for general information purposes only for clients and contacts of Blick Rothenberg and is not intended to amount to advice on which you should rely. Blick Rothenberg Audit LLP is authorised and regulated by the Financial Conduct Authority to carry on investment business and consumer credit related activity. blickrothenberg.com