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My PFS - Technical news - 21/11/16

Personal Finance Society news update from 8 November to 21 November 2016 on taxation, retirement planning and investments.

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Taxation and Trusts

Investment planning

Pensions

TAXATION AND TRUSTS

The triple lock

(RO4, AF3, JO5, FA2, RO8)

The Work & Pensions Select Committee has joined the chorus of voices against continuation of the triple lock ie. the increase in the State pension every year by the higher of CPI inflation, average earnings and a minimum of 2.5%.

The House of Commons Work & Pensions Select Committee, chaired by Frank Field, published its 3rd report on intergenerational fairness. Unsurprisingly, it sees "an economy skewed towards baby boomers [born 1945-1965] and against millennials [born 1980-2000]." The report quotes the frequently cited statistic that "pensioner household incomes now exceed those of non-pensioners after housing costs", creating a risk of the millennial generation "being the first in modern times to be financially worse off than its predecessors."

The crux of problem is that:

  • The birth rate during the baby boomer generation was between 800,000 and 1,000,000 a year, whereas subsequent generations have seen typically 700,000-800,000. There is thus a greater strain on the post-baby boomer generations to support the retiring baby boomers.
  • The swollen baby boomer generation is also hanging around longer thanks to improved life expectancy. The report notes that 'a boy born in 1955, in the middle of the baby boom, had an 83% chance of living to at least 65, compared with 45% of those born in 1895.' The net result of these two factors is that 'The share of the population aged 65 and over is projected to grow from 18% in 2014 to 24% in 2039, while the proportion 80 and over is expected to grow from 5% to 8% over the same period.'
  • The baby boomer generation was a winner in the housing lottery: 'The opportunities that were open to baby boomers to buy a home with a relatively small deposit are closed to today's young.' Getting onto the housing ladder early helped the baby boomers to build up wealth. 

The report's main proposal is that triple lock increases to the basic and single tier state pension should be abandoned when the current commitment to maintain it expires in 2020. Retaining the lock 'would… tend to lead to state pension expenditure accounting for an ever greater share of national income. At a time when public finances are still fragile, this is unsustainable.' The option of accelerating state pension age increases as an alternative to removing the lock is dismissed because it 'would disproportionately affect the young and those socio-economic groups with lower life expectancies in retirement,' a point which echoes concerns raised in John Cridland's SPA review for the DWP.

The report suggest that the triple lock should be replaced by a "smoothed earnings link". Under this mechanism the 2020 state pension would set the base and increases would normally be linked to earnings. In periods when earnings increases lagged behind price inflation, an above-earnings increase would be applied. Then, when real earnings growth resumed, (CPI) price indexation would continue until the state pension reverts to its 2020 benchmark as a proportion of average earnings.

Based on the estimate in the most recent Fiscal Sustainability Report from the Office for Budget Responsibility (OBR), the long term effect of reverting to an earnings link would be that state pensions rose by about 0.4% a year less than they would under the triple lock. That may not sound a great deal, but its cumulative effect is significant:  the OBR estimated that the annual cost of the triple lock relative to earnings uprating will be an additional 1.3% of GDP by 2064/65.

The report is also critical of universal pensioner benefits, such as the Winter Fuel Payment (cost about £2bn a year) and free TV licences for the over-75s. The report states such benefits 'have been deployed by successive governments for reasons of short term expediency. Such measures, which do not tend to be subject to indexation, lead to ill-targeted support, further complicate the benefits system and are politically and administratively far harder to put right than to introduce in the first place… They should …not be off limits when spending priorities are set in future Parliaments.'

There is growing pressure to remove the triple lock when it reaches its currently scheduled expiry date in 2020. However, as that year will see the next general election - assuming no Article 50 snap election - politicians must be prepared to anger the (baby boomer) grey vote and face the inevitable pension-snatcher headlines.

HMRC publishes detailed guidance on the residence nil rate band

(AF1, RO3)

HMRC has published detailed guidance on the residence nil rate band which is due to come into effect for deaths occurring on or after 6 April 2017. The guidance is supplemented by a series of  case studies that show how the new rules will work in a number of specific, less straightforward situations such as where the home is left to a trust, where the estate exceeds the £2 million taper threshold and where the deceased has downsized or disposed of their property  before their death.

The guidance confirms a number of important points such as the fact that RNRB (or combined RNRB in the case of second death claims) is set against the value of the estate first with the existing NRB (and any transferred NRB) then set against the remaining value of the estate; and that a non-UK domicile can benefit from RNRB if they have a UK property within the scope of IHT that they have at some point occupied as their home. However, the most complicated aspect of the new rules is undoubtedly the calculation of the downsizing addition and this is where the guidance will be most useful.

Downsizing addition will be available where a deceased has disposed of a former home that would have been eligible for RNRB had it been owned at the date of death, and either downsized to a less valuable home, or ceased to own a home, on or after 8 July 2015. The amount of the downsizing addition will generally be equal to the RNRB that has been lost as a result of the disposal.  However, the position will not always be this straightforward as the actual amount of 'lost RNRB' must be calculated in percentage terms in accordance with a fairly involved formula.

In a downsizing situation, the addition will generally be equal to the difference between the RNRB that would have been available at the date of death if a house equivalent in value to the former residence formed part of the estate, andthe RNRB that is actually available at the date of death by virtue of the downsize. The guidance makes it clear that:

  • For the purposes of the calculation, the RNRB that would have been available if the disposal of the former home had not taken place, is made up of the maximum RNRB due at the date of disposal and any transferred RNRB which is available atthe date of death
  • Neither the RNRB nor the downsizing addition will be available unless the new, lower value residence is closely inherited;
  • The actual amount of the downsizing addition depends on the value of other assets that are left to direct descendants (or their spouses); and
  • Where a person's right to occupy a home held in a trust ceases, for example on re-marriage, this is also treated as a disposal for the purposes of the downsizing rules.

These points may be best illustrated by examples

Example 1 - downsize - no transferred RNRB

Jeremy, a divorcé, downsizes from a large house worth £500,000 to a small flat in May 2018 when the RNRB is £125,000. He dies in September 2020, when the RNRB is £175,000, leaving the flat (worth £105,000) to his son, and the rest of his estate worth £50,000 to his 2 daughters. The RNRB available would be calculated in accordance with the following steps:

  1. Express value of former home as a percentage of RNRB at date of disposal (i.e. £500,000/£125,000) = 400%. Note that where this is more than 100% this is limited to 100%.
  2. Express value of new residence as a percentage of RNRB at date of death (i.e. £105,000/£175,000) = 60%
  3. Calculate difference between percentages at steps 1 and 2 (i.e. 100% - 60%) = 40%
  4. Multiply RNRB at date of death by % at step 3 to give total lost RNRB (i.e. £175,000 x 40%) = £70,000

Jeremy's estate will benefit from RNRB of £105,000 (as this is the value of the residence that is being closely inherited); plus downsizing addition of £50,000. Although the maximum downsizing addition available is £70,000, this is restricted to the value of other assets being closely inherited, giving a total RNRB of £155,000 (£105,000 + £50,000).

Example 2 - disposal - transferred RNRB

Elizabeth sold her home for £285,000 in October 2019 to go into residential care. The maximum RNRB in the tax year 2018 to 2019 is £150,000.

She dies in March 2021 when the maximum RNRB is £175,000. As Elizabeth inherited her husband's entire estate on his death in September 2017, Elizabeth's estate will be entitled to transferred RNRB of £175,000.

The RNRB to be used in Step 1 of the calculation is the maximum RNRB at the date of the disposal plus the transferred RNRB to which the estate isactuallyentitled at the date of death i.e. £150,000 + £175,000 = £325,000.

Where RNRB has been lost as a result of a disposal (so that there is no residence in the estate at the date of death), the calculation of the lost RNRB is simplified because the percentage at step 2 will always be 0% and the result at step 3 will always be the same as the figure at step 1. This means that steps 2 and 3 can be missed out and the downsizing addition will be equal to the lost RNRB (provided other assets equivalent in value to that amount are left to direct descendants). Putting the figures into the calculation will help illustrate this:

  1. £285,000/£325,000 = 88%
  2. £0/£350,000 = 0%
  3. Difference between 0% and 88% = 88%
  4. 88% x RNRB available at date of death = 88% x £350,000 = £308,000

The 'lost RNRB' is therefore £308,000.  However, the actual amount of the downsizing addition is the lower of the value of other assets left to a direct descendant and the lost RNRB. Provided therefore that Elizabeth leaves other assets worth at least £308,000 to her children, her estate will benefit from a downsizing addition of that amount, otherwise it will be restricted accordingly. Of course, Elizabeth's estate will also benefit from a standard nil rate band of £650,000 giving her a potential total NRB of £958,000.

The new rules - and the downsizing rules in particular - are extremely complicated and this is acknowledged by HMRC who reiterate the importance of professional legal advice throughout the guidance note.

One aspect of the new rules that is still not completely clear is how entitlement to the RNRB will be 'policed' - for example, what information and evidence personal representatives (PRs) will need to provide to satisfy HMRC that an estate should be entitled to downsizing addition or, indeed, RNRB itself. In this regard, the guidance simply confirms thatthe PRs will need to provide 'details of the amount due and supporting information on the IHT return following the death'. Record keeping will therefore be essential - particularly where a downsizing move or disposal occurs.

Further details will no doubt emerge over the next few months. In the meantime, the latest guidance and case studies will be a valuable resource for those trying to get to grips with the fundamentals of the new rules in advance of implementation next year.

IHT scheme involving settlement of reversionary interest in offshore trust held to be successful

(AF1, RO3)

The First-tier Tribunal have held that the transfer of a reversionary interest in an offshore trust that was settled by a non-UK domiciled individual was not a transfer of value for IHT purposes despite arguments that the scheme should be looked through because it served no commercial purpose other than to avoid tax (M L Salinger and J L Kirby v HMRC [2016] UKFTT 677).

The facts of the case are as follows. Mr Salinger had entered into a tax planning arrangement to reduce the amount of IHT payable on his death. The arrangement involved the transfer of a reversionary interest in an Isle of Man trust (apparently for no consideration) to the Salinger Family Trust ('the DSFT'). He died in February 2011.

The questions for consideration by the Tribunal were:

  • Whether the reversionary interest acquired by Mr Salinger was excluded property (or whether the interest had, in fact, been acquired for consideration and so was not); and
  • Whether Mr Salinger had made a transfer of value when his reversionary interest was transferred to his family trust subsequent to him purchasing an option to acquire the income interest in the same offshore trust in which he held the reversion, but before actually exercising it.

The Appellants' case was that the reversionary interest was excluded property because no consideration was given for its acquisition.  Further, in any event there had been no transfer of value when it was transferred to the DSFT due to it being essentially worthless at that time.

By contrast HMRC contended that whilst direct consideration had not been given, consideration had been indirectly given (because realistically the irrevocable acquisition of the reversionary interest was part of a composite series of transactions for which money was paid). Furthermore, Mr Salinger had made a transfer of value of £820,000 when he transferred his reversionary interest to the DSFT.

While the Tribunal agreed with HMRC that the reversionary interest had been acquired as part of a package for which Mr Salinger had paid £890,000 (the rest of the 'package' consisting of an option that, if exercised, would give Mr Salinger the rights to the income under the trust, thereby ultimately ensuring that his entitlement could not be defeated) and so was not excluded property; it held that its later transfer to the DSFT caused no loss to Mr Salinger's estate and so was not a transfer of value. The Tribunal dismissed HMRC's argument that by transferring the reversionary interest to the trust before he exercised an earlier-acquired option to purchase the income interest under the same trust - thereby deliberately blocking the possibility thatSaunders v Vautiermight apply - Mr Salinger omitted to do something he could easily have done resulting in him making a disposition of the total value of the trust fund.

This type of scheme has now been blocked by legislation introduced in Finance Act 2012 which ensures that any reduction in the value of a person's estate as a result of the acquisition of an interest in settled property in an excluded property trust is charged to inheritance tax (IHTA 1984, s74A-C). However, the arguments based on the failure of a beneficiary to exercise a power to bring a trust to an end have not been made before, and the decision that such an omission cannot be a disposition for inheritance tax (other than in specific circumstances laid down in statute) is useful confirmation of the point.

INVESTMENT PLANNING

The October inflation numbers

(RO2, AF4, FA7, LP2)

After four months in which CPI inflation rose from 0.3% to 1.0%, this month's inflation story took a different direction, with annual inflation dropping by 0.1% to 0.9%. Market expectations had been that the October inflation numbers would be 0.2% up on September's, so there was some surprise that the figure moved in the opposite direction.

The CPI showed prices up 0.1% over the month, the same as between September and October 2015. Thus, rounding has once again played its part in determining the final number. The CPI/RPI gap widened by 0.1% over the month, with the RPI flat on an annual basis at 2.0%. Over the month, the RPI was flat.

Aside from rounding, the fall in the CPI annual rate was due to two main "upward contributions" being offset by four main "downward contributions", according to the ONS:

Upward

Transport:The upward contribution came largely from motor fuels, with prices rising by 2.3% between September and October 2016, partly due to the depreciation of sterling against the dollar. Over the same period last year, fuel prices fell by 0.9%.

Furniture, household equipment and maintenance:Overall prices increased by 0.5% between September and October 2016, compared with a fall of 1.0% a year ago. This increase follows a period of unusually low prices between June and September, when a relatively high proportion of items were on sale compared with recent years.

Downward

Clothing and footwear:The downward effect came mainly from garments, for which prices rose by 0.2% between September and October 2016, compared with a rise of 2.3% a year earlier. However, this followed a relatively large increase in prices in September 2016, which resulted in an upward contribution to the change in the rate of a similar magnitude to the downward effect seen this month.

Recreation and culture:Overall prices increased by 0.2% between September and October 2016, compared with an increase of 0.8% a year ago.

Education: Overall charges rose by 2.0% between September and October this year compared with a rise of 3.6% between the same two months a year ago. The downward contribution came principally from UK and EU student tuition fees, where the impact from the rise in the cap for tuition fees was smaller this year than in 2015 because nearly all students are already paying the higher rate of fees whereas last year the fees for fourth year courses rose to the higher rates.

Restaurants and hotels: Overall prices fell by 0.1% between September and October 2016, having risen by 0.1% a year earlier. The ONS notes that prices for overnight hotel stays have been volatile in recent months.

Food and non-alcoholic beverages: Overall, this group made a small downward contribution to the rate, with the most pronounced effect from non-alcoholic beverages, which saw prices falling by 3.2% between September and October 2016, having been unchanged between the same two months a year ago.

Core CPI inflation (CPI excluding energy, food, alcohol and tobacco) was down 0.3% at an annual 1.2%. Three of twelve index components are now in negative annual territory, one more than last month. Goods inflation rose by 0.1%, but remained negative at -0.4%, while services inflation decreased by 0.2% from September to +2.4%.

While the CPI figures took an unexpected turn, the story on the producer price side was much as expected. Factory gate prices (output prices) for goods produced by UK manufacturers rose 2.1% in the year to October 2016, compared with a rise of 1.3% in the year to September 2016. The overall price of materials and fuels bought by UK manufacturers for processing (total input prices) rose 12.2% in the year to October 2016, compared with a rise of 7.3% in the year to September 2016. Between September and October, total input prices rose by a record 4.6%, compared with an increase of 0.1% the previous month.

These numbers suggest that the October dip in the CPI will soon be reversed.

PENSIONS

Should you top up?

(RO4, AF3, JO5, FA2, RO8)

If, as part of a financial planning exercise, a shortfall in state pension entitlement is discovered, should you top up?

To answer this question you will have worked out the following for your client:

  • The current accrued Single-tier State Pension (StSP)
  • The shortfall, if any, that needs to be made up
  • How many potential qualifying years there are from now to SPA
  • How many more qualifying years the client is likely to achieve from work or personal circumstances.

The answers to these will allow you to decide if there is a potential shortfall to be made up.

If there is a shortfall that needs to be made up, there are two options:

  • If there are likely to be tax years in the future where the client will not achieve a qualifying year because of insufficient earnings or Credits, then in those years, it is possible to pay Voluntary or Class 3 NICs.
  • If there are historic gaps in a client's NI record, it may be possible to pay Voluntary or Class 3 NICs as a one-off lump sum to make up any shortfall.

If a client has the option to make Voluntary Class 3 for future years and to pay them in respect of earlier years, the DWP will be able to provide a quotation for the cost of back-filling each available year individually. A decision can be made which year(s) it is most cost-effective to pay one or more one-off contributions to, based upon the DWP quote.

It is worth noting the following:

If there are eight tax years between the current tax year and 5 April prior to the client's birthday immediately prior to their SPA, it is only possible to pay Class 3 Voluntary Contributions to secure eight qualifying years. If additional qualifying years are needed, the only option will be to explore the potential for making contributions to back-fill any missing years.

Generally, it is only possible to fill historic gaps in qualifying years in respect of the previous six tax years. So, the deadline for the 2010/11 tax year is 5 April 2017.

The exception to the six-year cut off applies to males born after 5 April 1951 or females born after 5 April 1953 who have until 5 April 2023 to pay voluntary contributions to make up for gaps between April 2006 and April 2016. A discount is available if these contributions are paid on or before 5 April 2019.

Be aware if a client has got one or more historic gap years that can be filled, filling them now may be a waste of money if they achieve sufficient qualifying years in the future, but equally if the future anticipated qualifying years are not achieved for whatever reason, it may then be too late to make the Voluntary or Class 3 NICs for those historic years.

Lastly and probably most important of all, jointly with the client look back at any historic gaps in their qualifying years to ensure they were not entitled to NI Credits for any of those years. It is also always a possibility, albeit a remote one, that the DWP's records are not 100% accurate.

Are Class 3 NICs Good "Value for Money"?

The short answer is; "probably, yes"!

A payment of £14.10 p.w. will secure, in today's terms an indexed linked pension of £4.44 per week, but remember there is no spouse's pension under the StSP. Whilst this cost is paid out of taxed income, it is almost certainly a better return than making similar level of contributions to a PPP.

However, it is important to consider some of the drawbacks with the StSP, the main ones are:

The pension ceases on the individual's death.

If they retire abroad, residents of many jurisdictions do not receive any indexation of their State Pension.

Whilst indexation applies with residents of EU Member States, will that still be the case post-Brexit?

IFS Report on the latest AE data

(RO4, AF3, JO5, FA2, RO8)

The Institute of Fiscal Studies (IFS) has published new research on the results of automatic enrolment (AE) drawing on data from the Annual Survey of Hours and Earnings (ASHE) produced by the Office for National Statistics. The ASHE covers a 1% sample of employees in Britain, so it gives a good view of what is going on. The IFS highlighted the following findings (based on April 2015 data):

The impact of AE is estimated to have increased the proportion of eligible employees participating in a workplace pension by almost 37%. This means that for employers with 58 or more employees in April 2015, 88% had pension membership. Pre-AE the corresponding figure was 49%.

The biggest boost given by AE was among:

  • those aged 22 to 29;
  • those earning between £10,000 and £17,000 per year; and
  • those who have been with their current employer for less than a year.

For each of these groups, for whom pre-AE pension coverage was very low, AE increased membership rates by over 50% percentage points. In 2015 coverage among all of these groups had risen to over 80%.

To date most of those captured by AE have only low levels of contributions. There has been a 24% increase in the proportion of eligible employees who have contributions around the current AE 2% of qualifying earnings level.

AE has also raised the numbers of employees contributing much more than the current minimum amount into a workplace pension. The proportion placing 5% or more of their total earnings into a workplace pension has increased by 7% percentage points. The IFS believes that this appears to be a positive decision by employees and not simply the result of employers setting up 8% total contribution rates today, rather than waiting for the contribution minimum to reach that level in April 2019.

AE has more than doubled membership of workplace pensions among those not directly targeted, such as employees aged under 22 or over SPA and those earning less than £10,000 per year. Automatic enrolment increased pension membership rates across the excluded groups by 18%, with the largest effect (+28%) among those earning under £10,000 per year.

The IFS estimates that in April 2015 a total of £2.5bn a year more was saved in workplace pensions as a result of AE.

The IFS notes that "The story of automatic enrolment is certainly a case of so far so good." However, it also says that looking forward "A key issue is whether those brought into workplace pensions at low contribution rates will remain in when minimum contribution rates start rising."

It's important that planners keep up to date with current opinion about the success of AE so far and how much there is still left to do in terms of financial education of the savers.

Transitional Protection update

(RO4, AF3, JO5, FA2, RO8)

HMRC has recently updated its gov.uk page explaining how to make an election for individual protection 2014 or 2016 (IP14 or IP16) and fixed protection 2016 (FP16).

As well as being a useful summary of the rules, and which elections you can have and still apply for FP16 or IP14/IP16, it also explains:

In the case of an election for IP14 where there is also an election for FP16 it will be dormant and IP14 will be open. For all other protections, IP14 will be dormant until the earlier protection is lost or revoked. However, the page reminds readers it is necessary to inform HMRC in writing if either of these events occur.

IP16 will remain dormant if you have any other form of transitional protection, unless or until you write to HMRC to revoke the earlier election, or until you invalidate an earlier election.

FP16 will remain dormant if whilst there is a valid election in place for IP14

The page goes on to explain the different ways in which individuals can inform HMRC of a loss of protection. In many cases (where the protection is set out on a paper certificate) this needs to be done in writing, but in cases where there is only an electronic reference number, it is also possible to inform HMRC by e-mail.

It's well worthwhile bookmarking the relevant page on gov.uk as it is regularly updated and saves time!

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