Tax vehicles. They may not be the most exciting topic in the world but when employed correctly they can be an important tool in your wealth planning strategy, equally, if they’re mismanaged, they can result in unnecessary tax consequences. As an American overseas, if the disparity between tax vehicles on either side of Atlantic is not managed properly the result can be some pretty hefty, unwanted and unnecessary tax bills.
We’ve put together a glossary of terms of the main UK tax vehicles and included the matters for international Americans to bear in mind when using them.
Individual Savings Accounts (ISA)
Tax free saving accounts within the United Kingdom. An ISA provides a tax wrapper for assets to shield the account from both income and capital gains tax. The main types of ISAs are:
- Cash ISAs – Typically offered by high street banks and offer a fixed rate of return on the cash deposits.
- Stocks & Shares ISA – Monies can be invested into various financial instruments, including stocks, gilts, or collective schemes (like Unit or Investment trusts). The maximum contribution for the 20/21 tax year is £20,000.
- Innovative Finance ISA – Allows peer-to-peer lending with the interest received being tax-free.
- Lifetime ISA (LISA) – The aim of a LISA is to encourage saving towards a house deposit with the government offering to contribute 25% (£1,000) of the £4,000 maximum annual investment limit. Alternatively, LISAs can be utilised for retirement saving.
- Junior ISAs (JISAs) – Available for children under the age of 18 years old. The maximum contribution for JISAs is £9,000 for 2020/21. The investment income within JISAs are not taxable for the child or the donor.
A common misconception is Americans cannot invest in ISAs. The following two reasons show how they can be an effective tool for Americans in their tax planning arsenal:
Firstly, the ISA wrapper is viewed as a ‘see through’ by the Internal Revenue Service (IRS), this means for American taxes they will treat an ISA like a regular brokerage account and ignore the tax wrapper part. Therefore, an American taxpayer would still be liable to report and pay tax on the income and gains to the US. As the wrapper provides protection from UK taxation, there is a marginal benefit for interest earnings. To provide a comparison; the US top rate of tax is 37%, compared to the UK’s 45%. This 8% differential can be significant when compounded over many years.
The second reason is not the ISA structure itself, but the underlying investments held within. The IRS has a discriminatory view on non-US funds, classifying them as Passive Foreign Investment Companies (PFICs), and punitively taxing the arising income from such investments. Whilst these UK funds offer great diversification benefits to UK investors, a US person should invest directly in stocks of companies to avoid the potential pitfalls of PFICs.
The most popular scheme is the workplace pension, the UK government recognised there was a lack of retirement saving within the country and employed nudge theory to reduce the burden on the State pension needs and maintain the standard of living. The Nudge theory is a behavioural economics concept which aims to indirectly influence an individual or groups decisions. From 2018, the Government have auto-enrolled all work-aged persons, above the age of 22, into pension schemes.
In essence this means that employers are required to pay a small percentage into their employees’ pension every year, the amount is usually taken as a percentage of earnings, but this can vary.
Self Invested Pension Plan (SIPP)
A Self Invested Pension Plan (SIPP) is a type of pension which allows UK investors to save for retirement and choose your own investments in the process. A SIPP, like most UK pensions, grows tax-free, and tax relief is available on pension contributions at the point of contribution. However, the distributions from a SIPP are taxed at income rates.
- Annual Contributions – An individual can contribute £40,000 in 2020/21 to registered pensions schemes, however this figure may change depending on carry forward allowances or tapering down rules.
- Lifetime allowance for pensions is £1,073,100, which increases with the Consumer Price Index (CPI) each year. If a pension fund exceeds the lifetime allowance at the point of retirement, the excess can be taxed at unfavourable rates.
- How does someone benefit from using a SIPP? As mentioned previously the investments within can grow tax-free within pension pot. At retirement a tax-free lump sum of 25% can be withdrawn from your pension, known as the pension commencement lump sum (PCLS). Another notable benefit of a SIPP is it is not included in one’s estate upon death and out of the scope of UK inheritance tax.
- Can an American benefit from a SIPP? In short, yes. The issue comes around the reporting, generally, a pension scheme is not reportable, nor taxable. However, the IRS guidelines are a little unclear and the SIPP can be viewed as a foreign trust and therefore will need to report to the IRS according.
In order to qualify for a full state pension (almost identical to the US Social Security but we’ll cover that in part 2) you must have paid in 30 years of qualifying national insurance.
This entitles you to a regular payment from the UK government of £137.60 a week. There are a variety of factors that can change this such as gender, marital status and the number of qualifying years. If you are coming up to the state pension age, currently 68, it may be worth considering making voluntary contributions to ensure you receive the maximum amount possible.
Enterprise Investment Schemes (EIS)
These are UK specific schemes aimed at encouraging investment into start-up and early stage businesses by offering favourable tax relief on the initial investment. The different types of EIS and their specific benefits are briefly outlined below:
- Enterprise Investment Scheme (EIS) – An investment of up to £1 million can be made to a qualifying EIS scheme reducing an individual’s income tax liability by 30% on the investment amount, if held for three years (i.e. £1mn invested could attract £300,000 income tax relief in a tax year). If the same investment is held for three years, it can also benefit from a capital gains tax exemption.
- Seed Enterprise Investment Scheme (SEIS) – This scheme is targeted at start-ups and companies in their very early stages. The SEIS scheme allows for a £100,000 investment in any tax year, attracting a 50% relief in income tax. Like the EIS, there is a capital gains exemption if held greater than 3 years and an 50% capital gains exemption on reinvestment.
- Venture Capital Trusts (VCT) – Whilst an EIS investment may be a specific company, a VCT enables an investor to indirectly invest in multiple companies through offering shares, like a unit trust. The maximum investment to VCT in a tax year is £200,000, which can attract 30% tax relief and be free for capital gains tax liability, irrespective of the period it was held for. An additional advantage of a VCT is the dividends are received tax-free, this could have significant advantages for higher or additional rate taxpayers.
Unfortunately, due to the worldwide nature of US taxation the tax incentives offered through these UK schemes cannot be utilised by an American as the various tax reliefs are not reciprocated by the IRS. Whilst the full benefit may not be possible, there may be a marginal tax efficiency due to the differences in income rates between the two countries.
Offshore bond wrappers – are ‘foreign’ life insurance products for the purpose of UK taxation.
Offshore Bonds are based in jurisdictions which do not impose tax on the assets held within the bond, allowing the funds to grow virtually tax free. This tax favourable environment allows the investment to grow at a faster rate and benefit from compounding. An important point to note is these schemes are tax-deferred, rather than tax-free from a UK perspective.
An individual can withdraw 5% of the initial investment annually without attracting an income tax charge until 100% is withdrawn, up to 20 years. However, withdrawals greater than the permitted 5% and the final encashment of an offshore bond is chargeable at the individual’s highest rate of income tax. Nonetheless it is not all negative, the UK offers top slicing relief which allows the investor to spread the bond gains across the number of years held or last excess event period and reduce the income tax liability.
A US citizen should avoid Offshore bond wrappers as they are likely to fall foul of the PFIC regime. Offshore bonds are non-US investments and generally opaque, meaning the IRS cannot see through them, as a result the IRS assume tax evasion/avoidance and charge penal rates and additional charges for investing in such schemes.
Excluded Property Trusts (EPT)
An EPT is generally foreign based trust which is used to exclude assets from an individual’s estate, it’s a great tool given the low UK estate tax allowance of £325,000.
An EPT could be beneficial to a UK resident, who is currently non-domiciled in the UK or prior to become deemed domicile. Domicile is a legal concept for the purpose of UK taxation and describes where a person treats their permanent home, usually derived from their father’s home country. Individuals born outside of the UK are likely to be non-domiciled on their arrival to the UK, however if they remained in the UK for 15 of the last 20 tax years they would become deemed UK domicile and their worldwide assets fall under the scope of UK inheritance tax.
Prior to becoming deemed domicile, an individual may decide to set up an EPT holding ‘excluded property’ outside of the UK. An individual or settlor can contribute to the trust up until the point they become domiciled without attracting a UK tax charge, otherwise known as a Chargeable Lifetime Transfer (CLT). The trust will essentially be a discretionary trust controlled by designated trustees. Through utilising an EPT whilst being non-domiciled the settlor can reduce their estate which is taxable by the UK at their death.
This is particularly beneficial for US persons as their Lifetime gift allowance (currently $11.7m, albeit this is likely to be reduced to pre-2017 levels) is considerably greater than the UK £325,000 nil-rate band. If the trust holds ‘excluded property’, it will be out of the scope of the 40% UK Inheritance tax and has the potential to provide significant saving to a US citizen.
Brokerage accounts or General Investment accounts are the most common platform for an individual to invest in financial markets. These offer no specific tax benefits to either UK or US persons. All income and gains are taxed on the arising basis of taxation by both jurisdictions.
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