The 50% tax rate for earners over £150,000 and the restriction of personal allowances for earners over £100,000 took effect from April 2010, and next year, National Insurance rates are due to increase by 1% across the board. The marginal tax rate for employment and self-employment earnings between £100,000 and around £113,000 will then be an eye-watering 62%.

Also from April 2011, pension relief will be restricted for earners over £150,000, with relief limited to just 20% for earners over £180,000. However, for earners over £130,000 ‘anti-forestalling’ rules are in effect now to prevent you making the most of the full tax relief while it lasts. These impose a 20% tax charge on pension payments that are in excess of your previous ‘regular’ payments, where your total pension payments in the year exceed £20,000 (or in some cases £30,000).

This adds up to a significantly increased tax burden for many higher earners, and the way the pension relief is restricted could mean that a modest pay rise is almost entirely swallowed up by additional tax charges of one kind of another. For example, an individual earning £165,000 who makes a pension contribution of £40,000 will have their pension relief restricted to 35% (£14,000) under the new rules. If their annual earnings increased by just £10,000, their pension relief would be restricted to 25% (£10,000). The additional earnings themselves will be subject to income tax and national insurance of £5,200, with the result that from a pay rise of £10,000 the individual would receive only an extra £800 in his pocket.

Some more straightforward planning ideas to consider:

• Invest for capital gains rather than income. At the time of writing capital gains tax is still at 18%, a differential of 32% from the top rate of income tax, although indications are that this is unlikely to last. (However be aware that gains on life insurance bonds and certain offshore funds are taxed as income.)
• Make the maximum £20,000 (or if applicable, £30,000) pension contribution this tax year to maximise the full tax relief available now.

Tax reliefs through VCTs and EISs

Generous tax reliefs can be obtained by investing in Enterprise Investment Schemes (EIS) or Venture Capital Trusts (VCT). These are schemes promoted by the government to encourage investment in small and growing UK companies. The income tax relief available to investors in VCTs is 30% of the amount invested up to a maximum investment of £200,000 per year, and for EISs it is 20% income tax relief up to an investment of £500,000 per year, so that an investment of £100,000 can generate £30,000 and £20,000 of tax savings respectively. There is a minimum holding period however, of three years for EISs and five years for VCTs to avoid a claw back of the relief, but after this period the proceeds can be reinvested to obtain another 20% or 30% tax relief.

EIS investors can also obtain a deferral of capital gains arising in the last three years or the following single year. Any capital gains tax suffered is repaid and the gain only becomes taxable again when the EIS investment is sold, but can be deferred again by further EIS investments. In this way the gain could be deferred indefinitely (with further income tax relief with each reinvestment, subject to the minimum holding periods), and if the EIS is held at death, the gain is not taxable at all.
This ability to defer gains becomes particularly interesting where capital gains tax has been suffered at 40% in the last three years. This tax can be recouped, and when the gain becomes taxable again after the EIS is sold, the applicable rate is the capital gains tax rate at the time (it is currently 18%).

In general, the downside to EIS and VCT investments has been the investment risk inherent in investing in smaller growing companies. However, some providers are offering EIS funds and VCTs which are designed to protect your capital. In this case the return is the tax relief obtained. Tax relief of 20% on an EIS held for the minimum three years equates to an annual return of 7.72% net, and tax relief of 30% on a VCT held for five years equates to 7.39% net. Because these are net returns, a 50% tax payer would otherwise need to find a return of double this amount to match this.

EBTs and EFRBS

For those with companies, Employee Benefit Trusts (EBTs) and Employer Funded Retirement Benefit Schemes (EFRBS) can be used to extract corporate profits tax-efficiently. The trustees can invest the funds on behalf of the beneficiaries and even make loans to them. The loans themselves are not taxable while allowing use of the funds. There are versions that are designed to allow the company a tax deduction on its contributions to the EBT or EFRBS, although HMRC have stated that they do not think they work.

Film partnerships

These are still an investment opportunity that can offer tax benefits, although the ‘active trader’ rule now requires investors to spend an average of ten hours a week involved in the business before tax relief can be obtained. Various other trading-type structures have been developed, however, which are designed to fall outside this requirement.

Offshore life insurance policies

These ‘life bonds’ can be used to hold investments, and shelter them from income tax and capital gains tax. For this reason they are often described as ‘tax wrappers’. The investments can be bought and sold within the wrapper and the profits accumulated and reinvested free of tax, although any gain when proceeds are withdrawn are subject to income tax. However, offshore bonds come into their own if you become non-UK resident before cashing them in, in which case the proceeds are tax free; and because they are subject to income tax, you don’t need to be non-resident for five years or more as you would to avoid capital gains tax, and as little as one year away could do.

The future?

Given the current economic situation we may be unlikely to see a reduction in the top rate of income tax from 50% for some years to come, and indeed a further increase would not be out of the question. Higher earners will therefore be understandably keen to explore ways in which the effects of these changes can be mitigated, whether through the rearrangement of their affairs or investment strategies, or through the use of a legitimate tax planning measure along the lines of those described above.