Keiron Root assesses what the recent Budget means for investors.

Prior to his Budget speech, there was general agreement among tax specialists and investment professionals alike that Chancellor Darling had a delicate balancing act to perform – to try to stimulate the economy and ease the pressure on hard-pressed voters while, at the same time, trying to raise money to cover the growing public debt. In the days following the 2009 Budget, the consensus was that he hadn’t been too successful at keeping his balance.

Looking at the broader picture, John Redwood, chairman of Evercore Pan-Asset, suggests that ‘Investors and companies will fear more tax increases, and will understand the cruel logic of compound arithmetic as more debt is issued and more interest falls due. The Budget confirms our view that investors are better off investing in equities elsewhere, and that government debt is no longer attractive.’

He adds, ‘The tax increases on higher earners and upon higher rate contributions to pension funds make the UK a less attractive place for entrepreneurs and new businesses. A favourable regime for such activities, which was in place with a ten per cent capital gains tax and 40 per cent income tax, has been made much less competitive by the increases to 18 per cent and 50 per cent respectively. There are now larger incentives for portfolio investors to make gains rather than drawing income, to the extent that tax law allows.’

Limiting reliefs
Indeed, the emphasis of the Budget proposals as they affect savers and investors, is mainly on giving higher earners less incentives via the tax system. As Graeme Clark, head of private clients at Courtiers Investment Services, observes, ‘Reducing the fiscal deficit inevitably involves higher taxes, and high earners look as though they will bear the brunt of the cost. As expected, a new higher rate of income tax was announced, with a 50 per cent rate applying to income over £150,000 from April 2010. For these high earners, there is also a new rate of 42.5 per cent for dividend income. The new 50 per cent rate is five per cent higher and being introduced one year earlier than the proposal announced in last November’s Pre-Budget Report.’

Given the economic pressures that have been building up over the past 12 months, it is perhaps unsurprising that the chancellor has moved the goalposts. Graeme Clark points out that ‘From April 2010, there will also be a claw-back of the personal income tax allowance for those with incomes over £100,000. Again, this is an amendment to the proposals outlined by the chancellor last November, when the withdrawal of the personal allowance for earners over £100,000 was to be phased in by a two-stage process. The personal allowance will be reduced at a rate of £1 for every £2 earned over £100,000 until completely withdrawn, meaning that once your income exceeds £112,950, based on this year’s personal allowance, you pay tax on all your income.’

He adds, ‘The withdrawal of the personal allowance (above £100,000) creates an effective highest marginal rate of income tax of 60 per cent for those with income between £100,000 and £112,950. Not only are incomes above £100,000 taxed at 40 per cent, there is also a tax in moving income from zero per cent, i.e. the personal allowance, to the 40 per cent band at a rate of one in two, creating an additional 20 per cent tax rate, i.e. 1/2 x 40 per cent, on top.’

Pensions bear the brunt
Clark suggests that ‘For anyone earning just over £100,000, the new personal allowance claw-back will create a powerful incentive to sacrifice income in exchange for pension contributions from their employers. Unfortunately, salary sacrifice cannot be the answer for earners over £150,000, who will see restrictions on tax relief on pension contributions after April 2011.

‘From a level of income of £150,000, the value of tax relief will be tapered down until it is 20 per cent, the same relief as for basic rate payers, for those with incomes over £180,000. There are further restrictions on contributions made prior to April 2011 to prevent individuals bolstering their pension funds, and the message is really to get as much as you can into your pension for the next two years and then see where the land lies.’

Indeed, the change to the pension rules is likely to have a major impact on the financial planning of higher earners. John Richardson, head of technical planning at Towry Law, feels that ‘These new rules are complex and there is a real danger than many people will not understand them. Anyone with annual income over £100,000 should take pension advice as a matter of priority. For example, some of these people may be able to benefit from effective tax relief of 60 per cent when making a pension contribution.’

He adds, ‘While the government has said that 2011 is when pension tax relief could be restricted, it has also introduced new rules that are designed to prevent effective tax planning ahead of this start date. So the wrong decisions made now will have an adverse effect on retirement planning. In many cases, it is not clear whether people are affected by the new rules. So, as a first step, high earners need to find out whether the new rules apply to them and if existing pension arrangements are protected.’

Wider consequences
George Bull, head of tax at accountant Baker Tilly, argues that the pension reforms will hit owner-managed businesses and professional practices especially hard. ‘It is now clear that the Budget proposal to restrict higher rate tax relief for pension contributions is ill-considered. The “anti-forestalling” provisions will not give the protection needed by owner-managers and professionals who are not trying to flout the new rules.’

He adds, ‘It was announced that people making “regular payments” into an existing arrangement would be allowed to continue to do so in 2009/10 and 2010/11. If change was unavoidable, then this transition seemed reasonable. However, HMRC has confirmed that it will be applying the transitional rules in a way that some are describing as “harsh” or “bizarre”.’

Bull says, ‘Context is everything, and we must remember that on “A Day”, just three years ago, a new, heavily consulted pensions regime was introduced. This was designed, among other things, to allow all pension provisions for an individual to be governed by a single regime, with the rules governing the contributor’s “pension pot” as a whole. The Budget proposal threatens to destroy that principle. Under the anti-forestalling provisions, every pension contract is treated as a separate arrangement, and HMRC says it will look at each arrangement separately.’

Sting in the ISA tail
There were some more helpful proposals, although even these seem to have been bungled. Graeme Clark notes that ‘The government has recognised that, with interest rates so poor and with ISA limits having remained pretty much unchanged for the past decade, there needs to be an incentive to save. This is reflected in the increase in annual ISA limits for the over 50s to £10,200 (£5,100 of which can be in cash) with effect from 6 October this year. The limits will be increased for the under 50s from the start of the 2010-11 tax year.’

As to exactly why Mr Darling has proposed this temporary age discrimination for ISA allowances, no-one is entirely sure. Charlotte Black, director of corporate affairs at stockbroker Brewin Dolphin, says, ‘While we welcome the extension of ISA thresholds, which have at last caught up with inflation, limiting the saving to the over 50s for the first six-month period will cost the industry dearly.’

She adds, ‘Implementing a two-tier approach, whereby investors aged 50 or over will benefit from a gain in tax-favoured allowance from October, but younger investors will have to wait until April 2010, will incur massive implementation costs for ISA managers. Balanced against the hundreds of thousands it will cost the industry, the six-month tax benefit to investors in the over-50 bracket will be minimal.’

And there was a further sting in the tail for ISA investors. Paul Feeney, head of international distribution at BNY Mellon Asset Management, points out that ‘The long-awaited increase in the ISA allowance is welcome news and, if anything, was slightly higher than the industry was expecting. Unfortunately, this will be more than offset by the reduction in the tax relief that higher rate tax payers receive, down from 40 per cent at present to 20 per cent from April 2011.’

He adds, ‘This is particularly onerous given that, at the same time, the chancellor is raising the marginal tax rate for these individuals from 40 per cent at present to 50 per cent from April 2010. That’s a 25 per cent increase in the marginal tax rate at the same time as a 50 per cent reduction in tax relief on their pension contributions. For higher rate taxpayers, the message is very clear. You have until April 2011 to sort out your pension – after that you won’t have the money to do it with or the tax incentive to try.’