How to Avoid Paying More Tax than you need to

Please note – “Tax Evasion” is illegal, but “Tax Planning” uses legal strategies to reduce your tax burden.

What is Tax Planning?

Tax planning is a systematic evaluation of finances and investments, to reduce the tax burden in a legitimate and legal way. It involves understanding the tax implications of various cash inflows and outflows such as salary composition, property income, home loan, investments, sale or purchase of assets, gifts and interest-bearing deposits, to draw up an appropriate investment strategy that allows realisation of financial goals while at the same time reducing tax liability to a minimum.

Approaches

The two basic approaches of tax planning are

1. Reducing taxable income
2. Deferring payment of taxes to the extent possible

As a rule, the higher the income or profit, the higher the tax liability on such income or profit. Gross income is the total profits or income from all sources, and taxable income is such gross income less adjustments allowable under various tax laws and other provisions. Such adjustments are based on the nature of income and expenditure. Opting for the income or expenditure headings that allow maximum set-offs from gross income reduces taxable income, and by extension tax liability.

An often underestimated dimension of tax planning is timing investments and financial transactions so that the tax liability for such transactions arises at the farthest possible time. While this does not reduce the amount of tax payable, it delays tax outgoings, thereby effectively providing interest-free cash on hand. Individuals may not need to resort to such a strategy, but delayed pay-out is valuable for small businesses that very often face cash flow difficulties.

Tax Planning Benefits

The obvious benefit of tax planning is reduced tax liabilities, which by extension means the individual or the company retains more money for their own needs.

Businesses reducing their tax liability through tax planning can provide better returns to their investors and better wages to their employees. They can also spend the money otherwise payable as tax to increase working capital and thereby improve performance efficiency, or spend more on capital expansion and thereby expand market share.

Individuals applying tax planning will have more disposable income in their hands. Very often tax planning provides individuals with money to spend for their personal benefit or enjoyment, and failure to apply tax planning may lead to such money paid as tax.

Tax planning also provides the indirect benefit of allowing a sound control over your finances. It provides a valuable road-map to plan finances in the most optimal manner. It allows streamlining cash outflows, making planned expenditure, and committing to an informed investment decision.

The Tax Planning Process

Tax planning is much more than simply opting for the investment or financial route that offers the maximum tax breaks. It also does not entail making unnecessary expenditure or needless investment solely for reducing taxes.

Good tax planning remains integrated and interlinked to a wider exercise that brings stability to financial goals. Apart from ensuring lower-than-normal tax outgoings, the exercise requires considering other factors such as liquidity of investments, risk appetite, and the returns from investments after factoring in inflation.

The basic process of tax planning involves

1. Preparing financial goals
2. Estimating tax liabilities on existing income and investments, and possible liabilities on additional investments or expenditures to realise financial goals
3. Acquiring a good understanding of all available tax exemptions, deductions, rebates and allowances
4. Selecting the best investment or expenditure routes that provide the most tax breaks but still fulfil the stated financial goals and fit in with your investment tastes and attitudes

The process requires planning for various taxes, such as income tax, capital gains tax, corporate tax, inheritance tax and offshore tax separately.

Income Tax Planning

Income tax is tax on an individual’s income, and depends on the income level. In the United Kingdom, the basic rate is 20 percent of an individual’s taxable income and the peak rate is 50 percent of taxable income.

Understanding the various exemptions or set-offs to gross income available allows making the necessary financial transactions to enjoy such set-offs. The most popular exemptions are contributions to certain charities, and pension contributions.

The biggest applicability of income tax planning is for the self-employed and owners or directors of businesses. The law allows making set-offs of allowable expenses from gross business income. Some such allowable expenses are business mileage or fuel when using your own vehicle or a company car for business purposes, professional fees and subscriptions, tools and specialist clothing, purchase of certain capital machinery and more. People working from home may claim set off for some household expense and travelling costs.

Capital Gains Tax Planning

Any individual or entity attracts capital gains tax when they make profit from the sale of assets such as stocks, gold and jewellery, property, and other items outside the scope of normal business inventory. The capital gains tax rate in the UK ranges from 18 percent to 28 percent of the profit beyond a fixed threshold value.

As in the case of other taxes, the law allows exemptions, or deducting some amounts from the capital gain before calculating the profits eligible for tax. For instance, sale of principle private residence, investment in selected start-up ventures and profits from gilt funds are exempt from capital gains tax. Profit from companies where the individual owns 5 percent or more shares for a minimum of one year attracts a special 10 percent capital gains tax rather than the standard 18 or 28 percent tax. The law also allows set off of any capital losses from capital gains.

Corporate Tax Planning

Corporate tax or Corporation tax is tax payable on the profits made by companies, and on profits of permanent establishments of non-UK resident companies and associations that trade in the EU.

Corporation tax in the UK starts from a rate of 10 percent and extends to a maximum of 30 percent, depending on the profit amount. Like all tax, corporate tax is on “taxable profits” or “chargeable gains” rather than gross profits. In the UK, the calculation of such “chargeable gains” is on similar lines to capital gains tax, but without the relief applicable to individuals. However, companies can instead claim an indexation allowance to offset the effect of inflation.

Inheritance Tax Planning

Inheritance tax applies to “transfers of value” or estates of deceased persons, gifts made within seven years of death, and transfers into certain types of trust.

The tax rate is 40 percent and the threshold value for this tax is £325,000 in 2011-12. The law, as always, allows certain exceptions, which means that with careful planning, it becomes possible to pass on assets without having to pay Inheritance Tax.

Some of the major exceptions allowed are

• Gifts paid during one’s lifetime to spouse or civil partner
• Gifts made to a qualifying charity during one’s lifetime or by a will
• Gifts of £3,000 to anyone, in part or whole, every year. It is also possible to avail the unused allowance from previous years

Similarly, if the estate in question is a business, woodland, heritage or farm, there is some relief from the normal rates. Individuals would do well to consider such options, and plan or allocate their assets to eliminate or significantly reduce inheritance tax liability.

Offshore Tax Planning

Setting up companies abroad to save on corporate tax is an option for big corporates with multi national operations. For instance, while the corporate tax in UK is 28 percent, it is only 12.5 percent in Ireland, and Bermuda has no corporate tax. Special rules reduce the tax liability of non-residents on certain types of UK income. A careful consideration of such regulations allows leveraging the best possible solution.

However, residence and domicile status have big tax implications. UK residents who are also UK domiciled are liable to pay UK income tax and capital gains tax on their income and gains from anywhere in the world. UK resident but non-UK domiciled people can opt out of UK income tax and capital gains tax on foreign income and gains until the time they remit the money to UK. Opting for such a remittance basis may however be the expensive option.

Tax Planning Strategies

A good tax planning exercise involves drawing up the various tax saving options that fit the required financial goals, then comparing the pros and cons of such options to decide on an appropriate plan.

Many people delay tax planning until the last possible moment, which is the end of the financial year. This limits the options available, and very often results in missing tax breaks, or making investments that save tax but are ill-suited to the desired financial goals.

For best results, make tax planning an ongoing exercise. A good time to delve into a detailed tax planning session is during the middle of the financial year, when both the accrued expenditures and the proposed expenditures for the financial year would become apparent.