Tax Havens For Investors

Last week, we looked at tax havens for your cash. This week, we show you how to shelter your shares from the taxman!

A week ago, in Top Tax-Free Savings, I wrote about the most widely used tax shelters for cash deposits. To recap, they were cash Individual Savings Accounts (ISAs) and their forerunners (TESSAs and TOISAs), plus various savings bonds offered by the government-backed National Savings & Investments. This week, I will review the tax shelters most often used by stock-market investors.

Despite its sometimes dramatic ups and downs, over the past century or so, the UK stock market has returned an average of 11% a year to investors, including reinvested dividends (the income from shares). However, many investment commentators are predicting a future era of lower returns, perhaps no more than 9% a year.

Even so, compound growth of, say, 9% a year over thirty years produces some impressive returns. Indeed, over this period, £100 will grow to be worth £1,327, or more than thirteen times our initial investment. Of course, this performance looks less impressive after accounting for inflation -- the tendency of the price of goods and services to rise over time. For example, growing at 5% above inflation, £100 invested over thirty years produces a 'real' (after-inflation) value of £432.

Historically and over long periods, the returns from shares have outpaced those produced by other mainstream investments, such as bonds, cash and property. Hence, it's worth making an effort to protect these superior returns from taxes on any income and capital growth (profits) made. Here are four legal tax havens that UK investors often use to keep HM Revenue & Customs at bay. Standby for lots of TLAs (three-letter acronyms)!

Shares Individual Savings Accounts (ISAs)

If you have opened a cash ISA in any particular tax year, then your investment in a shares ISA is limited to £4,000. Otherwise, you can invest up to £7,000 per tax year into a shares ISA. The advantage of buying shares inside an ISA wrapper is that you enjoy tax-free dividends and capital gains.

However, only higher-rate taxpayers benefit from not being taxed on any dividend income inside an ISA, as the taxation of dividends inside and outside of an ISA is identical for basic-rate taxpayers. Nevertheless, it's worth having an ISA just to dodge a big CGT bill decades down the line!

Self-invested Personal Pensions (SIPPs)

Hundreds of thousands of investors who were fed up with the low investment returns and high charges associated with traditional personal pensions have turned to SIPPs to invest for retirement. A SIPP is simply a tax-free wrapper around a group of investments which you choose and manage, with or without the help of professional advisers and investment managers. SIPPs offer the same tax advantages as other pensions, but the difference is that investors make their own investment decisions and therefore have complete freedom, flexibility and control over their assets.

For a higher-rate taxpayer, a £5,000 investment into a SIPP costs just £3,000 after 40% tax relief, making it an attractive vehicle for retirement saving for higher earners. Also, as with all pensions, dividends and capital gains are tax free. My research into over eighty different SIPPs identified the Hargreaves Lansdown Vantage SIPP as the cheapest, as this article confirms.

Venture Capital Trusts (VCTs)

With VCTs, we move into riskier territory. However, if you're a seasoned investor with a stomach for higher-risk, higher-return investments, then it might be worth looking into Venture Capital Trusts. These listed (that is, quoted on the London Stock Exchange) investment companies invest in start-up businesses and small compnaies, where failure rates can be high and portfolio concentration can work for or against investors, depending on a fund's success.

The big draw of VCTs comes in the form of the tax incentives they offer. A £10,000 investment into a VCT qualifies for an upfront income-tax rebate of 30% (£3,000), provided the shares are held for at least five years (the rebate was reduced from 40% to 30% in the Budget of March 2006). In addition, all capital gains and dividends are tax free, subject to a three-year holding period.

However, as always, don't let the 'tax tail wag the investment dog'. Before investing in a VCT, ask yourself whether you would do so if it didn't offer generous tax breaks? Your answer will determine whether VCTs are really up your street!

EnterpriseInvestment Schemes (EISs)

With an EIS, you make a direct investment in an unquoted company which must satisfy certain criteria regarding its size (it must have gross assets of no more than £7 million immediately before investment) and the type of trade performed. In return for holding onto the shares for three years, you receive four tax benefits.

First, you receive 20% income-tax relief on up to £400,000 per tax year invested in new shares. Second, you are exempt from capital gains tax on any gains made on qualifying shares. Third, you get loss relief against income or capital gains for losses made when you dispose of qualifying EIS shares after three years. Fourth, you received unlimited CGT deferral. CGT can be deferred if an EIS share investment is made within one year before or three years after the disposal which produced the gain to be deferred. However, although EISs offer attractive income-tax relief and CGT deferral, dividends are not tax free.

Here's how EIS tax reliefs stack up:

In effect, HM Revenue & Customs gives an EIS investor an interest-free loan of the CGT which is repaid when the EIS shares are sold.

Again, EISs are complex, potentially risky investments which are only suited to experienced investors, so it's worth taking professional advice from an expert advisory firm such as Allenbridge Group, publishers of the Tax Shelter Report.

Finally, there are other tax-avoidance schemes open to UK investors, such as investing in shares listed on the Alternative Investment Market (AIM), film partnerships, or timber companies. However, with the exception of AIM shares, these are niche investments, so I won't cover them here.

More: Use the Fool to find top tax-free investments!