No investment is an island

tax planning Even the best plans hinge on swings in the economy, says Mike Truman
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The Independent Online
PEPS DO not exist in a vacuum. Interest and investment in PEPs depends on many factors - what other tax-free investments are available, what is happening in the markets, even the outcome of the next election. So what is the tax climate for PEPs?

One of the reasons why the rules governing investment in PEPs are now better than when they were launched is an accident of timing. They began in January 1987, so before the end of their first year everyone had learned that share prices could fall out of bed overnight. Since PEPs were originally intended to encourage investors to buy shares directly, the take up was initially very poor. It was only when they were allowed to invest the full annual limit in unit trusts that they began to take off.

Last November's budget extended the range of investments to include some corporate bonds and preference shares, which will no doubt add to the interest in PEPs. But the Budget also included measures that may ultimately harm PEP investment.

One was improvement in the Enterprise Investment Scheme (EIS), successor to the Business Expansion Scheme (BES). When it was introduced in January 1994, it carried a much lower tax incentive than BES. Not surprisingly, the take up was very low during 1994.

The budget introduced a surprising new relief, permitting investors with capital gains to defer their gains tax liability by reinvesting the gain into EIS shares. This seems likely to increase the interest of companies active in sponsoring BES issues. An increase in the funds invested in EIS shares may mean less money going into PEPs. Perhaps more worrying is the fear that a change of government might mean a restriction in the investment freedom of PEP managers. At the last election the Labour party said it would keep PEPs, but would focus them more strictly on encouraging British enterprise. They did not propose to remove tax exemption from existing PEPs.

But does it take truly "retrospective" legislation to have a severe impact on previous tax planning? A popular way of minimising inheritance tax in the mid 1980s was to transfer money into a settlement for your children, but on loan rather than as a gift. The loan was interest-free and repayable on demand. The money was invested in a single premium insurance bond, from which withdrawals were made each year. These were used to provide an effective income to the original settlor, but were expressed as repayments of the loan. All future growth in the bond would take place outside the settlor's estate.

This tax planning scheme was, in effect, outlawed in 1986 but, in line with normal practice, existing schemes were not affected. The latest Finance Bill, however, as originally published, would have imposed a heavy tax on them. It proposed a charge where a loan was outstanding interest-free to a settlement. Even though the person making the loan did not receive any income, they would have been taxed as if they had. Strictly, this was not retrospective legislation, since it only proposed a tax charge from 6 April 1995 onwards, but it had severe repercussions on past decisions.

A massive campaign against these proposals started immediately the details were known, and the Government announced on Wednesday they were going to "reconsider" the proposals. Malcolm Gunn, editor of the professional magazine Taxation, is not surprised. "As soon as the complaints started the Inland Revenue sent the life companies away to estimate the size of the problem," he said. "They came back with an estimate of about a hundred thousand plans. The plans were popular throughout the early 1980s, and sold in their thousands in the years immediately before they were outlawed."

This is the second shock for inheritance tax plans in less than 12 months. Last July a surprise ruling in a case about an Aetna Life insurance bond held that it was not technically an insurance policy at all. Since the tax regime for insurance policies is central to the way inheritance tax plans work, this could have had a serious impact. The case has gone to appeal, and the Revenue has said it will not seek to apply the ruling to past cases whatever the final result in the case.

These scares have shown that the results of tax planning are not set in stone. It is a lesson PEP investors should bear in mind.