Exploring Eligible Tax Incentives in P2P Lending
Compared with other major asset classes, peer to peer lending (P2P) may not stick out as one which provides tax advantages for investors. In the 2016-17 tax year, Stocks & Shares ISA and Cash ISA accrued a combined £61.3 billion worth of subscriptions, while the Innovative Finance ISA (IF ISA) or "P2P ISA" - the tax wrapper that exclusively holds P2P loans - attracted only £17 million. The reason for such poor performance was down to the lack of IF ISAs on the market, not the characteristics or merits of the asset class, as discussed in Innovative Finance ISA: The Future is Bright. Since then, the number of IF ISA offerings has increased dramatically and the 2018-19 tax year may well prove to be the platform for the IF ISA to flourish.
Aside from the ISA providing tax relief, we have also seen an emergence of partnerships between SIPP providers and P2P platforms, but a relative lack of appetite from major SIPP providers.
For investors, it’s worth understanding first how P2P lending is taxed and then what mechanisms can be taken advantage of to generate tax relief on their returns.
How P2P lending is taxed
Peer to peer lending is taxable as income. This means that you are required and responsible for declaring the tax on interest earned from P2P investments. Depending on your level of investment, there’s a chance you will not incur tax on your returns due to the Personal Savings Allowance, enacted April 2016 (more below). Here are the key facts to bear in mind when considering taxation in P2P lending:
- Interest is taxable as income
- Investors are required to declare tax on interest earned in their annual tax return
- Investors can deduct eligible bad debt (P2P losses)
- Investors can take advantage of their Personal Savings Allowance
- Investors can shelter returns from tax by holding loans in an Innovative Finance ISA
- Capital Gains Tax (CGT) is unlikely but can be incurred if you buy and sell the same loan part – gains may then be taxed. *
*Secondary market transactions (where loans can be bought and sold) are considered to be purchases/sales of the original loan, which is deemed “simple debt”. As such, they are not usually liable for CGT.
Personal Savings Allowance
The Personal Savings Allowance allows basic rate taxpayers to earn up to £1,000 in savings income tax-free. For higher rate taxpayers, they are allowed to earn up to £500 tax-free.
This is particularly useful as P2P lending falls within the eligible classes which benefit from this allowance.
For example, should you invest £20,000 in a 1-year P2P loan at 5% per annum, the £1,000 interest earned will not be liable for tax if you are a basic rate taxpayer.
Innovative Finance ISA
The IF ISA has finally reached a level of maturity where it can be considered more seriously alongside other tax wrappers. It should always be noted that P2P lending is not a savings product and holding cash in a cash ISA is very different to holding P2P loans in an IF ISA. Rules apply, such as:
- You can only subscribe your current tax-year allowance to one IF ISA per tax-year
- You can transfer as many old ISA subscriptions, from any ISA type, to as many IF ISAs as you like
- You must sell out of your P2P loans, transforming the investment to cash, so you can withdraw from your IF ISA. There are no guarantees, and while selling your loan is likely to happen reasonably quickly, it is dependent on new investors substituting your loan commitment.
What’s important to consider, is the market in which the given IF ISA provider (P2P lending platform) operates within. Zopa was the first of the “big three” platforms (Funding Circle, Zopa, RateSetter) to launch its IF ISA mid last year. However, the platform was closed to new investors from January 2017 to January 2018 amidst concerns around origination and a lack of borrower supply. The consumer-credit market has been ballooning and investors should consider the risk/reward trade-off between tax-efficiency and potential rising defaults in the consumer-lending market.
There are now 21 peer to peer lending platforms offering Innovative Finance ISAs to investors. Of the largest players, RateSetter is the final platform yet to launch its ISA product.
Self-Invested Personal Pension (SIPP)
Current HMRC rules do not prohibit SIPPs from entering into P2P lending, but there are significant hurdles. While many of the major SIPP providers are yet to adopt peer to peer lending, some have partnered with established P2P lending platforms. The concern for major providers is the relative infancy of the asset class, which has not suffered an economic recession, and also a struggle to get comfortable with primary rules, such as ‘connected parties’.
HMRC rules do not allow loans from a pension to be made to a member of the scheme, a person or company connected to a member of the scheme (such as a relative), or anyone connected to a scheme employer. If you are using a P2P platform where you can select the loans you invest in, this issue should not be a concern. It is where capital is auto-diversified across a loan book, such as with Zopa, Funding Circle and so on, where the problem surfaces.
With this being said, major P2P players are partnering with SIPP providers. RateSetter, for example, has established relationships with a number of SIPP providers (incidentally, it is one such platform where loans cannot be manually selected).
In short, there are tax-relief mechanisms available to be taken advantage of when investing in peer to peer lending. The Innovative Finance ISA is the standout, entering the market in 2016 and experiencing significant media attention over the past two years. With dozens of options now available to choose from, opening an IF ISA as the end of the tax year approaches may be an opportune decision. Moreover, the advent of the Personal Savings Allowance could be the catalyst to encourage more people to diversify into P2P. For those considering their SIPP, again, there are options, but it will likely be some time before the major SIPP providers resolve their issues with P2P.