You and Your Money – August 2009

In the last of our four-part series, Johnny McNamara looks at the danger of counter party risk and shows you how to minimise the external threat to your own personal economy.

In previous articles I have developed the concept of managing and controlling your own personal economy. The key to achieving this is to identify the areas of your finances that are in your control and to recognise the areas that are outside of your control. Where you identify an area that you have no control over, this becomes a risk to your personal economy and so, it is vital to minimise these risks every way you can.

One of the biggest risks to our wealth today is known as “counter party risk.” This can be defined as the risk to each party of a contract that the other party will not live up to its contractual obligations. In most financial contracts, counter party risk is also known as “default risk.”

Counter party risk is apparent in almost all aspects of our financial lives from our savings and investments right through to our pension arrangements. The effects of counter party default have been particularly evident in the current economic climate, which has seen the collapse of many large financial institutions both here and across the world. This has led to the images we have all seen of people queuing outside banks for fear of losing their money.

So how do you remove counter party risk from your personal economy? Unless you are going to store all your wealth in gold bullion and carry it around with you, it is impossible to remove all elements of counter party risk. However, the key to gaining more control is to remove as much counter party risk as possible.

In my last article I developed the concept of taking ownership of your pension funds. Taking ownership of all of your assets – whether they be in pension or any other form – is the first step in helping to eliminate counter party risk. Once you have been able to establish ownership, the next question must be: what asset classes should you look to invest in to further remove the threat of counter party risk?

A good starting point is to look at the concept of ownership versus loanership assets within your personal economy. To understand this concept fully, we must identify the difference between ownership assets and loanership assets or in other words, real assets versus financial assets.

A real asset is a tangible or physical asset that will only ever appear on one side of the balance sheet, i.e. the asset on one side does not create a liability on another balance sheet. Therefore a real asset does not carry any form of counter party risk as it is direct ownership. Gold is a prime example of a real asset that is tangible and has a value in its own right due to its scarcity and people’s desire to own it.

A financial asset is an asset that is essentially a contract between two or more parties that merely represents an asset. The financial asset itself has no intrinsic value because it is not a tangible or physical asset, but merely a representation of one. A financial asset therefore sits on both sides of a balance sheet. For one party entering in the contract there will be an asset (bonds, share certificates etc.) and on the other hand, the other party will have a liability (repayment of bond, value of share etc.)

This is where counter party risk is generated, as the asset owned is only as good as the other party’s ability or willingness to honour their side of the contract.

When you bring in other financial assets that include debt derivatives, you often find that this increases the amount of counter parties involved and so, increases further the risk of default somewhere along the chain. A great example of this can be seen from what happened with the sub-prime mortgage market, where the debt was repackaged further and further away from the real asset until eventually the chain collapsed. If you are at the end of the chain, you are the one who suffers most financially from the counter party risk and subsequent default.

Many people have been fooled into thinking that financial assets should be considered as savings. However, as we have seen over the last few years, through counter party default these assets can become worthless very quickly. When looking at where to invest, it is important to remember that real investment brings with it real assets and real capital formation, which is the cornerstone on which future wealth is built.

With this in mind, what can you do now to take back ownership of your personal economy? It is my opinion that a significant part of your wealth should be invested in real assets through structures in your ownership and control. The amount to which you hold your wealth in real assets will come down to your faith or lack thereof in the financial system as it currently stands. Recently we have seen a massive amount of mistrust generated in our financial systems – both locally and globally – which has already seen a shift in investment towards real asset classes.

Counter party risk is evident in every part of our financial lives and represents a big risk. One of the biggest counter party risks out there is what’s happening in the global economy. We know that we cannot control factors at play in the global or local economy, but we need to understand how they affect us so we can plan for the future. However, we also know that there are factors that can be controlled through ownership. It is only through ownership that you can gain control and it is only through control that you can gain the ability to manage your personal economy.

To arrange an appointment with McNamara & Associates, call 01 230 9000.

Johnny McNamara looks at how improving efficiencies in one area of your personal economy can have a dramatic knock-on effect in the other areas of your financial life.

The Celtic Tiger brought with it unprecedented access to credit facilities, which were gladly lapped up by the Irish public. However, the legacy of poor financial planning from this era is now plain to see.

During this boom, many people found themselves owning multiple rental properties without ever examining how these portfolios should be structured to maximise efficiencies in all areas including cash-flow, tax planning, wealth creation and wealth protection. Now that the economic conditions have changed so dramatically in tandem with a tightening of cash-flow, the lack of planning is having a direct impact on how people are managing their own personal economy and possibly limiting chances to generate future wealth.

Take the example of an individual who has found themselves owning multiple rental properties, but who has never taken the time to put appropriate financial planning controls in place. Poor planning may have resulted in a situation where the individual has to use some of their own money to help cover the cost of owning these properties.

Where an individual owns investment properties, these properties should be selffinancing assets. This means that the money receivable (rent) should be greater than the costs associated with owning the property. If the property is not self financing and you have to contribute some of your own money to cover the costs, it becomes highly inefficient as the money that you will be using will most likely be coming from your salary on which tax has already been deducted.

In such a situation you have not only tied up your wealth in an illiquid asset, but have also created a drain on your cash-flow. In most cases, it is possible to create a situation whereby you can improve your cash-flow position through restructuring the finance arrangements and also ensuring that you minimise any tax liability.

If, through appropriate tax and financial planning, the individual in question can create a situation where the rental properties are now self-financing and possibly providing a surplus income, the whole picture changes.

In this situation, you have now freed up your cash-flow, which allows you to use this money to fund other areas of your personal economy and implement plans to generate future wealth. So what should you do to help develop your personal economy now that you have freed up some of your cash-flow? The answer to this will be different for each individual. However, there are a few fundamentals that all people should look at.

Credit card debt and other short-term debt is a burden that most of us are faced with. This debt is very expensive due to the high rates of interest payable and therefore, clearing this debt should be high on your priority list.

Using the money that you have been able to free up, you can now focus your attention on paying off any short-term debt. By clearing this debt as soon as possible, you can help to free up even more cash-flow, which can in turn be used in other areas of your personal economy.

Once you have managed to clear the short-term debt and have been able to free even more cash-flow, you can now look at clearing longer term debt such as the mortgage on your home. Your home is the most important asset that you own, as it provides shelter for you and your family. Therefore, you should look to remove any threat to this security and as such, clearing the mortgage on your family home should also be high on the priority list. By using the improvement in cash-flow to pay off your mortgage early, you will not only increase your security but could also save but could also save thousands in interest repayments.

There is also an element of long-term planning that needs to be implemented as part of any balanced financial plan, and the area of retirement planning should also be addressed. Many people are currently underfunded in their pension arrangements and while this is not a short-term problem, it is important that you look to the future so that you can enjoy retirement.

Freeing up your cash-flow in one area may enable you to increase pension contributions and help to ensure a secure retirement. By contributing to the pension, you can also take advantage of the generous tax reliefs available and therefore increase your efficiency in the area of tax planning.

As mentioned, each individual will require a different plan to suit their needs. However, you will now see the knock-on effects that improving the efficiency in one area of your finances can have on all other areas of your personal economy. You will also see how the improved efficiency can snowball through your personal economy to save money, improve cash-flow and develop your wealth.

This is just an example of how you can develop and grow areas of your personal economy by maximising efficiency in just one area of your finances.

There are many other areas where efficiency can be improved through sound tax and financial planning, resulting in the same opportunities for growth and wealth creation. You can therefore see how vital it is to take a holistic approach to your financial planning in order to maximise efficiencies in all areas of your finances.

For more information or to arrange an appointment, call McNamara & Associates on 01 230 9000.

Next month, we will look at controlling and managing your personal economy in the event of redundancy.

The rate of capital acquisitions tax is being increased from 22% to 25% in respect of gifts or inheritances taken from midnight on 7 April 2009.
The current tax free thresholds are being reduced by 20% as follows:

This reduction applies in respect of gifts or inheritances taken from midnight on 7 April 2009.

VAT

VAT MARGIN SCHEME FOR SECOND-HAND CARS
A margin scheme is to be introduced for dealers of second-hand cars. The new scheme will apply from 1 July 2009. Second-hand cars acquired after that date and later resold will be taxed on the dealer’s margin. Second-hand cars in stock on 1 July 2009 and sold after that date will be taxed on the re-sale price. Further details will be contained in the Finance Bill.

EXCISE DUTIES

INCREASE IN MINERAL OIL TAX ON AUTO-DIESEL
The mineral oil tax on auto-diesel will be increased by 5 cent per litre (including VAT) with effect from midnight on 7 April 2009.

TOBACCO EXCISE

The excise duty on a packet of 20 cigarettes will be increased by 25 cent (including VAT) with a pro-rata increase on other tobacco products, with effect from midnight on 7 April 2009.

FUTURE TAXATION MEASURES

The Budget speech gave clear indications that future tax increases, and the removal or reduction of various tax reliefs, are imminent. These changes can be expected to commence in Budget 2010 which will be presented in December 2009, by which time the Commission on Taxation will have reported.

While the particular tax increases and reliefs to be affected are not yet known, the Minister for Finance in his speech, specifically mentioned the following:

• the elimination of “unnecessary” or “unjustified” reliefs and shelters
• ensuring that capital is taxed in a “fair” manner
• a review of all areas of tax exempt incomes
• the introduction of a Carbon Tax
• a form of property tax and
• review of the taxation of pension lump sums

In view of the proposed changes, and in particular the signalling of a future focus on taxing capital assets, taxpayers would be well advised to avail of the tax reliefs on capital assets before they are withdrawn or diminished.

PERSONAL TAX

INCOME LEVY

The income levy rates which were first introduced in October’s budget will now double and the income thresholds will reduce with effect from 1 May 2009.

HEALTH LEVY

The health levy contribution rates will double with the lower rate of 2% increasing to 4% and the higher rate of 2.5% increasing to 5%. The entry point to the higher rate
threshold will reduce from €100,100 to €75,036 with effect from 1 May 2009.

EMPLOYEE PRSI ANNUAL CEILING

The PRSI contribution ceiling will increase from €52,000 to €75,036 with effect from 1 May 2009.

MORTGAGE INTEREST RELIEF

Mortgage interest relief will be discontinued for any mortgage over 7 years from 1 May 2009.

DEPOSIT INTEREST RETENTION TAX AND TAXES ON LIFE ASSURANCE POLICIES AND
INVESTMENT FUNDS

The rates of retention tax that apply to deposit interest, together with the rates of tax that apply to (a) life assurance policies and (b) investment funds, are being increased by 2% in each case and will now be 25% and 28% respectively. The increased rates will apply to payments, including deemed payments, made from midnight on 7 April 2009.

BUSINESS TAXATION

INCOME FROM DEALING IN RESIDENTIAL DEVELOPMENT LAND

The special 20% rate applied to the trading profits from dealing in or developing residential development land is being abolished. The income will be charged at the
person’s relevant marginal rates of income tax or the 25% rate of corporation tax. This change will apply as regards Income Tax for the year of assessment 2009 and
subsequent years and as regards Corporation Tax for accounting periods (or part thereof) ending on or after 1 January 2009.

TRADING LOSSES FROM DEALING IN RESIDENTIAL DEVELOPMENT LAND

Where trading losses have been incurred from dealing in or developing residential development land in circumstances where, if trading profits had been made, they
would have been eligible to be taxed at 20%, and a claim to use those losses has not been made to and received by the Revenue Commissioners before 7 April 2009, the
losses will generally only be relievable (on a value basis) up to a maximum of 20%.

Where any such loss is a terminal loss, the restriction will be implemented by “ringfencing” the loss and preventing an offset against other income.

Full details of both changes will be contained in the Finance Bill.

CAPITAL ALLOWANCES

The property-related accelerated capital allowance schemes in the Health Sector are to be terminated. This scheme covers private hospitals, registered nursing homes, convalescent homes and associated residential units as well as mental health centres.

Transitional arrangements will be put in place for projects that are at an advanced stage of development. The Finance Bill will contain further details on this measure.

Schemes for palliative care units and childcare facilities will remain in place.

RESTRICTION IN INTEREST RELIEF FOR RENTED RESIDENTIAL PROPERTY

The maximum amount of interest which can be claimed as a deduction against rental income for residential properties is being reduced to 75% of the total interest paid (previously 100%) with immediate effect. This measure will apply to both new and existing mortgages.

Commercial properties are not affected.

CORPORATION TAX

The corporation tax rates of 12.5% and 25% will remain unchanged.

INTELLECTUAL PROPERTY

A scheme of tax relief is being introduced for the acquisition of intangible assets including intellectual property. Further details to be published in the Finance Bill.

STAMP DUTY

LIFE ASSURANCE POLICIES

A new 1% levy will be charged on Life Assurance Policy premiums received by an insurer on or after 1 June 2009.

NON-LIFE INSURANCE POLICIES

The current non-life insurance levy of 2% is being increased. The new rate of 3% will apply to renewals and offers of insurance issued by an insurer on or after midnight on 7 April 2009, where premiums are received by the insurer on or after 1 June 2009.

STAMP DUTY “TRADE-IN” SCHEME

A Stamp Duty “Trade-in” Scheme will be established. No stamp duty will be payable by a person who accepts a traded-in property in exchange or part exchange for a new house/apartment. Stamp Duty will apply when the person subsequently sells on the traded-in house. Full details will appear in the Finance Bill.

CAPITAL GAINS TAX

The rate of capital gains tax is being increased from 22% to 25% in respect of disposals made from midnight on 7 April 2009.

This leaflet is only a summary of the Budget Speech and is not intended to be a comprehensive guide.
Produced & Issued 07/04/09