The ultimate guide to the Innovative Finance ISA
Section 1: Introduction to IFISAs
Although peer-to-peer lending (P2P) only became known to the UK, and indeed the world, in 2005, since the economic downturn of 2008 the sector has propelled towards the economic and investment mainstream. Indeed, as Bank of England rates have plummeted, returns on savings followed suit while the stock market and other higher-risk investments have been characterised largely by volatility ever since. Rates on annuities, too, have offered pensioners short shrift, with rates continuing to tumble to record lows.
All in all, this created a vacuum for good-value investment opportunities offering stable returns, and P2P lending has certainly stepped up to the plate in this regard.
Background to ISA inclusion
One of the strongest signs of vindication for the P2P lending industry was the announcement at Budget 2014 by then-Chancellor of the Exchequer George Osborne, who revealed that P2P lending would be included within Individual Savings Accounts (ISAs). This effectively meant P2P investors would be afforded the ability to shield interest on P2P loans from taxation – in much the same manner as those with cash and/or stocks & shares ISAs.
What was unclear at the time was exactly how P2P loans would be integrated into the ISA framework. Many predicted that it would be incorporated within the existing structure of stocks & shares ISAs. However, this prospect was viewed as less than ideal by platforms and industry experts. After all, P2P lending, by its nature, positions itself as a midpoint between savings and stocks & shares in terms of risk and reward, so to be lumped in with an asset class with which it shared few properties would have created complexities for both platform and investor.
Instead, the hope was that P2P lending would be allocated a separate wrapper, and this wish was all but granted at the Summer Budget in 2015. HM Treasury (HMT) confirmed that P2P loans would fall under a new category of ISA, namely the Innovative Finance ISA (IFISA), from the commencement of the 2016/17 tax year on 6 April 2016. This new wrapper is not necessarily exclusive to P2P lending (or ‘loan-based crowdfunding’ as it is sometimes referred to), and there is suggestion that equity-based crowdfunding could be included at some point. However, at this time, no other investment classes have yet been granted IFISA status, thus giving the P2P lending sector a high degree of prominence.
Below is a diagram outlining the three different categories of ISA:
* Please note: This is not an exhaustive list
The issue of full FCA authorisation
In order to ensure that the IFISA was implemented in a smooth and optimal manner, HMT subsequently commissioned a public consultation in which all stakeholders were invited to weigh in. One of the significant outcomes of this was that only those platforms who have received full authorisation from the Financial Conduct Authority (FCA), as opposed to operating under interim permissions, would be able to apply to HM Revenue & Customs (HMRC) to become an ISA Manager and therefore be able to offer the IFISA.
The FCA took over the regulation of the peer-to-peer lending sector on 1 April 2014. While new entrants to the market would require full FCA authorisation in order to start trading, any pre-existing platforms were able to continue to trade under interim permissions as they had previously held a licence issued by the Office of Fair Trading (OFT) (which regulated consumer credit prior to the FCA). The deadline for application for full FCA authorisation for interim permission P2P platforms was 31 October 2015, and all of the UK’s major platforms submitted timeously. However, given that the review process was expected to take 12 months or more, while the subsequent application for ISA manager status with HMRC can take up to a fortnight, it meant that it was unlikely any of these platforms would be approved by 6 April 2016 - and so it came to pass.
Lending Works became the first P2P platform operating under interim permissions to receive full FCA authorisation, in October 2016, thus paving the way for the Lending Works ISA, which went live in February 2017. The below graphic illustrates a basic timeline of events for the industry as a whole:
* 'Major' refers to firms previously operating under interim permissions
Section 2: Benefits, tax efficiencies and allowances
Despite some levels of frustration with the delay in the launch of the IFISA, there can be no question about the long-term benefits the new wrapper will bring. For P2P income earned outside an IFISA, the investor may be required to declare these to HMRC via a self-assessment tax return, with the gains being taxable at the individual’s marginal rate. The advent of the IFISA will thus, for many investors, take P2P income out of tax. Here we summarise the benefits of the IFISA, along with another useful tax efficiency.
Benefits of the IFISA
Quite simply, the implications from a tax perspective are significant with the IFISA. Being able to shield P2P income from tax on annual subscriptions of up to £15,240 (for the 2016/17 tax year – potentially £20,000 from April 2017) will be music to the ears of investors. Bear in mind that the ISA allowance doesn’t include transfers of ISA funds accumulated in previous years, nor does it include interest earned and compounded, so all gains can take their place in the wrapper without ‘using up’ any part of an individual’s ISA allowance.
There had also been some debate regarding whether P2P income should be taxed at source, as opposed to the responsibility being put on the individual to do so via a self-assessment tax return. However, this has almost become a moot point, as many shrewd investors should be able to manage their portfolio such that P2P loans will no longer be taxable, courtesy of the IFISA – especially when you consider the generous ISA allowance on offer for subscribed funds, and the lack of limits on transfer of those ISA funds in other categories of ISA, accumulated in previous financial years (discussed in further detail in Section 4).
Although the issue is subject to the discretion of each platform, most P2P platforms have already made it clear that it is unlikely they will be offering a lower rate of return to those who make use of the IFISA, compared with those who don’t, which represents more good news for investors.
The Personal Savings Allowance
Taxation on P2P returns could also be further reduced - or even completely removed - from tax by virtue of the Personal Savings Allowance (PSA), which includes savings interest and P2P income. What this means is that, for basic-rate taxpayers, up to £1,000 of interest each year can be shielded from tax. For higher-rate taxpayers, this figure drops to £500, and for additional-rate taxpayers the PSA is removed.
* The above assumes that no other savings interest is received during the tax year
You should note that the PSA is independent from an ISA, and you can take advantage of both separately.
The ISA allowance
All individuals over the age of 18, who are resident in the United Kingdom, are eligible for a tax-free ISA allowance each financial year. This 'subscription limit' has increased significantly in recent years, most notably since the launch of the 2010/11 financial year. At the start of that period, the total annual subscription limit was increased from £7,200 to £10,200, and six years later this allowance has soared to £15,240. It was announced at Budget 2016 that this would increase to £20,000 for the 2017/18 tax year.
Nevertheless, this limit can be used for subscriptions across any or all of the three categories of ISA, though it’s important to remember that it's a collective total. So if you've already exhausted your ISA allowance with subscriptions to cash and/or stocks & shares ISAs, you'll have to wait until the following tax year to contribute to your IFISA.
The below diagram gives an example of correct and incorrect ways in which to make use of your annual ISA limit:
* 2016/17 tax year
Section 3: How to set up your IFISA
When the time comes to set up your Innovative Finance ISA, it’s important to understand exactly what’s involved. Each platform has its own set of rules and provides a different user experience, but the principles will likely be much the same across the board.
Please note that you will only be able to subscribe funds to one IFISA, with one P2P platform for each tax year. Yet with respect to funds transferred between ISAs, this rule does not apply. We explain in further detail in section 4.
IFISA and Classic accounts
Prior to launching the Lending Works ISA, an investor’s user account would simply comprise a single area, known as the 'Classic account'. Once you've signed up for an ISA, you'll see your account split into two sections, your ISA account and your Classic Account.
The below diagram provides an elementary overview of how this will appear:
Both accounts will work in exactly the same way. Of course, it won’t be obligatory to invest funds in both parts of your account, and you'll be free to continue investing only in your Classic account if you so wish. However, for those looking to make use of the ISA wrapper, it will be a simple case of transferring funds via this area of your dashboard, and then lending out your funds from there.
On loan funds, your ISA limit and right of cancellation
In terms of your ISA allowance, it makes no difference whether you've actually lent out the funds you've invested within your IFISA or not. Once you subscribe monies to this account, you will have used up that portion of your ISA allowance, even while your funds remain un-lent. However, the good news is that every investor will be entitled to a 14-day right of withdrawal or 'cooling off' period once they open their ISA account. So this will give you two weeks to withdraw those funds from your IFISA, free of charge, and thus restore your ISA allowance to what it was prior to the deposit, if you have a change of heart. But remember, this right of withdrawal will only apply when you open your ISA account, and will not apply each time you subscribe funds into your ISA account.
The below diagram illustrates the impact on your ISA subscription allowance, depending on whether you exercise your right to withdraw within 14 days or not.
* Please note: ISA Managers have discretion on how to implement 14-day cancellation
It’s also worth noting that, as an ISA manager, the P2P platform will only be able to reimburse this withdrawal as cash. This means that if your funds are already on loan, you'll be required to sell your contracts to other lenders before these funds can be returned to the cash part of the IFISA. Once this has occurred, you'll be free to withdraw these funds from your account.
Section 4: ISA regulations, subscriptions and transfers
From a P2P lending standpoint, the aim is to make the exercise of incorporating an Innovative Finance ISA into your portfolio as straightforward as possible. However, there are regulations which are standardised for all ISA types, and it is worth educating yourself on the most relevant rules. In this section, we’ll cover all of your questions pertaining to the finer complexities involved with transferring ISA funds both into and out of your IFISA – along with other nuances such as the number of IFISAs you can hold and the limitations for subscription of funds into them.
Transferring pre-existing P2P loans into an IFISA: Yes or no?
Unfortunately, in accordance with the outcome of the consultation carried out by HM Treasury, there will be no mechanism through which those with pre-existing P2P loans can directly transfer these into the new ISA. Although platforms sympathise with the disappointment this may cause for P2P investors, it is an understandable decision given the complexities that would be involved with loan transfers.
However, that doesn’t mean that you're out of options. You could look to withdraw your pre-existing investment from the platform entirely, and then subsequently transfer this into your new IFISA. Bear in mind though that most platforms will charge a fee for withdrawal of funds still out on loan.
Alternatively, some platforms, including Lending Works, offer the option of automatically transferring repayments direct to your bank account. What you could do is direct these into the IFISA section of your P2P user account instead. Furthermore, if you then organise the settings such that any funds going into the cash section of the IFISA are automatically re-lent, then you will be able to drip-feed your old P2P investments into your IFISA without having to lift a finger. While it would undoubtedly take a bit of time to get all these funds into the new wrapper, the big advantage of doing it this way is that you will not incur any fees.
Transferring pre-existing ISA monies into an IFISA: Yes or no?
There is nothing stopping you from transferring funds subscribed and accumulated in a cash and/or stocks & shares ISA into your new IFISA, and, depending on the platform, this shouldn’t incur any fees either. Once again we must underline that transfers between ISAs can only take place in the form of cash, so if you're transferring from a stocks & shares ISA into an IFISA, these investments will need to be converted to cash within the stocks & shares ISA itself before a transfer to the IFISA can be actioned.
However, do not at any stage manually transfer these funds into your bank account in between, as they will then lose their ISA status. Instead, it will be the job of the new ISA manager to request and arrange the transfer of funds from your old ISA manager into the IFISA directly with the new ISA manager, the P2P lending platform.
The below diagram illustrates this important point further:
Transferring current year ISA subscriptions
It's very important to distinguish between funds subscribed into another category of ISA during the current financial year, and those accumulated over previous years. That’s because the latter is not subject to the same levels of restriction in terms of transfers.
If you have subscribed, say, £10,000 into a cash ISA during the current tax year, you are entitled to transfer all of this amount into an ISA of a different category (e.g. an IFISA), and your remaining allowance for the year would still be £5,240 (in the case of the 2016/17 tax year).
Please note though that you will only be able to subscribe funds to one ISA provider in each category during each tax year. So that means if you wish to contribute some or all of your remaining ISA allowance into an IFISA during the same financial year, you will be obliged to do so into this same IFISA with your chosen provider. This is because your subscription to the Cash ISA will be deemed to have been made into the IFISA originally (upon transfer), and you will have been deemed to have subscribed the money to this IFISA all along in the context of ISA regulations.
The below gives a good illustration of this process:
Transferring previous year(s) ISA subscriptions
Once the tax year comes to its conclusion, the ISA funds articulated above are treated very differently. For the purposes of this guide, we will refer to ISA monies accumulated in previous financial years as ‘old funds’. Unlike funds subscribed during the current financial year, there is no limit on the amount you can transfer, nor the number of ISAs you can transfer into with respect to old funds. This applies to whether you are transferring between ISAs of the same category and between different ISA types.
As an example, if you have, say, £50,000 saved up in a cash or stocks & shares ISA over the years, then as per ISA regulations there is nothing stopping you from transferring any or all of this amount into an IFISA. In fact, you could transfer this into as many IFISAs, with as many IFISA providers, as you wish, all in the current tax year. There are essentially no restrictions in this regard if the funds were subscribed into any ISA in previous financial years. The same logic above will also apply in the future if you wish to transfer old funds out of your IFISA, either into a new IFISA, or into an ISA of a different category.
The below diagram illustrates various examples of how old ISA funds can be transferred:
* 'Old funds' refers to ISA monies accumulated during previous tax years
Once again though, we must reiterate the fact that ISA managers can only accept cash, so if you are transferring from stocks & shares ISAs, you will need to convert this into cash first. And again, make sure you request a transfer using the process set out by your new ISA manager in order to ensure that these funds’ ISA status is preserved at all times.
Workarounds for transferring subscribed ISA funds
While the freedoms relating to old ISA funds may make you feel as though you’re in a bit of a straightjacket when it comes to new funds, the good news is that there are ways of transferring funds between IFISAs if you have a change of heart during the tax year.
For example, if you contributed £10,000 into an IFISA with P2P Platform 1, but soon after were drawn to offers from an alternate platform (let’s call it Platform 2), there is nothing stopping you from transferring this £10,000 into an IFISA with Platform 2.
However, it is important to note that if you do wish to transfer subscribed monies to another provider within the same ISA category during the same financial year, you will be obliged to transfer the whole amount - including any interest gained or received on that amount (£10,000 plus any returns on this in the above example) - across, as, unlike with old ISA funds, you cannot transfer a partial sum.
If you are so enamoured by the offer of Platform 2 that you wish to subscribe further funds into an IFISA with them during the same tax year (ie: in addition to the amount you wish to transfer from Platform 1), there are two ways in which you can go about about this. The first option is to make this additional subscription into the IFISA with Platform 1 first (ie: before you transfer out the £10,000 that was already in there), and then transfer all these monies (£10,000 + interest + additional subscription) across to Platform 2.
The diagram below illustrates this process more clearly, using lender John as an example:
Alternatively, John could also transfer his original subscription within Platform 1 (£10,000 + interest) across to the IFISA with Platform 2, and then subsequently make this additional subsription into Platform 2 once the transfer is complete:
Remember, the maximum additional subscription John is entitled to make above (£X) cannot exceed his remaining ISA allowance for the remainder of the tax year.
Another way of going about moving money between IFISAs during the same tax year would be to transfer the £10,000 (and any subsequent desired investments bound for an IFISA with Platform 2) into an ISA of a different category (eg: a Cash ISA). That’s because once these monies are transferred to a new category of ISA, it will be deemed in the eyes of ISA regulation as having always been subscribed there, thus voiding the original subscription into Platform 1. This would subsequently free you up to transfer the £10,000 (and any subsequent investments) into an IFISA with Platform 2, via this Cash ISA (remember to ensure that you do not conduct this transfer via a bank account at any time, and that your funds maintain their ISA status throughout the process).
Once again, at the conclusion of the tax year, all of these restrictions will cease, and these ISA monies will enjoy the less-stringent limitations associated with old funds.
SECTION 5: The future of peer-to-peer lending and ISAs
The dawn of the ISA era in P2P lending is a watershed moment for the industry, and it comes as little surprise that many experts are predicting that the UK sector will skyrocket to £50bn as a direct result of the Innovative Finance ISA.
Weighing up the risks and rewards
P2P lending platforms are unique in the sense that they generally treat scrutiny with a warm embrace. FCA regulation was seen as a tremendous positive, while the P2PFA is an organisation formed by the UK’s more established platforms. As members, there are a strict set of Operating Principles which platforms must adhere to, including publishing their full loan book on their websites and many other key statistics relating to loan performance.
The following is a small snippet of Lending Works' arrears and default statistics (accurate as at 8 February 2017):
Within such transparency, the hope is that every investor fully understands the risks and rewards involved, particularly with P2P lending’s popularity set to soar in the ISA era. The most important thing to note is that, unlike money in a cash ISA, your capital is at risk and is not covered by the Financial Services Compensation Scheme (FSCS). Platforms mitigate this risk with security measures of their own, for example using security, provision funds and even insurance against borrower default, but ultimately it is important that every investor is aware that their capital and returns are not guaranteed.
Like most investments, it’s up to the individual to make an assessment of risk versus reward, and make an informed decision from there. But the competitive and stable returns offered by prime platforms in the UK have already been a key driver of P2P lending’s exponential growth. In addition, high standards of loan underwriting and a steadily developing track record is seeing it stack up more and more as a standout asset class.
The arrival of the Innovative Finance ISA, coupled with additional boosts such as the Personal Savings Allowance, will only make it more appealing, with more pounds ending up in the pocket of the investor – where they belong. And at a time when low interest rates and market volatility across various asset classes looks set to continue for the foreseeable future, the future prospects for the industry, particularly with the tailwinds of IFISA in its sails, look very positive indeed.
- Oxera report - The economics of peer-to-peer lending
- Lending Works hails dawn of new Innovative Finance era
- Quick guide to lending