Budget June 2010 commentaries - Capital Gains Tax

"The commentaries below are written in general terms. Details can also be found in our downloadable Budget Report brochure. You are strongly recommended to seek specific advice before taking any action based on the information given, both in the commentaries and in the publication."

Initial thoughts from:

Richard Mannion, Head of National Tax

“Simplicity, competitiveness and fairness are the watchwords here; the new rules appear to underline the fact that CGT isn’t a big money spinner. CGT is part of a defensive shield to protect the tax base.

It’s unprecedented to have a change mid-way through the tax year. This will complicate the tax return for 2010/11 as it will mean pre and post budget day gains will need to be reported separately. As a result, many investors are going to find these rules hard to apply.  However, it is good news that the threshold of £10,100 has not been reduced which will be particular helpful to the country’s moderate savers.

Increasing CGT to 28% for higher rate taxpayers will encourage the transfer of assets to spouses paying basic rate tax before they are disposed of."

Adrian Walton, Tax Director

CGT for Private Equity

“Whilst an increase in the capital gains tax rate for higher rate tax payers was expected, the increase up to 28% (from 18%) means that the Government has stopped short of aligning CGT rates with income tax rates.  Implementing this increase from midnight tonight is a surprise, and represents an unprecedented move to change rates of CGT during a tax year.

The increase of Entrepreneurs’ Relief (ER) from the first £2m of lifetime gains to £5m is a welcome boost to entrepreneurial activities in the UK. However this will mean increased scrutiny on which assets qualify for the relief (broadly assets used in a trading business, or shares in a personal trading company), as the relief could be worth as much as £900k on a gain of £5m (gains qualifying for ER will continue to be taxed at 10%).”  

Capital gains tax (CGT): rates

For gains arising on or after 23 June 2010 there are three potential CGT rates for individuals, namely 10%, 18% and 28%.  The 10% rate is only available with respect to assets which qualify for entrepreneurs’ relief (ER) as discussed below.  For non-qualifying gains the rate will either be 18% or 28%.

The 18% rate introduced in Finance Act 2008 continues for basic rate taxpayers. The 28% rate applies where total taxable income and gains are in excess of the upper limit of the income tax basic rate band (£37,400 for 2010/11). It will apply to gains (or any parts of a gain) above that limit.  This means that where an individual’s taxable gains are such that he or she straddles the limit, the portion in excess of the upper limit will be subject to the 28% rate.  Allowable deductions and the personal allowance (currently £6,475) are deducted to arrive at the total taxable income figure.  To arrive at the total taxable gains figure, capital losses and the CGT annual exemption are deducted.  The CGT annual exemption remains at £10,100 for the current year (2010/11) and in future years will continue to increase in line with inflation.

The CGT legislation was not written with a mid-year rate change in mind and so there will be special rules for the current tax year.  The Budget material covered the more basic issues. For those taxed on the arising basis, unless a deferral/roll-over claim is made, gains which arose (or are deemed to have arisen) prior to 23 June 2010 will be taxed at 18% and will not be taken into account in determining the rate (or rates) at which gains arising on or after 23 June 2010 should be charged.  Losses for the tax year as a whole and the CGT annual exemption can be offset in the most beneficial manner for the taxpayer. The comment with respect to losses is of course caveated if the losses are covered by specific anti-avoidance legislation such that their use is limited, for example clogged losses which occur if an asset is disposed of at a loss to a connected person such as a close relative.

In determining whether there is deemed to be any surplus rate band, such that gains (or part of a gain) can be taxed at 18%, the ER gains (realised after 22 June 2010) which are taxed at the lower 10% rate are set against the basic rate band in priority to other gains.

Gains realised after 22 June 2010 for which ER cannot apply (or has not been claimed) are set against any unused basic rate band in priority to other gains. 

Where a pre 23 June 2010 gain is (or has been) deferred or rolled over it will be subject to tax at the rates prevailing when it comes into charge.  This means that for a higher rate taxpayer, if the rates remain the same, the gains will be subject to tax at 28%.

For trustees and personal representatives the general CGT rate on disposals of chargeable assets after 22 June 2010 will be 28% (with 18% applying to disposals realised prior to 23 June 2010).  The 10% rate will apply where there is a qualifying business asset disposal and ER is claimed.  It should be remembered that the conditions that have to be met for trustees to be able to claim ER on chargeable disposals are far more restricted than for individuals, with trustees of discretionary settlements not being able to benefit from ER on the disposal of trust business property. 

Comment

The Coalition Government had made it clear that there was to be a CGT increase on non-business assets.  In the Queen’s Speech, and accompanying notes, it was said that capital gains on non-business assets would be taxed at rates ‘closer’ to those applied to income tax, with generous exemptions for entrepreneurs. 

Whilst a mid year change was possible most commentators felt it was unlikely and so the Chancellor’s announcement came as a shock.  As stated above special rules are needed for a mid-year rate change.  Some CGT provisions deem gains to arise for a tax year (for example the anti-avoidance provisions with respect to offshore trusts and also the charging provisions with respect to temporary non-residents).  We will not fully understand how the rules will work until we see the provisions in the Finance Bill.  There may be significant complexity (particularly with respect to the offshore trust anti-avoidance provisions).

There was speculation that there could be a form of taper relief and/or relief for inflationary gains. The Chancellor said that he had considered these alternatives but felt they would introduce an unacceptable level of complexity. It may be that in the interests of encouraging businesses and long term investment the decision will need to be reviewed at a later stage or the scope of ER enlarged.

It should be noted that the supplementary document ‘Capital Gains – Rates and Entrepreneurs’ Relief Questions and Answers’ includes a question on whether the 28% rate will go up to a figure closer to the highest income tax rates (40% and the additional rate of 50%).  The answer provided is non-committal stating that a decision for 2011/12 will be made in Budget 2011.

Capital gains tax: entrepreneurs' relief

Entrepreneurs' Relief (ER) was introduced in Budget 2008 at the same time other major changes to the capital gains tax (CGT) regime for individuals, trustees and personal representatives were introduced.

The basic premise behind entrepreneurs’ relief is that an individual can claim relief on whatever qualifying business disposals he or she chooses but there is a cap on the relief and once aggregate gains exceed that cap the individual has exhausted his or her entitlement to the relief unless and until the lifetime allowance figure is increased. As originally introduced, where a claim is made, gains on qualifying business assets up to this aggregate lifetime limit suffer tax at an effective rate of only 10%. The 10% rate was achieved by:

• reducing the aggregate qualifying business gain (otherwise chargeable in full at 18%) by 4/9ths ; and
• applying the fixed 18% capital gains tax rate to the chargeable gain remaining.

When the legislation was introduced in Finance Act 2008 the lifetime limit was fixed at £1 million with no statutory provision for this limit to be increased.   The limit was raised in the last Finance Act to £2 million with effect from 6 April 2010.

It was announced that with effect from 23 June 2010 the lifetime limit would rise to £5 million and that all qualifying gains would be taxed at 10% regardless of whether the individual was a basic or higher rate taxpayer in the year of disposal. The 4/9 reduction will cease to apply (as this would not have worked to arrive at the effective rate for higher rate taxpayers) and a specific 10% rate will be introduced for qualifying gains with respect to which ER is claimed.

An individual who used (or uses) their £2m allowance on qualifying disposals effected prior to 23 June 2010 has an additional £3m allowance which can be claimed on disposals effected on or after that date. An individual who will not utilise all (or any) of his/her pre 23 June lifetime allowance on qualifying disposals effected prior to 23 June 2010, will from that date have a lifetime allowance equal to £5m less any relief claimed.

Comment

Given the small period during which the £2 million limit will apply (6 April to 23 June 2010) for the sake of simplicity one could argue that backdating the increase to 6 April 2010 would make sense.  Looking to the bigger picture ER was introduced in what can only be described as hurried circumstances.  Modelled largely on the old retirement relief provisions but targeted at a different audience the operation of ER is in places unfair and there are a number of technical uncertainties.  In addition, the definition of qualifying business asset is significantly narrower than the definition of business asset under the old taper relief provisions.  As such whilst the significant increase in the limit is welcome it does not shelter all disposals of business assets by higher rate taxpayers from the rate increase.  For example to qualify for ER on share disposals it is necessary that in the year prior to the disposal:

• the individual must be an officer or employee of the company or (if the company is a member of a group of companies) of one or more companies which are members of the trading group;
• the company must qualify as the personal company of the individual meaning that the individual is the holder of at least 5% of the ordinary share capital, and can exercise at least 5% of the voting rights by virtue of that holding.

Employees/office holders with holdings of less than 5% will not qualify for relief even if for a significant earlier period they did have a holding of 5% or more (their holding may, for example, have been diluted by share options being exercised or by an injection of third party capital so the business could be expanded).  There will also be no relief if the 5% condition is met but the individual leaves the employment or resigns as an office holder and has not disposed of their holding beforehand.

It is hoped that even if the public finances are such that a significant widening of the definition is not affordable there can be a review and targeted modification with respect to the rules for employees and to provide a period of grace where an employee/office holder or partner retires or leaves the business and does not dispose of his/her interest in the business before departure.