Capital gains tax review: the great corona cost clawback?

Will capital gains tax (CGT) rise dramatically as the government attempts to claw back the cost of extra spending during the coronavirus pandemic?

Last month Chancellor Rishi Sunak commissioned The Office of Tax Simplification (OTS) to investigate whether capital gains tax is ‘fit for purpose’.

This surprise review of CGT could lead to higher taxes on the wealthy and possibly middle-income earners, too.

“If people want capital gains taxed more like the highest rates on income that is a good discussion and maybe that is the way to help close government deficits.” Bill Gates, Co-Founder of Microsoft Foundation

What is CGT?

CGT is a tax on the profit when you sell (or ‘dispose of’) something (an ‘asset’) that has increased in value. It is only the gain that is taxed. This mostly applies to gains made on property and shares, but can also apply to other assets such as works of art. The Office for Budget Responsibility forecast that in 2019/20, CGT would raise around £9.1bn, which is about 1.1% of all tax paid in the UK.

An enormous amount of effort is put in by investors and their advisors to avoid paying the tax (there are lots of ways to do so). This puts a great burden on HMRC in terms of administration when the tax only brings in a comparatively small amount of tax revenues.

Private residences are exempt which means there is no CGT to pay if you make a profit when selling your home.

You are also only liable for CGT on gains of more than £12,300 for the current tax year. So, you could make £10,000 profit from share dealing and still not pay any CGT.

At the moment capital gains tax rates are at historic lows with basic rate income taxpayers paying 18% on second homes and buy-to-lets, and 10% on other assets. For higher rate taxpayers, the rates are 28% and 20% respectively.

Why is it being reviewed?

The Chancellor has asked the OTS to report on how CGT rates compare with other taxes, and how the present rules may distort behaviour.

Capital gains tax can distort investment decisions. For example, an investor might hold on to a shareholding longer than otherwise because a sale might trigger a large tax bill. A portfolio may end up containing a lot of companies with poor prospects and their market share prices might remain higher than they otherwise would be, i.e. the market in the shares is distorted.

It also causes sales of shares to take place when they might not be best timed, simply to use up capital gains tax allowances in the current tax year. Or investors may even decide to sell in anticipation of changes to tax rates and allowances because of decisions by new chancellors or new governments.

The Treasury played down expectations of any major policy change. But there are fears that with the manifesto vow not to raise Income Tax, National Insurance or VAT, there are few other places left for Sunak to find desperately needed income. As CGT is payable when a disposal occurs and funds are therefore readily available, CGT is relatively easy as a target to raise the additional revenues required to help meet the costs of Covid-19.

There is also the long-term problem that tax on unearned and inherited wealth is generally lower than the tax employees pay from working. This means that the wealthy often have an effective tax rate that is lower than a working person.

What changes could come in?

The Chancellor has three main options: raise the rates levied say from a maximum of 28% to 45% to bring them more in line with income tax rates, reduce the allowances (possibly abolishing the current £12,300 annual CGT-free band); and/or levy CGT on other assets – such as private homes and classic cars.

How will it affect homeowners?

‘Private residence relief’ means you do not pay any CGT on the gains made when you sell your home. If this relief was abolished, the tax take in 2019/20 is estimated to be £26.5bn, a 300% increase, according to Treasury estimates. A change of this magnitude is however unthinkable under a Tory government. Labour has also rejected ending the private residence exemption, preferring instead to consider higher annual property taxes.

The private residence relief has encouraged people to invest in a home as an asset for their retirement. This has powered the house price bonanza in recent years and encouraged people to occupy bigger houses than they need. Although encouraging home ownership is meritorious, it is not clear why gains from owning a home should be tax free. Reforming this could be a political hot potato.

That does not mean property is untouchable from a CGT standpoint. An easier target will be second homes and buy-to-lets; the CGT rate could be aligned with income tax rates – at 20%, 40% and 45% – meaning that the tax take on buy-to-let disposals would rise sharply. The problem for the Treasury is that it cannot force landlords to sell, and they might choose to hold on to property for longer without disposing of it.

What other CGT changes could come into effect?

The OTS is likely to consider a lot of tinkering around the edges. It could reduce Business Asset Disposal Relief which effectively means business owners and significant shareholders (over 5%) pay an effective CGT rate of just 10% on lifetime gains of up to £1m. Previously, until the Spring Budget, this relief was as high as £10million.

Or the OTS could overhaul the various mechanisms used to defer CGT or offset gains with losses made elsewhere.

What other taxes might the government consider?

A broader wealth tax, although an anathema to many in the Conservative party, is gaining some support. It already exists in several European countries; Norway has had one since 1892, with individuals paying a total rate of 0.85% on net wealth above the value of about £126,000. It raises around 1% of Norwegian tax revenue. In Switzerland, it is set at between 0.3% and 1% of a taxpayers’ net worth, depending on the canton in which they live. Spain imposes a tax of 0.2% on assets over €700,000, rising to 2.5% on fortunes over €10.7m, although as each region can set their own allowances, it is considered an ineffective tax.

CGT rates and indexation

It seems irrational to have different rates for capital gains and income, which is currently the arrangement and this is one simplification that could be made.

One big problem is the lack of indexation on capital gains, which was scrapped some years ago by Gordon Brown and replaced by allowances. This means that you pay tax not on the real change in the value of a share, but on that created simply by inflation when the shares are worth no more in reality. This may not seem a major issue in a period of low inflation, but with money being printed like it is going out of fashion by governments, high inflation might well return. Even a low rate of inflation over many years can result in a very large tax bill, and even worse, investors may not always have the option to retain the holding. A takeover bid for a company can effectively force a sale. Indexation could be reinstated as it was not difficult to take it into account in when submitting tax returns.

These defects might be considered an argument for scrapping CGT altogether but that is unlikely. However, an alternative proposal would be to reform it so that a rollover of investments does not incur tax. In other words, if you reinvested the proceeds from a sale of shares or other assets into new assets within a certain period then no tax would be payable.

Interaction between CGT and IHT

Do people even care about paying tax on their profits when they die? Capital gains tax liability currently disappears on death and that might need to be changed if rollover was permitted but there is interaction with inheritance tax which would also need to be reconsidered.

Entrepreneurs

Capital gains tax has always had a negative impact on business creators although there are allowances that reduce their liability when a business is sold. Much tax planning activity is prompted by such outcomes which typically undermines the tax take. Another related issue is that high capital gains tax rates encourage wealthy entrepreneurs to move to countries where capital gains taxes are lower or even zero. The country loses their expertise and also they spend their money in other countries as a result.

Conclusions and recommendations

In summary capital gains tax is ineffective, generates relatively little in tax from very few individuals and is a disincentive to entrepreneurial activity. It can result in tax being paid on purely inflated share prices and when no actual cash is realised as the profits are often reinvested. It can therefore discourage new investment and distorts the stock market.

There are several steps investors can take to reduce or avoid capital gains tax, for instance by holding investments in tax-efficient wrappers such as:

Individual Savings Accounts. £20,000 can be invested each tax year and a family of four can invest £58,000: £20,000 for each adult and £9,000 for each child.
Pensions wrapper. Investments held within pensions do not incur CGT when sold within the wrapper and contributions into pensions receive income tax relief in line with the investors marginal rate of income tax.
Holding investments in an offshore bond structure can mitigate higher rates of CGT. Because this wrapper is provided by an offshore insurer, the assets within it are not subject to UK income tax or CGT although they may be subject to withholding tax which cannot be reclaimed.
Investors with substantial assets might benefit from setting up a private investment company particularly if tax rates rise. Assets held within a private investment company do not incur CGT but are liable to corporation tax. Although this tax rate at 19% is not a lot different to the current CGT rate, it could be less punitive if CGT rates are increased.
Finally, it is important to take advantage of the annual CGT exemption of £12,300 in the current tax year so gains up to that amount can be realized without incurring CGT. The proceeds can be reinvested after a period of 30 days thus resetting the tax base. You can also transfer assets to a civil partner or spouse without incurring CGT, enabling both of you to take advantage of the annual CGT allowance.

In light of the Government requesting a review of CGT and the possibility that this might lead to an increase in rates and/or a reduction in allowances, now might be an appropriate time to review CGT regime based assets. Values and therefore gains are likely to be lower than a few months ago allowing greater opportunity to reposition portfolios to reflect the current economic environment and the possible changes ahead. As ever specialist advice is vital and Clarion are here to help, so please feel free to contact us at any time.