Phil Carroll assesses the effect recent changes to capital gains tax will have on people's investments
At the time of writing, Mr Darling had just announced a new tax relief for entrepreneurs in response to much lobbying following his Pre-Budget announcements on reforming the capital gains tax (CGT) regime. This is good news but only addresses one area of concern. We will have to see what the Finance Act actually delivers, but let's hope there are no new surprises.
However, on the face of it, the Chancellor's Pre-Budget Report (PBR) announcement of simplification of the CGT regime should be welcome news and an excellent opportunity for long-term investments. The new headline rate of 18% for individuals and trustees stole the limelight in October. It is now important for advisers to work through what this will mean in practice for both existing and new clients. If we look at the impact of the rate change and the loss of indexation and taper relief, we can quickly draw conclusions about winners and losers. Understanding these changes will present a number of planning opportunities to take advantage of.
As a simple overview, Table 1 compares the current and future headline rates.
The numbers in red indicate where the new headline rate will result in higher tax than currently. To understand this in detail it is worth revisiting how indexation and taper relief are currently applied to gains, as shown in example 1. The simpler calculation for the new regime is shown in example 2.
Example 1 - calculating CGT liability pre-6th April 2008
Consider Tom, who purchased a buy-to-let flat in December 1993 for £50,000 and sold it in December 2007 for £200,000. As he sold the flat before 6th April 2008, then indexation relief for the period December 1993 to April 1998 will be calculated, then taper relief applied. The CGT liability is:
- Indexation relief = indexation factor (0.146) x £50,000 = £7,300
- Gain = £200,000 (disposal proceeds) - £50,000 (acquisition cost) - £7,300 (indexation relief) - = £142,700
The asset has been held for nine years but the rules provide for an additional year and thus maximum taper relief is available. This means only 60% of the gain is taxable.
- Chargeable gain = 60% of £142,700 = £85,620
- Tom has not used his annual CGT exemption so can now reduce this by £9,200.
- Taxable gain = £85,620 - £9,200 (annual exemption) = £76,420.
- If Tom is a higher rate taxpayer then tax due = 40% of £76,420 = £30,568.
- However, if Tom had no income then the gain would be assessed through the following tax bands:
- £2,230 x 10%
- £32,370 x 20%
- £41,820 x 40%.
- Total tax payable = £23,425.
From this example, Tom's personal income tax allowance would remain unused. It is worth remembering that from 6th April 2008, the 10% tax band will only be applicable for savings income.
Example 2 - calculating CGT liability post-6th April 2008
If instead, Tom waits and sells the flat on or after 6th April 2008 then according to the latest proposals the CGT liability will be:
- Gain = £200,000 - £50,000 = £150,000 (no taper relief available)
The whole gain will be liable to tax at 18% after any exemptions.
- Taxable gain = £150,000 - £9,200 (annual exemption) = £140,800
- Irrespective of whether Tom is a higher-rate taxpayer or has no income, tax due = 18% of £140,800 = £25,344
Under the new proposals, if Tom is a higher-rate taxpayer he will be better off, but if he had no income he will be worse off.
Using the CGT exemption
Continuing with our example, consider if Tom re-invests £100,000 of his proceeds into a collective investment scheme (unit trust or OEIC) and wants to take the profits year on year. If the OEIC returned 9.2% in capital growth after charges in the first year, Tom would have to sell his whole portfolio in order to fully use his annual exemption. Clearly £9,200 could be withdrawn but this only uses some of his exemption, as a proportion of the capital has been surrendered not the whole amount. This would not give rise to a tax liability today, however future calculations under the part disposal formula would become more complex. There is no proposal to amend these part disposal rules. So, where withdrawals are being taken year on year, a clear understanding is required to ensure tax efficiency is maximised.
Advisers should be aware that the pre-Budget simplification does not extend to removing the current rules preventing sales and purchases of the same funds within 30 days (often referred to as 'bed and breakfasting').
There remains a requirement to report some gains to HM Revenue & Customs, including those that do not give rise to any tax liability due to falling within the annual exemption. Gains in excess of the annual exemption, or where total proceeds exceed four times this amount (£36,800 in 2007/08), need to be filed with the client's self-assessment tax return.
In many situations, a flat rate of 18% and the removal of indexation and taper relief will make life a lot easier in that the calculation of tax will be simpler. However the effect on the tax bill depends on the circumstances of the individual; for some resulting in a higher tax bill and for others a lower tax bill.
As table 1 demonstrates, many basic- and lower-rate tax payers who have invested for the medium- to longer-term will pay a higher rate of tax under these proposals. Advice will clearly be required in order to benefit from the current regime. Crystallising gains before 6th April 2008 may be the right action for some but care should be taken, particularly where clients are in poor health, as CGT is not applied on death.
It is certain that the proposed changes to CGT have presented the tax and financial planning industry with a further opportunity. Clients' need for informed advice has grown significantly and advisers with the necessary knowledge will be well placed to demonstrate added value to their customers.
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