Where next for capital gains tax?
Rather surprisingly, the Office of Tax Simplification (OTS) has rushed out its initial report on capital gains tax (CGT). The report was issued only two days after the closing date for submissions and despite the fact that the Government has announced that there will be no Budget until next year.
The report is intended to cover issues relating to the design and principles underpinning CGT. A more detailed report focusing on technical and administrative issues will follow early next year.
Although the OTS' remit, as its name suggests, is to advise on possible simplification of the tax system, the Chancellor put the OTS in a difficult position by asking it to consider ways in which the existing rules might distort behaviour or do not meet their policy intent. Inevitably therefore the report strays into areas of policy and deals with matters which have nothing to do with simplification such as rates of tax.
Indeed, the main headline-grabbing recommendation of the report is that rates of CGT should be more closely aligned with rates of income tax, with the estimate that (ignoring behavioural change) an alignment of rates could raise as much as £14bn a year for the Government.
There are however other recommendations which have received less publicity but would nonetheless have a significant impact on many individuals. In this note, we have a look at some of the key recommendations.
Rates of tax
The report stops short of recommending an alignment of income tax and CGT rates, instead referring to rates being "more closely" aligned.
Its justification for this is partly that the differential in rates encourages people to try and convert income into capital gains and partly that it would simplify the tax rules as there would be no need for complex anti-avoidance provisions policing the boundary between income and capital gains.
Against this, the OTS accepts that, if CGT rates and income tax rates are aligned, there would be a need for other changes which would increase complexity. This includes:
- the possibility of averaging gains over the holding period of an asset so that a basic rate taxpayer does not have to pay tax at higher rates just because a large gain is realised in a particular tax year;
- making some allowance for inflation;
- allowing more flexible use of losses; and
- discouraging people from using companies as asset holding vehicles in order to access the lower rates of corporation tax compared to any increased rate of CGT.
Another issue recognised by the OTS is that increasing CGT rates will encourage people to hold on to assets rather than to dispose of them, so giving rise to the inefficient allocation of capital as well as creating different distortions in behaviour to those which might currently exist.
The disincentive to realise gains could of course have a very significant impact on the amount of money which the Government might raise by increasing the rate of CGT.
There is no doubt that current CGT rates are historically low. Some increase in the CGT rate would not therefore be surprising. However, alignment of CGT rates and income tax rates seems unlikely given that there is reportedly strong opposition within the Conservative party.
It is also worth noting that, when the top rate of CGT was changed to the current 28% in 2010, the research which was then undertaken led to the conclusion that this was the optimal rate in terms of raising revenue. Anything higher would lead to less rather than more tax being paid as a result in changes in taxpayer behaviour.
In terms of timing, there is a clear consensus that now is not the time to increase tax rates. There will be a budget in the spring of 2021. It is possible the rates may increase from 6 April 2021 but there is no realistic likelihood of any increase for the remainder of this tax year.
The annual CGT exemption is currently £12,300. The OTS conclusion is that, if the purpose of the annual exemption is to simplify administration by taking out of tax those individuals who realise small gains, a more realistic level would be to set it somewhere between £2,000-£5,000. This would reportedly increase revenues by somewhere between £500m-£900m but result in 300,000-400,000 more individuals having to pay CGT, most of whom do not currently have any need to file a self-assessment tax return.
Any additional tax as a result of reducing the annual exemption would however fall mainly on those at the wealthier end of the spectrum. This may therefore be attractive for the Government. In cash terms, it is insignificant for the very wealthy and so is likely to hit hardest those on middle incomes with modest wealth.
Taxing share sales as income
In the absence of aligning the rates of income tax and CGT, the OTS has suggested that some complexities or distortions could be reduced by taxing certain share sales as income. The two particular areas they have in their sights are share incentives for employees and retained earnings in small owner-managed businesses.
Whilst recognising that there are policy reasons for certain approved share incentives, the OTS draws attention to arrangements such as growth shares (shares which have a low value when issued but grow quickly in value if the company is successful). These are often conceptually similar to share options but any profit on the sale of the shares gives rise to CGT rather than income tax (which is charged on the profits arising on the exercise of a share option). Their recommendation is that consideration should be given to taxing more share-based rewards from employment as income rather than capital gains.
Given the already complicated rules dealing with employment-related securities and approved share incentive schemes of one sort or another, it must be questionable whether this is an area which the Government will want to look at in detail. It is however possible that growth shares and other similar arrangements which result in rewards relating to employment being subject to CGT rather than income tax will come under greater scrutiny.
The question posed by the OTS is whether an individual who accumulates trading profits within a company and then sells the company, paying capital gains on the profits from the sale, should be in a better position than somebody who carries on a business in their own name or receives the profits by way of salary or dividends.
The argument is that these profits all relate to the individual's labour and so, in principle, should be subject to income tax rather than CGT.
The suggestion is that, on a sale or a liquidation of a close company which is classified as "small", any part of the profit which represents accumulated earnings should be subject to income tax rather than CGT.
However, the OTS' examples focus on personal service companies rather than companies carrying on trades which involve significant expenditure in order to generate any income.
Singling out owners of small companies in this way seems hard to justify, particularly as the OTS acknowledges itself that there may be many reasons why it is appropriate to accumulate profits within a company. It also recognises that knowing where to draw the line is very difficult and that there is a significant risk of creating further distortions or an arbitrary cliff edge. It would also create more complexity.
In our view, such a change is likely to be very unattractive politically and is unlikely to be adopted.
Lifetime gifts and gifts on death
On death, the CGT base cost of an asset is uplifted to market value without any CGT liability arising. In effect, any unrealised capital gain is wiped out. This is the case whether or not any inheritance tax is payable.
In its report on inheritance tax last year, the OTS recommended abolishing this tax-free CGT uplift on death. That recommendation is repeated in the CGT report.
The primary recommendation is that there is no tax-free CGT uplift if the asset is not subject to inheritance tax (for example as a result of the spouse exemption or full agricultural property relief or business property relief). Instead, the beneficiary would acquire the asset with the same base cost as the deceased. CGT would be paid when the beneficiary disposes of the asset.
From a policy point of view, this recommendation is not surprising. It is difficult to justify a tax-free CGT uplift on death if no inheritance tax is paid. However, it is certainly not simplification as it requires either the executors of the estate or the beneficiaries to try and piece together the deceased's historic base cost in relation to all of the assets comprised in the estate.
In order to mitigate this, the OTS suggests that there might be a general CGT rebasing. However, no doubt in an effort to limit the tax cost to the Exchequer, their suggestion is that the new base cost for assets should be their value in the year 2000. Given that this is 20 years ago, such a rebasing would be of limited help. It might be more appropriate for example to rebase assets to their value in 2015 as taxpayers are required to keep records for at least six years. This would be similar to the position which was taken in 1988 when the CGT base cost of assets was rebased to their value in 1982.
The OTS goes on to suggest that the tax-free CGT uplift on death should be abolished for all assets, even those where inheritance tax is payable. The logic for this is that the existence of the uplift on death disincentivises individuals from making gifts during their lifetime as they know that if they keep the assets until their death, any capital gain will be wiped out.
In order to align the tax treatment of lifetime gifts and gifts on death, the OTS also recommend that, if the tax-free CGT uplift on death is removed and, instead, the beneficiaries of the estate receive the assets at their historic base cost, there should be no immediate CGT charge on lifetime gifts. As with death, the donee would receive the asset with the donor's base cost and tax would only be paid on a future disposal by the donee.
Although the OTS discusses the need to consider the way in which inheritance tax and CGT interact, there is no suggestion that inheritance tax should be imposed on lifetime gifts where the donor survives for the relevant period of time after the gift is made. This is currently seven years, although, in its report on inheritance tax, the OTS proposes that this should be reduced to five years.
This produces a somewhat surprising result as it would mean that lifetime gifts of any asset could be made without any immediate charge to inheritance tax or to CGT whereas gifts on death, whilst not subject to CGT, would be subject to inheritance tax unless an exemption or relief applies.
In the light of this, it seems inevitable that any change to the CGT treatment of gifts either during an individual's lifetime or on death would require a review of the inheritance tax treatment of such gifts.
Given that inheritance tax is a political hot potato and that successive governments have shied away from any significant changes to inheritance tax, it seems unlikely that any of the recommendations made by the OTS in relation to gifts will be implemented. They do not simplify the tax system and, taken as a package, the measures (based on the figures in the OTS report) are close to being revenue neutral. In the current climate, it would be surprising if the Government was interested in embarking on politically sensitive changes which did not raise any significant revenue.
Entrepreneurs' relief/business asset disposal relief
It seems surprising that business asset disposal relief (BADR) is still under scrutiny given the changes made last year, in particular reducing the maximum relief from £10m to £1m.
However, the OTS recommends that BADR should be abolished entirely and replaced with some form of retirement relief, recognising that owner/managers may well build up value in their businesses as a form of pension arrangement.
This would bring CGT relief on the disposal of shares in closely-held trading companies back to pretty much where it was when CGT was first introduced.
Retirement relief was abolished in 2003 on the basis that it had become too complex and was replaced with reliefs which were designed to encourage entrepreneurial activity more widely. It is of course debatable whether BADR has achieved its objective. The OTS conclusion is that it has not.
There is certainly a case for having a relief for the disposal of shares in a closely-held trading company which is targeted more at retirement. It does however seem odd that the OTS is recommending this change at the same time as suggesting that retained earnings in a small, closely-held trading company should be taxed as income rather than as a capital gain.
Given the recent changes to BADR, it may be unlikely that the Government would now be interested in abolishing it entirely and replacing it with a different relief, the design of which would, inevitably, be controversial.
With barely a page of analysis, the OTS recommends that investors' relief should be abolished. The main reason is that, since it was introduced in 2016, there is little evidence of people making use of the relief.
In a sense, this is not surprising since, realistically, the first year in which disposals might have taken place which would qualify for relief is the 2019/20 tax year in respect of which tax returns are not due until 31 January 2021.
Again, it is difficult to see why the Government would want to tinker with this relief without carrying out a wider review of the reliefs available to encourage investment into unquoted trading companies and deciding how best those reliefs should be targeted. This is more likely to be a medium to long-term project rather than something which the Government would want to initiate at the same time as trying to deal with the fallout from Covid-19 and Brexit.
How will the Government react?
The Government is of course looking for ways to raise tax revenue in a way in which is politically acceptable. This will inevitably include raising more from the wealthy and CGT is one of the ways in which that can be done without breaking any manifesto commitments.
Some modest increase to the rate of CGT therefore seems likely although alignment of rates of CGT with rates of income tax and some of the more radical recommendations from the OTS are much less likely to be pursued. It is interesting that the Financial Times is already reporting that allies of the Chancellor are distancing him from the recommendations in the OTS report.
The reality is that the real purpose of the Chancellor in asking the OTS to review CGT was to see what the public and political appetite was for raising more money from CGT. The answer seems to be that modest increases might be accepted but that more radical reform would not be tolerated.