TAX NEWS - JUNE 2010

Britain Tax: Capital punishment - detailed Capital Gains Tax (CGT) changes

The pending announcement of the detailed Capital Gains Tax (CGT) changes will declare the real winners and losers

by Danny Cox, 03 June 2010 -- It has been confirmed, capital gains tax rates will change.

The Tory-Lib Dem joint statement said: "We further agree to seek a detailed agreement on taxing non-business capital gains at rates similar or close to those applied to income, with generous exemptions for entrepreneurial business activities."

The detail of the how and when this tax will change could be released as early as the Budget, on 22 June. Second to VAT, Capital Gains Tax (CGT) for non-business assets is the obvious tax to rise. The gap between the current rate of 18 per cent, after the annual capital gains tax allowance, compared to the top rate of income tax at 50 per cent is huge.

Historically, the Capital Gains Tax rate has been chosen to encourage:

- investment - unlike earnings chargeable to income tax, the investor is putting capital at risk.

- long-term investment - hence the previous indexation and taper regimes.

- enterprise - lower Capital Gains Tax rates for certain business assets.

The simplicity of a flat rate of Capital Gains Tax (CGT) has been popular with advisers and investors. Many spoke of relief at not having to explain taper relief – again. However the problem with the flat rate is a lack of reward for long-term investing and no accounting for inflation – tax is paid on the whole gain not just the real gain.

A realignment with the rate of income tax paid, capped at 40 per cent, should be accompanied by a reintroduction of some form of accounting for inflation and a reward for longer-term investors. Whether this will be a return to the indexation of the base cost or a relief for time invested is yet to be seen. For some, this change to Capital Gains Tax (CGT) could also result in tax reductions, not increases. The definitions of business assets could also be altered.

The annual Capital Gains Tax allowance is also under threat - the Lib Dems wanted to reduce this to £2000. This would widen the CGT net to the extent that it would catch modest investors, potentially low earning staff saving diligently into SAYE schemes. Hardly a prime tax target or in the spirit of fairness. A reduction in the allowance would also be difficult to administer, substantially increasing the numbers of tax returns.

The next question is when might the tax change? A change to Capital Gains Tax (CGT) without notice would only force investors to sit on their gains - investors do not like realising taxable gains at the best of times. Announce a change now, with effect from the 2011/2012 tax year and the tax planning window created should stimulate activity and increase the tax take.

It is worth noting that when Capital Gains Tax (CGT) changed to the flat rate, the announcement was made in the October 2007 pre-Budget report and took effect from 6 April 2008.

A split year would also add complication. Retrospective taxation, taxing gains already made between 6 April 2010 and the date of an announcement, would be deeply unfair.

Certainly the re-linking of Capital Gains Tax rates to income increases the need for planning and advice. It is now not just for income reasons why investments should be held in the name of the spouse who pays less tax.

Investors and their advisers should also be reconsidering asset and wrapper allocations. For example, the consensus has been to hold income producing assets in an Isa and a Sipp. Now should a high-rate taxpayer hold low yielding absolute return or emerging market funds outside tax wrappers only to risk being taxed at perhaps 40 per cent on gains?

A CGT change may also bring investment bonds back in from the cold. Despite what some might tell you, onshore investment bonds have a limited appeal. Why pay up to 20 per cent tax immediately on growth and potentially a further 20 per cent tax upon encashment, compared to a deferred tax at 18 per cent? Furthermore, a loss on a collective can be offset against gains. A loss on a bond is just a loss.

Offshore bonds, under the right charging structure can be more attractive than onshore bonds, but only if the tax deferral outweighs the additional costs. The key issue being the rate of tax which is paid upon encashment.

The current markets for investment bonds are generally:

- Trusts: to defer 50 per cent tax rates and simplify reporting

- Income investors caught by the age allowance trap

- High-rate taxpaying income (mainly fixed interest) investors

Assuming there is no change in the Capital Gains Tax allowance and the investor has fully utilised their Isa allowance, bonds may be considered for personal investment once the risk portfolio generates annual capital growth in excess of the Capital Gains Tax allowance. For example, an assumed straight line growth rate of 7 per cent equates to portfolios of £150,000 and above.

After a re-alignment of Capital Gains Tax (CGT) to income tax rates, the investment bond market will widen providing the tax deferral benefits are greater under a bond than a collective. Understandably we cannot be sure of the winners and losers until the detail of the change is released.

Onshore bonds may retain their ability to index capital gains within their funds, reducing the effective tax rate year on year, to lower than 20 per cent. However, this still results in paying tax which, under the right circumstances, could be deferred. Offshore bonds are likely to remain more attractive since more tax is deferred.

In the meantime advisers are left a little in limbo, unsure which wrapper to use. There will be those who will take this opportunity to blindly increase investment bond sales. This will probably be more about indemnity commission than tax planning.

Even with this uncertainty, investment planning should not come to a standstill. In most cases, the wrapper can still be chosen now. Advisers not wanting clients to be out of the market could opt for a wrapper which gives them the flexibility to change at low cost at short notice if they need to do so. This points towards collectives rather than bonds. Considering the tax scenarios upon early encashment, it is also unlikely a client will be any worse off from a tax perspective opting for a collective now than a bond.

Certainly proactive advice given to clients on Capital Gains Tax (CGT) issues now and on an ongoing basis will help minimise their tax liabilities and show your worth as a financial planner.



Capital Gains Tax planning check list

1.Make full use of both spouse's capital gains tax allowances

2.Consider realising large gains at current rates

3.Offset losses against gains

4.Shelter existing investments from tax using investments not subject to capital gains tax. The most popular are Isa and Sipp. Venture Capital Trusts are another alternative

5.Minimise taxable income to reduce the rate of Capital Gains Tax (CGT) payable including using tax free national savings and investments products and moving investments into the name of the spouse who pays the lowest amount of income tax

6.Review asset allocation and wrapper strategies

7.Use Sipp contributions to extend the basic rate tax band to help reduce Capital Gains Tax (CGT)

8.Consider multi-manager investment funds. The buying and selling transactions within a multi manager investment fund do not trigger a chargeable gain