The Chancellor will announce the next Budget on 3 March 2021. Many speculate that he will increase the rates of capital gains tax to help raise cash necessary to recoup the public costs arising as a result of the COVID-19 pandemic.
The proposed capital gains tax reforms, of which any Budget announcement would form a part, have the potential to significantly affect shareholders selling their business, and business reorganisations. An increase in capital gains tax rates may also affect partners in partnerships disposing of carried interest or co-invest and employee shareholders.
Will the capital gains tax rates increase in 2021?
For months now there has been speculation that capital gains tax rates will go up in the forthcoming Budget. The British economy, which suffered under the COVID-19 pandemic, has been propped up by the furlough scheme and a number of other financial emergency, placing pressure on the Exchequer’s purse. To finance increased Government borrowing and continuing business support measures, it is argued that the Exchequer will need to increase tax rates, including capital gains tax rates. Helpfully for the Chancellor, a report on Capital Gains Tax reform by the Office of Tax Simplification published on 11 November 2020 recommended closer alignment of income tax and capital gains tax rates. Read our review of the proposals.
As well as the question of whether and how any changes to capital gains tax might take effect, there is also a question of when is the right time for them to take place. The difficult balance to be struck between management of the public finances on the one hand and stimulating the fragile economy on the other hand is widely acknowledged. In practice, any Budget announcement is expected to be impacted by progress in the fight against COVID-19 between now and 3 March.
How much might the capital gains tax rate go up by?
If the Chancellor equalised capital gains tax with the rates of income tax, this would push the top rate of capital gains tax to 45% (the income tax rate for additional rate taxpayers), a rise of 25% for a higher and additional rate taxpayers. Basic rate taxpayers, would face an increase of 10% to 20% capital gains tax) – or higher rates on large gains treated as the top slice of income. This would bring the capital gains tax rates to the levels comparable to the early 2000s when it was last equalised with income tax.
While equalising rates is a possibility, another, perhaps stronger possibility, is that the capital gains tax rates go up, but by a smaller amount. This could mean a new capital gains tax rate of 25% to 30% for higher and additional rate taxpayers. This would partially satisfy the Exchequer’s need for increased cash collection whilst mitigating against the dis-incentivising effect that equalising the capital gains tax with income tax would have on investment and entrepreneurship - an important consideration if the Chancellor wants to attract new business into the country after Brexit.
Will carried interest be affected by capital gains tax changes?
The current capital gains tax rate in relation to carried interest is 28%. If the capital gains tax rates go up for shareholders, the capital gains tax rates for disposals of carried interest will also likely go up by a similar amount.
If a change is announced in the Budget, when will the capital gains tax rates go up?
Based on the way the government has introduced tax changes in the past, there are two likely possibilities:
- The changes will be effective from the date of the Budget, 3 March 2021; or
- The changes will be effective from the new tax year, starting 6 April 2021.
When the Treasury introduced changes to the Entrepreneurs’ Relief (now Business Asset Disposal Relief) in the spring 2020 Budget, the government outlined the proposed changes to the legislation some of which were effective from the Budget date, 11 March 2020. There was no transitional period for the new rules. This meant that the taxpayers were given no chance to prepare for the changes and arrange their affairs accordingly. A repeat of this scenario is not unlikely in the 2021 March Budget.
In contrast, the removal of taper relief was announced in the pre-budget report of 2007 to apply from 6 April 2008 which allowed taxpayers to enter into commercial transactions prior to the change taking effect – raising capital gains tax revenues considerably in that year.
It is not possible to know which of the above scenarios is likely to apply but the potential for changes to capital gains tax rates is likely to influence business behaviours, including a possible decision to sell shares or business assets in advance of the Budget.
Will it make a difference to the shareholders if they accelerate their share disposals before the Budget date?
Many business owners who are already in the process of selling their business have decided to complete their disposals before 3 March 2021 to mitigate against the potential effects of the Budget on the tax treatment of their disposals.
Business owners who are contemplating a share sale or a business restructuring and who have not yet started the process need to proceed with caution, as anti-forestalling provisions may apply to their transactions. When the government introduced changes to Entrepreneurs’ Relief in March 2020, new legislation included anti-forestalling provisions which meant that certain non-commercial transactions entered into before the Budget date (but in anticipation of the Budget changes) were not effective in crystallising gains under the pre-existing regime. The government may introduce anti-forestalling rules as well in March 2021 Budget.
We do not expect the Budget to include grandfathering provisions – for example, for share options already granted but not exercised.
Will higher capital gains tax rates affect which share plan should be used to reward and incentivise employees with shares on my existing employee share incentive plan?
Companies that wish to give shares to employees should consider the possibility of changes to capital gains tax rates when deciding which share plan is suitable for the company and its employees. We have developed a free tool which will help you determine which share plan is the best for your company. You can access the tool here: Which Share Plan?
Despite the proposed changes to capital gains tax rates, we expect that rewarding and incentivising employees with equity, such as growth shares or EMI options, will continue to be more tax-efficient than rewarding them with cash or non tax-advantaged share options. Employee ownership is strongly supported by the UK government because companies that award equity to management and employees tend to out-perform those that do not.
Changes to capital gains tax rates will cause some incentive share plans to perform better after-tax than others. The terms of the existing employee share plans may need to be reviewed to establish whether they are still fit for purpose given the capital gains tax changes. For example, an award of shares may be relatively less attractive to an award of options, given the corporation tax recoverability differences of both schemes. A holistic approach which considers all aspects of employee incentivisation and taxation will be necessary taking into account potential tax changes.
If you would like to discuss the impact of potential tax changes in the Budget on your management shareholdings or incentive share plans, please contact Andy Goodman or Matthew Emms.