Helen Jones, Tax Partner, reviews the latest proposals on simplifying capital gain tax.
The Office of Tax Simplification was tasked with undertaking a review of capital gains tax (CGT) by the Chancellor and the first report on the ‘principles’ of CGT “Simplifying by design” has now been published.
The report draws on the responses the OTS has received (including from BDO) to the first part on the consultation on policy and analysis of taxpayer data specifically commissioned by the OTS. It goes on to set out a framework of policy choices for the Government to consider over four areas:
- CGT Rates and boundaries
- The Annual Exempt Amount
- Business Reliefs
- CGT interaction with lifetime gifts and Inheritance Tax.
CGT rates and boundaries
Setting tax rates is not as easy as it sounds: it is difficult for Governments to strike a balance between simplicity and fairness. For example, a flat tax rate of CGT would be simple to understand and operate – especially in comparison with the four rates that can currently apply, together with the complex interaction with the income tax basic rate band for the taxpayer. However, whether it is fair that the wealthy pay the same rate of tax as those less well-off is, naturally, a highly charged question.
The OTS says the fact that CGT rates are lower than income tax rates distorts the behaviour of taxpayers – ie encourages them to seek a return that is taxable as a gain rather than income. I would argue that to some extent that is the point of the current rates. Lower rates of CGT encourage taxpayers to make risky equity investments on which gains are subject to CGT. At a time when the UK needs all the investment it can get, I don’t see this as an unwelcome ‘distortion’.
The OTS says that if the Government wants to address this distortion, it should “consider more closely aligning Capital Gains Tax rates with Income Tax rates”. However, it recognises that this would carry a significant ‘lock-in’ risk with taxpayers simply not selling assets that have appreciated in value and instead holding them until they die so that they can be passed on to the next generation (sometimes tax free). This might well prove to be a more damaging distortion to the economy. In my view, to enable the economy to thrive, it is essential that capital gains tax rates remain lower than income tax rates so that we incentivise individuals and businesses to keep investing into the UK.
More helpfully, the OTS does say that if the Government does not wish to address the distortive impact of lower rates of CGT, it could still simplify CGT by “reducing the number of Capital Gains Tax rates and the extent to which liabilities depend on the level of a taxpayer’s income”.
In respect of boundaries with other taxes, the OTS have identified the use of shares and securities as a form of remuneration as an area where income tax should potentially apply. They are differentiating between investments on similar terms to external investors against an investment of ‘labour’.
The annual exempt amount
We now have a number of small income exemptions to ensure that individuals with a small amount of savings, trading and property income (under £1,000) do not have to complete a tax return. The CGT annual exemption originally started out with the same purpose but over the years it has been increased by various Chancellors to the current level of £12,300. HMRC statistics show that many investors sell assets each year to effectively use this exemption as a tax relief. This is hardly a surprise, if you offer an exemption, you should not be too surprised if people use it!
The OTS recommends that the annual exemption is scaled back to between £2,000 and £4,000; alongside increased digitalisation by moving to real time CGT for all transaction (we already have a 30 day reporting deadline for property related CGT) and improved reporting by Investment Managers. I am unsure how much tax would be collected by such a change. Surely, reducing the exempt amount would just reduce the amount of gains people choose to realise each year?
The replacement of Entrepreneurs’ Relief with the much less valuable Business Asset Disposal Relief in the last Budget was perhaps the biggest change to taxes for business owners for many years. The stated reason for its removal (that it was not achieving its objective of encouraging entrepreneurial activity) was hotly debated at the time although respondents to the OTS call for evidence suggest that upfront tax relief (similar to that provided buy the Enterprise Investment Scheme) would be more effective that the new Business Asset Disposal relief (BADR).
The OTS suggests BADR should be more closely targeted on retirement scenarios. They go on to recommend that Investors Relief is simply abandoned because it is hardly ever discussed or used. Given it was only introduced from 6 April 2016 and shares must be held for at least three years from 6 April 2016, this is not surprising! I think it’s too early to say if Investors Relief will ever prove an effective incentive but, some form of tax relief to encourage entrepreneurial risk taking would be of benefit. If such a relief is created, it is probably right for BADR to then be used simply to protect retiring business owners for whom their business is frequently their only pension.
CGT and IHT
I have to agree with the OTS report when it says that “the way Inheritance Tax and Capital Gains Tax interact is incoherent and distortionary”. And in some cases it is true that there is “a significant ‘lock in effect’, discouraging people from disposing of assets before they die, because no Capital Gains Tax is charged on death”: why would anyone choose to pay more tax that the law requires them to?
However, I do take issue with the OTS’s proposal that the capital gains uplift on death is removed and all assets are transferred to your beneficiaries at their original cost when you die. How this is simpler is not clear to me: a taxpayer may have owned an asset for over 50 years – how likely is it that the full base cost details will be available to their executors to work out the gain at death?
To address this issue the OTS suggest cost values are based as if they were acquired in 2000 (or their actual value if acquired later). In practice, it is hard to argue that this is simplification: a rebasing of assets to their value on 1 January 2000 adds complexity and uncertainty to both the taxpayer and the Exchequer. Surely, any rebasing can only be effectively introduced prospectively, ie by giving taxpayers advance notice that from say 2025 CGT will be worked out using the 1 January 2025 value of the asset sold? HMRC will then have time to work very hard to educate people to help them understand their new record keeping obligations.
As we and many respondents to the OTS’s call for evidence pointed out, reform of CGT should go hand in hand with IHT reform. An overhaul of UK taxes on wealth (both CGT and IHT) is long overdue: they are far too complex, poorly understood by taxpayers and well past their natural expiry date.
The prospects for reform?
A Treasury spokesman has pointed out that this is a routine report from the OTS and it does not automatically mean that CGT rules will change in the next Budget. And it is true that, ultimately, CGT reform is a political choice. Some commentators have suggested that the Chancellor will use CGT reform as cover to raise much needed tax revenue. Given CGT only raises £8 - £9bn a year, whereas taxes such as VAT raise over £130bn, the changes mooted will not cover the deficit.
In practice, making widespread reforms to CGT looks like a difficult approach to sell for a Conservative chancellor facing uniquely challenging times for the economy. So I suspect that proper reform of CGT may be some way off yet. But, Chancellor, if it is possible to simplify capital gains tax rates whenever the next Budget comes along, that would be a good start.