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The Office of Tax Simplification (OTS) has recently published its first report following its review into capital gains tax (CGT). The report follows the request by the Chancellor of the Exchequer, in July 2020, for the OTS to undertake a review of CGT to “identify opportunities relating to administrative and technical issues as well as areas where the present rules can distort behaviour or do not meet their policy intent.”
The report, entitled “Simplifying by Design”, focuses on the “policy design and principles underpinning the tax.” It is to be followed by a second report (due to be published early next year) which will look at the technical detail and practical operation of CGT.
The report has attracted much attention in the media due to some of its more radical recommendations which, if adopted, would result in an overhaul of CGT as we know it.
The OTS makes recommendations across four interlinked areas: (i) rates and boundaries; (ii) the annual exempt amount; (iii) capital transfers; and (iv) business reliefs.
Rates and boundaries
It has been difficult to miss the headlines concerning a “doubling of CGT rates”. What the OTS report in fact recommends, is for CGT rates to be more closely aligned with income tax rates, or for the Government to consider addressing boundary issues between CGT and income tax to reduce distortions. The report observes that the disparity between CGT rates and the comparatively higher income tax rates acts as an incentive for taxpayers to try and generate capital gains rather than income.
The OTS recognises that, if the Government were more closely to align CGT rates with income tax rates, this would create other issues, not least that individuals would be less inclined to dispose of assets. The OTS recommends a number of measures for the Government to consider, including : reintroducing a form of relief for inflationary gains; reviewing the interactions with the tax position of companies (as corporation tax rates are lower than income tax rates, taxpayers may be more incentivised to hold assets through companies, such as family investment companies); and allowing a more flexible use of capital losses (to avoid taxpayers’ attempts to re-characterise capital losses as income losses).
Many commentators have expressed concern that if CGT rates are significantly increased it may deter investment, particularly from outside the UK, leading to a detrimental effect on the UK economy.
If CGT and income tax rates are not aligned, the OTS recommends that the number of CGT rates should be cut, suggesting two would be better than four, to reduce complexity. The dependency of CGT rates on income tax rates should also be reduced or removed so as to enable taxpayers to predict their CGT liability at the time of their disposal (rather than waiting until they know their total income for that tax year). The report notes that the CGT rate structure has fluctuated over the years between a flat rate and multiple rates, reflecting the continual struggle between trying to achieve both neutrality and simplicity.
In terms of addressing boundary issues between CGT and income tax (if rates are not aligned), the report highlights the disparity between the taxation of some share-based remuneration as compared to cash bonuses, and the accumulation of retained earnings in smaller companies where the benefit is realised on sale or liquidation (triggering a charge to CGT) rather than being withdrawn as dividends (and taxed as income). To address this, the OTS recommends that the Government considers a more consistent treatment of employees and owner-managers’ rewards from personal labour, and considers charging income tax rates on more of the share-based rewards arising from employment and the accumulated earnings in smaller companies.
The report notes that wealthier taxpayers have greater opportunity to obtain professional tax advice, enabling them to set up corporate structures which allow them to choose the extent to which they are subject to income tax or lower level CGT, depending on whether they receive dividend income or leave profits to accumulate within the company.
Interestingly, the report also observes that the majority of gains relate to a relatively small number of taxpayers who report very significant gains. In tax year 2017/18 2,000 taxpayers reported net gains of over £5 million, which accounted for 34 per cent of the total net gains.
As to whether the Government decides to raise CGT rates or address the boundary issues between CGT and income tax is a policy choice for the Government, but the report highlights the benefits of a more neutral tax system.
The annual exempt amount (AEA)
Another policy choice for the Government is whether the AEA (which is currently £12,300) is intended to operate as an administrative de minimis, a relief, or as a means of compensating for inflation. The report highlights that the high value of the AEA “distorts investment decisions” and recommends that, if it is the Government’s policy that the main purpose of the AEA is an administrative de minimis, it should consider reducing its level to somewhere between £2,000 to £4,000. If the AEA is reduced, the Government should also consider making a number of other reforms to counter the effect that more people would be brought into the scope of CGT. These include: introducing a broader exemption for chattels where only certain categories of assets are taxable; improving the administrative arrangements for real time CGT reporting; and requiring investment managers to report CGT information to taxpayers and HMRC to simplify compliance for individuals.
The OTS recognises that there is a balance to be found between the additional tax generated by a lower AEA and the administrative costs involved (for both the individual and HMRC) in terms of reporting the gains. The report refers to HMRC’s estimates that a reduction of the AEA to £2,500 would result in 360,000 more individuals needing to report a capital gain with £835 million more tax being generated in the first year alone. However, these figures take no account of the behavioural changes likely to be brought about by a lower AEA, particularly in those taxpayers who currently use it as an allowance within which to realise investment gains. Given the likely behavioural effects, one wonders whether reducing the AEA would lead to such a significant increase in tax take.
Ultimately the Government will need to consider the role and purpose of the AEA and then set the threshold accordingly. If the Government decides that the role of the AEA is as a relief (rather than an administrative de minimis), some respondents to the CGT review suggested tapering the AEA by reference to a threshold, like the income tax personal allowance.
The report flags the “incoherent and distortionary” interaction between CGT and inheritance tax (IHT), such that similar transactions can lead to a charge to one tax, both taxes, or neither tax due to the combined effect of IHT exemptions and reliefs, and the CGT exemption and tax-free uplift in value on death. Repeating the recommendation made in their review into IHT, the OTS recommends that where an IHT relief or exemption applies, the Government should look at abolishing the capital gains uplift on death and, in its place, introduce a “no gain no loss” approach such that the asset is inherited with the deceased’s historic base cost.
The report refers to the “lock in effect” caused by the CGT free uplift on death, which can deter individuals from disposing of assets during their lifetime. Consequently the OTS recommends that the Government should consider removing the capital gains uplift on death more widely (i.e. even where an IHT exemption or relief does not apply) so that assets are inherited at the deceased’s historic base cost. To help mitigate the resulting administrative challenges, the OTS recommends a general rebasing of all assets from 1982 to perhaps the year 2000, and extending gift holdover relief on lifetime gifts so that it applies to a broader range of assets than just trading businesses. This would help neutralise the treatment of gifts made in lifetime and on death by deferring the payment of CGT until a subsequent sale in both cases.
There is no doubt that removing the capital gains uplift on death would lead to a significant administrative challenge for personal representatives, who would need to establish historic base costs in many cases where records do not exist. The OTS envisages that executors would calculate notional capital gains on death alongside their IHT calculations and would record them on “executor certificates” of gains which the beneficiary could refer to on a subsequent sale.
Although not contained within the main body of recommendations, practitioners will be relieved to hear that the report raises the possibility of a new allowance for personal representatives of smaller estates (i.e. in the form of an increased AEA), or an exemption in respect of the proceeds of lower value assets sold in the administration period. The OTS also envisages that the pre-death gains on a main or only home would continue to be exempt from CGT.
If the Government were to abolish the capital gains uplift on death, consideration would need to be given to situations where IHT was also due, if the Government wanted to avoid creating a new distortion in favour of lifetime transfers. The OTS suggests two possible options: (i) the value of the chargeable estate for IHT purposes could be reduced by the CGT that would be due if the asset had been sold at the time of death; or (ii) IHT could be paid in full on the basis that on the eventual sale of the asset, it would be set against the CGT bill. Either way, one cannot help but feel that this would be anything but a simplification.
The final part of the report focuses on investors’ relief and business asset disposal (BAD) relief (previously entrepreneurs’ relief), both of which are intended to encourage investment by reducing the rate of CGT payable on the disposal of qualifying business assets to 10 per cent. However, the OTS queries to what extent BAD relief encourages investment given that it applies not at the time the investment is made but (as its name suggests) on the eventual disposal of the investment.
The OTS indicates that there is a policy judgement for the Government regarding the intention behind BAD relief. It recommends that the Government should consider replacing it with a relief more focused on retirement. The idea would be to provide a specific relief for when business owners retire in acknowledgement of the fact that a person’s business may be their pension. If the Government agrees with this objective, the OTS suggests several specific measures including: increasing the minimum shareholding from 5 per cent (to possibly 25 per cent) so that the relief is targeted at owner-managers rather than employees; increasing the holding period from two years to 10 years; and reintroducing an age limit, possibly with reference to pension freedom age thresholds, so that it mainly benefits those who are retiring.
Investors’ relief is a new relief which external investors have been able to claim in relation to investments made from April 2016 and disposed of from April 2019. Consequently there is limited evidence regarding the use of the relief, but the OTS observes (from the responses to their consultation) that the relief has had minimal interest or use. Accordingly the OTS recommends that it should be abolished. This is arguably premature given that earliest point at which the relief could be claimed is in 2019/20 tax returns, which do not need to be submitted until January 2021. One would hope that, even if the relief is abolished, the Government will introduce something else in its place to encourage entrepreneurial risk-taking.
Whilst some commentators have suggested that CGT rules may change in the next Budget, it is worth remembering that we are still waiting for the Government’s response to the OTS review of IHT — the OTS published its first report in November 2018 and its second report in July 2019) — so an overhaul of CGT may be some way off yet and, hopefully, might be done in conjunction with IHT reform given the interconnection between the two taxes.
That said, there is no doubt that the Government is under increasing pressure to raise tax revenue given the amounts they have spent in response to the Coronavirus pandemic. It is noteworthy that the Conservative party manifesto made no promises not to raise CGT rates (unlike income tax, national insurance contributions and VAT), so CGT reform may seem like an easy win.
[accessed 25 November 2020].