CAPITAL GAINS TAX – WINNERS AND LOSERS

The Chancellor has now published his thoughts on the change to the Capital Gains Tax system for individuals, trusts and estates.  In the pre-Budget statement in October, the Chancellor announced that, as from 6 April 2008, there would be one flat rate for Capital Gains Tax of 18%, and that both taper relief (business and non-business) and indexation allowance would be abolished.

In addition, 31 March 1982 Market Value would become the mandatory base cost for all assets held on that date.

When the Chancellor says that he will reduce a tax from 40% to 18%, the immediate reaction is joy.  However, in this case that joy is not particularly unbounded.  Entrepreneurs, generally considered the engine room of the country, who create businesses, employ staff and then later on sell their businesses, would normally expect to pay Capital Gains Tax at an actual rate of 10%.   Furthermore, between 1982 and 1988 there is indexation allowance, designed to ensure that the gains taxed were real rather than inflation.  The 10% rate will disappear as will indexation allowance, and so our entrepreneur instead of paying 10%, and having the benefit of indexation if his company goes back that far, will pay 18% on the total gain. 

The winners are those that have non-business assets.  Those whose wealth is in stock and shares or commercial property would have been paying at 40%, after the 6 April will pay at 18%.  Conversely the entrepreneur, the person who has built a business, will pay at 18% rather than 10%.  Those who have held onto their assets for a long period of time, and who otherwise would have the benefit of an indexation allowance will lose that overnight and could be significantly worse off.   

There will be occasions where the 40% rate is better than the 18% rate, because the 40% rate carries with it indexation and taper relief.  Let me illustrate.  Mr. Smith has been in business for many years and his shares are worth £760,000.  Their value in 1982 was £260,000, and so he has a gain of £500,000.  If he sold those shares in the present tax year, when the Capital Gains Tax rate was 40%, his tax would be £22,778.  This is because indexation allowance would increase the base cost by more than £270,000, and taper relief would reduce the effective rate of tax to 10%.

If he sells after 6 April 18% tax will be £90,000, more than four times as much.

So what do you do? Well, one thing that entrepreneurs can do is sell their company in the current tax year to a family trust and pay the 10% rate, and where appropriate take advantage of indexation.  Granted you will pay the tax somewhat earlier, i.e. by 31 January 2009, but you will be paying less tax.

Another method to consider is transferring assets between spouses.  Assume that Mr. A has a farm, which he bought in April 1982 for £500,000.  It is now worth £1.4 million.  He does not want to sell it yet, but he knows that if he sells it after April he will lose both indexation and taper relief.  The solution is to transfer it to his wife, because as between husband and wife there is no tax, but his wife will take the asset at the value including his indexation allowance.  If he bought the farm for £500,000 the indexation allowance is £503,000, and so the wife’s base cost for Capital Gains Tax is £1,003,000.  If that is done and she later sells then the Capital Gains Tax will be £71,460.  If he had not done that and he had sold next year the tax would be £162,000.

What this means is that the tax change is not as good as it appears to be.  If you are a 10% taxpayer then there is, for the most part, an 80% increase.  If you are a 40% taxpayer there could still be an increase.

Somewhat late in the day Mr. Darling introduced what he called his Entrepreneur’s Relief.  What that means is that for certain businesses only, the first million pounds of gain will be taxed at 10%, with the rest taxed at 18%.  So, Fred retires in October 2008, and sells his company making a gain of £5 million.  Under the old regime he would pay £500,000 in tax.  Under the new regime he will pay £820,000 in tax.  This represents an increase of 64%.  And, not everybody qualifies for this relief.  The relief can only be claimed if the individual making the disposal is (i) a director or employee of the company, (ii) owns at least 5% of the company’s ordinary share capital and (iii) holds at least 5% of the voting rights.

David Endicott
Managing Partner
Spratt Endicott Solicitors