"The continued flat rate of capital gains tax at 18% was a big surprise and must be unsustainable in the longer term, given its disparity with the higher rates of income tax. The CGT rate could once again become linked to income tax rates in the not too distant future so it's a case of use it while you can and anyone thinking of disposing of assets should get a move on. This potentially represents a window of opportunity worth thousands of pounds for some people - but blink and you could miss it."
Realistically,we need a CGT system which recognises long term investment and provides certainty for investors," said Richard Mannion, national tax director at Smith & Williamson, the accountancy and financial services group.
Capital Gains Tax: the way forward
Richard Mannion, of Smith & Williamson accountants and investment managers, calls for a capital gains tax system which recognises long-term investment and provides certainty
Capital gains tax has enjoyed something of a chequered history since its introduction 45 years ago. At times the rate has been linked to income tax rates, whilst at other times there has been a flat rate. One constant has been the amount of tinkering that has gone on throughout the 45 years which indicates the lack of a long-term plan for a tax that impacts particularly on savers and businesses. The discussion points for that long-term plan are outlined below:
Case against increase in CGT rates
- Any major change to CGT now would be the third major change in 12 years. Such constant change is damaging to investors' plans.
- There are fears that some of the wealthiest taxpayers could leave the UK if the rate of CGT increases (non-residents are not usually taxable on gains arising in UK) and they could include entrepreneurs who generate wealth for others.
- By definition capital gains are different to income – they often accrue over lengthy periods and involve significant risk of loss and so unless relief is given for inflation they should be taxed at a lower level.
- If there are fears about alchemists converting income into capital they could be tackled by the use of targeted legislation.
- CGT currently contributes approx £4bn to the Exchequer's coffers every year so even if it is doubled it won't fill the gap.
- Increasing the rate of CGT will change taxpayer behaviour. Consequently, transactions that otherwise might have been done now would be delayed in the hope of lower rates in future.
- Likely to have a disproportionate effect on pensioners who rely on capital gains to supplement their savings income.
Case in favour of an increase in CGT rates
- The current gap between the top rate of income tax and CGT is unsustainable and will lead to aggressive tax planning.
- Short term gains have similarities with income.
- No hard evidence that the lower rate of CGT encourages entrepreneurs to start up in business.
- With low inflation rates, there is no need for lower tax rates for assets held long term.
Policy points
The Government needs to decide the role and purpose of CGT. In particular, the following points should be addressed:
- Is CGT intended to be a money-raiser or is it purely a defensive mechanism to prevent the leakage of income tax by redesignating income as capital?
- Should long-term investment gains be taxed more liberally than income?
- If all gains and income are subject to common rates of tax should there be relief for inflation or should the gains be tapered in accordance with the length of time they are held?
- If the flat rate is retained, but increased, that increase should reflect the fact that many taxpayers are liable at a top income tax rate of 20%.
- Is it a tool to stimulate business or entrepreneurial behaviour or should all different types of investment be treated the same?
- Should it be used a social policy tool, for example, by encouraging homeownership?
CONCLUSIONS
- CGT is never going to be a huge money spinner for the Government, therefore its main purpose is in completing the range of taxes in order to prevent leakage of income tax.
- We need to have a CGT system which is as simple as possible and that will last for the next 10 years or so to provide certainty for all..
- The annual exemption works well in taking a large number of small transactions out of the net.
- Past experience indicates that the timing of transactions involving business assets is affected by the tax regime.
- Whether or not a would-be entrepreneur starts a new business venture is probably affected more by the general levels of bureaucracy and admin burdens imposed on small businesses in the UK like employment law, health and safety issues, PAYE and VAT etc.
- The most difficult areas are arguably the treatment of business assets and the private home:
- Should business assets be liable at a lower rate of tax and if so how best to accommodate that policy; and,
- Should private homes be liable to tax. The lack of tax cases on the subject over recent years suggests that the present system for dealing with private homes works and so one would recommend the "if it ain't broke, don't fix it" principle.
- With the benefit of hindsight the taper relief system has much to commend it with capital gains initially taxed as the top slice of income, but with the effective rate reduced by the length of ownership and whether or not the asset was used for business purposes. The detailed legislation was perhaps over-complicated, but nevertheless the system itself seemed to produce the right policy objectives, namely rates of tax that were aligned, simple reliefs for business assets, and a discount for length of ownership.
- The forthcoming election affords an excellent opportunity for a long-term plan to be devised after a sensible period of consultation.
Background: the history of capital gains tax
Prior to 1963 capital gains were free of tax and during the period 1963 to 1965, short term capital gains were charged to income tax.
In 1965 a separate capital gains tax was introduced to cover both short term and long term gains. Exemptions were included for the principal private residence and motor cars amongst others. Reliefs were included for certain transactions involving business assets. In later years relief for inflation was introduced.
Initially gains were charged at a flat rate of 30%. The rate of tax payable varied over the years as follows:
- Up to 1987/8 – flat rate 30%
- 1988/9 to 2007/8 – gains taxed at income tax rates as top slice of income.
Major reforms took place in 1998 when taper relief was introduced. Essentially, the new taper reliefs replaced inflation relief and linked the amount of gain chargeable to the type of asset and the number of years it was held. The amount of taper relief was significantly more generous for business assets so that a gain on the sale of a business asset that had been owned for two years was taxable at an effective top rate of 10%. The effective top rates for a non-business asset varied from 40% to 24% depending on how long the asset had been owned.
During 2007/8 there was significant comment about the fact that taxpayers in the private equity market were achieving the 10% rate on substantial gains. Following on from this the Chancellor announced in the 2007 PBR that taper relief was to be abolished with effect from 6 April 2008 and all subsequent chargeable gains would be subjected to a flat rate tax of 18%.
This announcement produced a backlash from the small business community who suddenly saw their prospective CGT bills rise from 10% to 18%. As a result of the subsequent lobbying, the Chancellor introduced the entrepreneurs' relief which was intended to ensure that the 10% rate remained in place on gains on business assets of up to £1m.
Entrepreneurs' relief was modelled on the old retirement relief legislation that had been replaced by taper relief in 1998 on the grounds that it was too complicated!
So for the years 2008/9 and 2009/10 we have had a flat rateset at the historically low level of 18% compared to the top rate of income tax of 40%. The income tax top rate increases to 50% thereby exacerbating the large differential between CGT and income tax rates. There has been increasing anecdotal evidence that that large differential means that taxpayers are changing their behaviour and seeking to convert income (taxed at 50%) into capital (taxed at 18%).
All of which brings into question the decision in 2007 to switch from a system which started by charging gains at the top income tax rate and then tapered the liability depending on the length of ownership and type of asset to a system whereby all gains are taxed at a substantially lower level than income. With the benefit of hindsight that decision seems like a knee-jerk reaction to the private equity issue that could perhaps have been dealt with by adjusting the length of ownership required to achieve the maximum taper relief.
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