Piers Master, Partner and Lyndsey West, Professional Support Lawyer, Charles Russell, London, UK
Lyndsey West and Piers Master analyse the capital gains tax rate increase provided for in the UK Budget.
The Conservatives/Liberal Democrats’ Coalition agreement provided for non-business capital gains to be taxed at rates ‘similar to or close to those applied to income tax’. Given that the top rate of income tax had risen to 50 per cent on 6 April 2010 for individuals with income exceeding £150,000, the Coalition commitment provoked much uneasy speculation about the possibility of capital gains tax (CGT) rates rising to 40 per cent or even 50 per cent. In the event then the top CGT rate of 28 per cent announced in the Budget on 22 June 2010 was less radical than many commentators and advisors had anticipated. The announcement by George Osborne before the House of Commons Treasury Committee on 15 July that he is not planning to ‘revisit’ the CGT top rate also provides grounds for cautious optimism.
On the other hand, the new CGT rate became effective on 23 June 2010 which did not therefore allow taxpayers time to organise their affairs before the rate rise. Furthermore, there were concerns about the logistics of introducing a new CGT rate part way through the tax year and therefore many commentators and advisers had anticipated a rate rise taking effect only from 6 April 2011. As will be seen in this article, a mid-year change in tax rates has introduced some complexities.
With a switch from a relatively generous flat rate of CGT of 18 per cent to a top rate of 28 per cent it is easy to forget that the 18 per cent rate had prevailed for only two years, since 6 April 2008. Until then the top rate of CGT was 40 per cent and this rate was paid by individuals, trustees and personal representatives. However, it was subject to taper relief, which effectively reduced the CGT rate from 40 per cent to 24 per cent for non-business assets held for at least 10 years. For business assets the tax rate was reduced to 10 per cent for assets held for only two years. For individuals’ gains, taper relief had replaced an indexation allowance on 6 April 1998, which had been designed to eliminate inflationary gains. Significantly, no mechanism has been introduced in tandem with the new CGT rate to replicate taper relief or indexation. The new CGT rate therefore bears particularly heavily upon those who have owned their assets for many years and who will therefore be liable for CGT on purely inflationary gains. For these taxpayers the 28 per cent rate is significantly less benign than it might at first appear.
The Coalition has sought to rationalise the selection of a 28 per cent top CGT rate, viewing this level of taxation as less likely to provoke taxpayers into avoidance schemes, for example, by converting income (taxable at top rate of 50 per cent) into capital. Indeed, according to the Chancellor’s Budget statement most of the £1 billion or so of additional tax to be raised by the increase in the CGT top rate will be in the form of income tax. Again according to the Chancellor’s Budget speech, a 28 per cent CGT rate is “in line with our international competitors”.
In broad overview the new CGT rate applies to taxpayers whose marginal rate of income tax is 40 per cent or above. Taxpayers whose combined income and gains fall below the upper limit of the income tax basic rate band continue to pay CGT at the rate of 18 per cent.
Importantly, trustees and the personal representatives of estates are liable to CGT at the new rate of 28 per cent, with no basic rate band. Trustees and personal representatives of estates are therefore treated more harshly than individuals, as they were for the rise in income tax to 50 per cent commencing on 6 April 2010. Moreover, while the 50 per cent income tax rate applies only to the trustees of discretionary trusts, the 28 per cent CGT rate applies to all trustees, except for trustees of bare trusts.
There is a generous increase in the lifetime allowance for entrepreneurs’ relief from £2 million to £5 million of lifetime qualifying gains on disposals of qualifying business assets. Entrepreneurs’ relief has been available since 2008 to reduce to 10 per cent the (effective) CGT rate on qualifying disposals. Initially the lifetime allowance of relief on gains was £1 million, increased to £2 million from 6 April 2010. The recent increase to £5 million therefore represents the second extension of this relief within a few months.
With publication of the Finance Bill on 1 July 2010 we can begin to see how the new top rate of CGT will work in practice. Given that CGT is a tax charge payable by reference to complete tax years, introduction of a new CGT rate part way through the tax year entails the need for careful consideration of transitional provisions for the current tax year (2010/2011) to ensure that the introduction of the new rate will be effected smoothly. This article is based on the Finance Bill and its accompanying explanatory notes published on 1 July 2010.
The impact of the new CGT rate on individuals, trustees and personal representatives of deceased’s estates
An individual whose aggregate income and gains is within the upper limit of the income tax basic rate band (currently £37,400 but to be adjusted downwards next year for higher rate taxpayers) continues to pay CGT at 18 per cent. An individual whose income takes him/her above the upper limit of the income tax basic rate band automatically pays CGT at the new rate of 28 per cent (subject to any available reliefs, including entrepreneurs’ relief). If part of an individual’s income tax basic rate band is unused, then to the extent that gains fall within the unused part, such gains are liable to CGT at 18 per cent while the remainder of the gain is charged at the new rate of 28 per cent. In effect then, for the purpose of determining the applicable rate of CGT, an individual’s gains are treated as forming the top slice of his/her income/gains. However, any gains receiving entrepreneurs’ relief are treated as forming the first slice of chargeable gains. To the extent that this falls within the unused part of the taxpayer’s income tax basic rate band, entrepreneurs’ relief will be less beneficial since the CGT saving will be at only eight per cent, instead of 18 per cent.
Any CGT losses deductible from capital gains, as well as the CGT annual exempt amount (currently £10,100), may be allocated in the way most beneficial to the taxpayer. This presumably means that if an individual has some gains in a tax year which are liable to CGT at 18 per cent and some gains liable at 28 per cent, then the annual exempt amount and any losses may be set against the gains liable to CGT at 28 per cent. The ability to allocate losses and the annual exempt amount in the manner most beneficial to the taxpayer is also relevant in relation to the transitional provisions described below. This is subject to any special legislative rules which specify how losses are to be allocated. For example, losses realised by an individual on disposals to a so-called “connected person” are deductible only against chargeable gains accruing to such individual on disposals to the same “connected person”.
In determining whether an individual’s aggregate income and gain exceeds the upper limit of the basic rate tax band, you will need to take account of each individual’s income tax personal allowance (currently £6,475 but to be increased to £7,475 from 6 April 2011 for basic rate taxpayers) the individual’s basic rate income tax band (currently £37,400), the individual’s available CGT annual exempt amount (£10,100) and any allowable losses. Note, however, that UK resident non-domiciliaries electing for the remittance basis do not get any income tax personal allowance or CGT annual exempt amount. According to the HMRC “Questions and Answers” published on Budget Day, individuals paying the £30,000 remittance basis charge are deemed to have used up the whole of their lower rate income tax band so that (assuming no allowable losses or CGT reliefs) they will be liable to CGT on any remitted gains at 28 per cent. This does not appear to be reflected in the draft legislation. Further clarification is therefore needed on this point.
As mentioned above, trustees and personal representatives are particularly affected by the new tax rates since they have no basic rate income tax band. Effectively they are liable for a flat rate of CGT at 28 per cent. Against this they may set their annual exempt amount. For trustees the annual exempt amount is half that available for individuals, that is £5,050 per trust (or less if two or more trusts have been established by the same settlor). The new rate will apply to the gains of both discretionary trusts (under which income and capital is paid to beneficiaries in the trustees’ discretion) and interest in possession trusts (under which one or more beneficiaries are entitled to the income). In relation to bare trusts, however, the beneficiary’s CGT rate applies, rather than the trustees’ 28 per cent rate.
Finally, entrepreneurs’ relief, where available, reduces the rate of CGT from 18 per cent or 28 per cent to 10 per cent. (Previously the relief had operated by reducing to 4/9s the proportion of the gain that was chargeable, so producing an effective CGT rate of 10 per cent, but with the new dual CGT rate the previous mechanism would no longer have worked to produce the intended 10 per cent rate).
Many commentators had expressed concern about a CGT rate change part way through the tax year. An important reason for this is that CGT is payable by reference to complete tax years. A CGT rate change part way through the tax year is not workable without special transitional provisions to cover the current tax year (2010/11) in which the change occurs. The new CGT provisions provide that in 2010/11 the CGT rate change applies only to gains accruing on or after 23 June 2010. Pre-23 June 2010 gains continue to be taxable at 18 per cent. They are furthermore ignored in working out whether the taxpayer has used up his income tax basic rate band in relation to post-22 June 2010 gains. As mentioned above, an individual’s CGT annual exempt amount and any capital losses he may have in the tax year may be applied in the manner most beneficial to him. If he has both pre-23 June 2010 gains and post-22 June gains taxable at 28 per cent, it is to his advantage to allocate his annual exempt amount and any losses against the latter gains. The Finance Bill appears to permit this. There are special transitional provisions to deal with the allocation of entrepreneurs’ relief where disposals have been made both before and after the change in the lifetime allowance limit from 23 June 2010.
There are other transitional adjustments to specific statutory provisions. Under s 10A of the Taxation of Chargeable Gains Act 1992 (“TCGA 1992”) an individual who has been UK resident for four out of the preceding seven tax years and who then becomes non-UK resident for fewer than five tax years before resuming UK residence is liable to CGT in the year of his return in relation to disposals made by him during his non-resident period of assets he acquired when UK resident. Since, as mentioned above, CGT applies only to full tax years, without any transitional adjustment, we would not know at what rate such an individual should pay CGT in the year of his return. The transitional provisions provide that if such an individual returns to the UK in 2010/2011, then any gains falling within s10A TCGA 1992 are to be treated as having accrued before 23 June 2010. Therefore if the individual, having realised s10A gains both before and after 22 June 2010, subsequently returns to the UK on 22 December 2010, he is liable to CGT at only 18 per cent on such gains. This appears to be generous to the taxpayer but is presumably drafted in this manner in order to sidestep the drafting complexity which might otherwise be involved in apportioning the gains between the 18 per cent and 28 per cent tax rates.
The special provisions in TCGA 1992 dealing with UK resident but non-domiciled individuals who are taxed on the remittance basis also have to be adjusted to include transitional provisions for 2010/11. This is because foreign gains realised by a UK resident, non-domiciled individual in a tax year are treated as chargeable gains accruing in a tax year in which the foreign gains are remitted. In order to deal with the position where some foreign gains are realised before, and others are realised on/after 23 June 2010, the Finance Bill provides that such gains are treated as accruing on the day on which they are remitted to the UK. The effect of this is that the new CGT rate applies to gains remitted on or after 23 June 2010, even if the foreign gains in question were actually crystallised offshore before 23 June 2010.
In some instances there are no transitional provisions. For example, under the main CGT provisions the chargeable gains of a non-UK resident company (which would be a close company if UK resident) are treated as accruing to shareholders with an interest in the company exceeding 10 per cent who at the time when the chargeable gain accrues to the company are resident or ordinarily resident in the UK. Here the chargeable gain is treated as accruing to the shareholder at the point when it accrues to the company. So the existing statutory provision already identifies a point in the tax year at which the gain accrues. A transitional provision is not therefore needed for this purpose.
Another case where there is no transitional provision relates to hold-over elections on gifts. (A hold over election can be made on certain gifts into and out of trust and on gifts of business assets. The effect is that the transferee is treated as acquiring the gifted asset with the donor’s base cost and there is no CGT chargeable on the gift itself.) Since there is no transitional provision, the entire gain, including that previously held over, will accrue in the year in which the asset is disposed of and at the CGT rate applicable in that year.
Non-UK resident trusts, beneficiaries and the 28 per cent CGT rate
Special transitional provisions are also needed to deal with the gains of non-UK resident trusts. Broadly speaking CGT applies to such trusts in one of two ways. First, if the settlor is UK resident and domiciled and the trust is “settlor-interested” (by reason of the settlor himself or of persons connected with him having interest under the trust) then any gains realised by the trustees are taxable on such settlor. Here the transitional provision is particularly generous. It provides that any gains accruing throughout the tax year 2010/11 are to be treated as accruing before 23 June 2010 and hence will be taxed at the old CGT rate of 18 per cent.
The second way in which the gains of a non UK resident trust may be taxed is under the provisions of sections 87 to 87B TCGA 1992, which provide for the so-called “beneficiary charge”. In this case, if the non-resident trustees realise gains which, had they been UK resident, would have been liable to CGT, such gains count as so-called ‘s 2(2)’ gains. These become chargeable to tax upon being attributed to beneficiaries receiving capital payments from the trust. Gains realised by the non-UK resident trustees are matched with capital payments to beneficiaries on a ‘last in first out’ basis so that the most recent gains are attributed out first via capital payments, before the earlier gains. The gains are therefore treated as accruing in the tax year in which a beneficiary receives a capital payment to which is matched a s 2(2) amount for the relevant tax year or any earlier tax year. The transitional rule applicable in 2010/11 provides that chargeable gains resulting from the matching of s2(2) gains with capital payments received on or after 23 June 2010 are to be treated as accruing on or after 23 June 2010. In other words, post-23 June 2010 capital payments are subject to the new tax rates, even if the gains attributed via such capital payments to beneficiaries were realised off-shore by the trustees before 23 June 2010.
For every full tax year of delay between the trustees realising a gain and the gain being attributed out to a beneficiary via a capital payment, the amount of tax payable by the recipient beneficiary increases by 10 per cent (the ‘surcharge’) for a maximum of six tax years. This means that with a top CGT rate of 28 per cent, the maximum possible CGT rate, including the surcharge on a distribution from a non-UK resident trust to a UK resident beneficiary, is 44.8 per cent (up from the previous maximum of 28.8 per cent), assuming a maximum six year delay between realisation of the gain by the trustees and its attribution out to a beneficiary via a capital payment.
Qualifying corporate bonds
If on a disposal of a company, shares are exchanged for qualifying corporate bonds (QCBs) the TCGA 1992 provides that there is no CGT due on the exchange of shares for QCBs; rather the CGT that would have been payable on disposal of the shares is instead payable on eventual disposal of the QCBs. (QCBs themselves are not chargeable assets for CGT.) The position in relation to such deferred gains is that where the deferral occurred before 23 June 2010 but the deferred gain comes into charge only after 22 June 2010, it is the new rates of CGT that apply. This appears to follow from the existing provisions without any need for special transitional provisions.
There are, however, new provisions to deal with the situation where the original disposal could have qualified for entrepreneurs’ relief. Where the original disposal on an exchange for QCBs occurred before 23 June 2010 and could have qualified for entrepreneurs’ relief, then under the pre-23 June 2010 rules the taxpayer could claim the entrepreneurs’ relief. The gain, as reduced by entrepreneurs’ relief, would come into charge on the eventual disposal of the QCBs. Under the new rules, where the deferral on an exchange for QCBs occurs after 22 June 2010, the taxpayer may elect either to pay CGT immediately with the benefit of entrepreneurs’ relief (although there may be cash-flow problems with this) or to defer the tax charge but pay the full CGT rate (up to 28 per cent) on eventual disposal of the QCBs.
The Finance Act 2008 transitional provisions on the introduction of entrepreneurs’ relief (the relief has been available since 6 April 2008) have been amended. Under the original transitional provisions, gains deferred on an exchange for QCBs before 6 April 2008 could receive entrepreneurs’ relief (provided they qualified and a claim was made) when the deferred gain came into charge. The new rules enable the reformulated entrepreneurs’ relief at 10 per cent to be received where a gain deferred before 6 April 2008 first comes into charge on or after 23 June 2010.
There are separate provisions transitional provisions dealing with gains which have been deferred through investments into Enterprise Investment Schemes and Venture Capital Trusts.
Although the new top rate of CGT at 28 per cent is not as steep a rise as many had anticipated, it nevertheless bears heavily on some taxpayers, notably on trustees and personal representatives and on individuals who have held assets over a long period of time and who might therefore find themselves paying CGT at 28 per cent on significant inflationary gains. It remains to be seen to what extent taxpayers will be motivated to seek ways of planning to minimise their exposure to the higher CGT rates. However, it is clear that care in any event is needed for this first transitional year to ensure for example that losses and annual exempt amounts are allocated in the most beneficial way for the taxpayer. And while there have been some attempts to avoid over-complexity in the drafting of the transitional provisions, there nevertheless remain some ambiguities which need to be resolved.
Piers Master, Partner and Lyndsey West, Professional Support Lawyer, Charles Russell, London, UK