There is a Capital Gains Tax (CGT) overhaul on the horizon, according to Craig Simpson, Tax partner at Bates Weston. Craig has been looking at the Office of Tax Simplification’s (OTS) first report on its Capital Gains Tax Review.
The Office of Tax Simplification (OTS) published its report on the simplification of capital gains tax (CGT) last week. It is perhaps not surprising that some of the recommendations were controversial. The challenge for the Chancellor is to raise income in a post-Covid world and a CGT rate of 20% seems out of line with other personal taxes.
My first observation is that the OTS’ remit now seems to be one of potential policy maker rather than simplifying the tax although to be fair they are only answering a question and task they have been asked to complete by the Chancellor. The great difficulty for the OTS is that it is not that simple to simplify taxes.
Take capital gains. They could be relatively short term or might be earned over the longer term. There are different asset classes where someone might gain from their own hard work and wealth creation and then other areas where they gain from being a passive investor. There are reliefs to encourage entrepreneurial behaviour and annual exemptions to simplify reporting and exposure to CGT for small gains.
It is clear to the writer and the OTS that there is arguably a boundary issue between income and capital gains. An obvious example is where someone buys a second property, renovates it and sells it on. They would almost certainly feel this was a capital gain. But if they do it several times they are likely to be trading. The difference in tax rates is considerable. Aligning the rates would be an easy solution and one the OTS suggests should be considered.
We certainly agree there should be some more thought on whether to introduce relief for inflationary gains or longer term gains. Readers will recall indexation relief and business and non-business asset taper relief of years gone by.
Turning our attention to owner-managed companies, we were alarmed to read at the bottom of page 8 of the report which is recreated here:
In relation to the accumulation of retained earnings within smaller owner-managed companies, the issue is that business owners are taxed at lower rates if they retain profits arising from their personal labour in their business and realise the benefit on sale or on liquidation, than if they withdraw them as dividends.
One approach would be to tax some or all of the retained earnings remaining in the business on liquidation or sale at dividend rates (in effect shifting the boundary between Capital Gains Tax and Income Tax). This could make the treatment of cash taken out of the business during and at the end of its life more neutral.
This shows a complete lack of understanding of how businesses operate and grow and the differing capital requirements of different sectors. It is also a rather one sided lack of understanding of a company balance sheet. Businesses make profit and typically reinvest to grow, so on one side of the balance sheet are the assets less liabilities and on the other side the retained profits that have funded that growth. The result of growth is good for all concerned as it typically means more employment and more taxes for the exchequer.
So when someone sells their business why would the retained profit used to fund that growth and create the strong balance sheet be something that should be taxed as income? After all, without it the business would not be saleable. The suggestion is perhaps that there is some sort of tax avoidance by not paying dividends. One argument against such a move might be that some sectors require more investment in capital and working capital than others and so why should they be penalised for this by taxing proceeds as income. Take the tech industry – this type of policy might certainly favour them where there is a high price paid for intellectual property on a sale which isn’t represented on the balance sheet.
There will certainly be instances where surplus cash is retained in the business that is not required for ongoing trading and the writer can see the perspective that there may be arguments to tax this as income, but that again is not clear cut as there are many reasons why businesses retain a strong balance sheet. So more thought it needed here.
The Capital Gains Tax Review report recommendations don’t stop there and also target gains from share based incentive schemes and recommends considering taxing these as income. Again, it is worth just understanding why businesses implement such arrangements. It is to lock key people into the business with a sense of capital ownership. If done well this provides the benefit of economic growth as a business grows, creating more employment, wealth and taxation.
One recommendation is to remove the CGT free step up on death where an Inheritance Tax (IHT) Relief applies. So for example, shares in a trading company currently might be left on death with the benefit of Business Property Relief (100% relief from IHT) or between spouses and the result is no IHT and also a step up to market value for CGT purposes. So an asset could be sold immediately after death with no immediate IHT or CGT. It is a strange outcome and one can see the logic to correcting it.
What conclusions can be drawn? Well this is only a recommendations report, and in the current situation it is difficult to see the government implementing an overhaul of the CGT rules. But an increase in rate is likely in the short term. As an educated guess, one rate of CGT of 30% in the interim is quite possible whilst the reform is considered carefully to ensure that any changes do not stifle business growth and risk taking.
The taxation system can be an incredibly powerful tool to incentivise certain behaviours and outcomes and we feel there is an opportunity to reform the CGT system to encourage people which should be grabbed and actioned with pro-business positivity and enthusiasm.
Disclaimer: The information contained in this article is generic in nature. You should take no action based upon it without consulting ourselves or an alternative professional advisor. All information correct at time of publication: 18 November 2020