Rising asset values and an increase in transactions have seen the amount of capital gains tax (CGT) collected by HMRC double since 2008/9 and up 43 per cent between 2012/13 and 2013/14 according to HMRC. Also to blame is the lack of reward for long-term investment. Since taper relief was abolished in April 2008, which itself took over from indexation in 1998, investors have been faced with paying CGT on their inflationary gains.
Despite this, once tax breaks have been fulfilled it usually makes sense to invest in the CGT regime, rather than the income tax regime as the headline CGT rate paid is lower than the headline rate of income tax paid. See Table 1 for more.
CGT charging
CGT is charged on the profits made when certain assets are sold, or transferred. If all gains in a tax year fall within the annual CGT allowance (£11,100 for 2015/16) there is no tax to pay.
Providing there is no disposal, gains and their liability to tax can be deferred indefinitely, and since CGT is washed out on death, it is a tax which can be avoided altogether.
When gains are realised, CGT is charged at either 18 per cent or 28 per cent depending on an investor’s other taxable income. Provided combined taxable income and gains don’t exceed £42,385 (2015/16), 18 per cent CGT on gains above the annual allowance is paid. Where gains and taxable income exceed £42,385, 28 per cent CGT is paid.
If gains fall into two bands, taking the investor from the basic rate into the higher rate, CGT is paid at 18 per cent on the amount which falls in the basic rate band and at 28 per cent on the amount which falls in the higher rate band.
Business assets continue to be treated more generously through entrepreneurs’ relief. Business assets are generally a share (or interest) in the company or firm at where an individual works. They have to hold at least 5 per cent of the shares to qualify. Entrepreneur’s relief, where available, reduces the CGT rate to 10 per cent for the first £10m of profit.
Annual exemption
The annual exemption for capital gains tax cannot be carried forward or back into other tax years, and is therefore lost if not used. Therefore it makes sense to use this annual exemption to take the opportunity to reduce the level of taxable gains from a portfolio.
Care needs to be taken when doing so, not least due to the transaction costs of a sale and repurchase and the anti- “bed and breakfasting” rules.
Anti-bed and breakfasting
Realising gains to increase the base cost of an investment was popular until April 1998. Now, under anti-avoidance rules, units or shares cannot be sold and then repurchased within 30 days to rebase the holding cost.
This 30-day rule applies to repurchases of identical shares or units in a unit trust made by the same person (in the same capacity).
However the anti-bed and breakfasting rules do not apply:
1. Where a different investment is bought after the sale. This means a similar holding – one in the same market or sector – could be bought
2. Where the purchase is then made in a tax wrapper through “bed and Isa” or “bed and Sipp”
3. Where the repurchase of the same holding is made after 30 days
4. Where the repurchase is made by a spouse (“bed and spouse”).
This means the annual exemption can still be used in a number of ways to help mitigation CGT in a portfolio. Further strategies are also available:
CGT mitigation: It starts with using the annual CGT exemption. A married couple (or those in a registered civil partnership) can make gains of £22,200 a year between them without any charge to tax. Investments can normally be transferred between spouses without an immediate tax charge to make full use of two allowances. Given the changes to dividend taxation from 6 April, it also makes sense for planners to revisit how taxable investments are shared between couples to maximise allowances.
Offset losses against gains: If an investment is sold at a loss, the loss must be offset against any gains made in the same tax year. If there are more losses than gains, the net losses can be carried forward indefinitely to set against future gains in excess of the annual exemption, provided those losses are registered with HMRC on the individual’s tax return.
Sell when tax is paid at a lower rate: The rate of CGT is now charged based on the rate of income tax paid. Therefore lowering taxable income in any one year could reduce the CGT rate from 28 per cent to 18 per cent. Reducing taxable income can be done in a number of ways; waiting for retirement and a change from earnings to pension income; the strategic limiting of income withdrawals from a flexible access drawdown; deferring the state pension; greater use of Isa (income from Isas does not count towards taxable income calculation); or transferring taxable income bearing assets such as cash deposits to a lower earning spouse.
Transferring assets before selling: Married couples (or those in a registered civil partnership) where one spouse pays tax at a lower rate than the other, may have the option to transfer investments into their name before selling to lower the rate of CGT paid.
Use pensions to reduce capital gains tax: A pension contribution can also be used to reduce CGT liability for many investors by taking advantage of the tax relief on the contribution. Effectively the basic-rate tax band is increased by the amount of the pension contribution, meaning larger gains might be realised before the higher rate of CGT is payable. For example, a pension contribution of £3,600 will extend the basic-rate tax band from £42,385 to £45,985. Then, providing taxable income and gains are less than £45,985 in this tax year, CGT will be paid at 18 per cent and none at 28 per cent.
Holdover relief
Investments with large CGT liabilities can benefit from deferral strategies. These include settling assets into a discretionary trust or using an Enterprise Investment Scheme (EIS), both of which allow gains to be held over or deferred.
Gifts into a discretionary trust could attract an immediate inheritance tax (IHT) charge of up to 20 per cent, which somewhat negates the CGT holdover. The annual CGT exemption for trusts is also half the rate for individuals, and there could be periodic and exit IHT charges which need to be considered.
EISs are free from IHT after a two-year holding period as well as offering income tax relief on certain contributions. The tax benefits are generous as the investor risks are often substantial.
Danny Cox is a certified financial planner and a chartered financial planner at Hargreaves Lansdown
