Office of Tax Simplification Report on Capital Gains Tax
James Paull, Head of Incentives Group, examines the Office of Tax Simplification’s report on capital gains tax.
James’ article was published in Accountancy Today, 30 November 2020, and can be found here.
Following Rishi Sunak’s request in July, the Office of Tax Simplification has published its report on capital gains tax and suggested some areas where there could be administrative reform or where the rules “distort behaviours”. It also comments on the interaction between other taxes, particularly income tax and inheritance tax. Most of the headlines focus on the possibility of income tax and capital gains tax rates being aligned but there are many other suggestions contained in the report.
The report is very detailed (135 pages) and on the face of it is balanced in that it acknowledges that there are some risks or potential knock on complexities resulting from its recommendations. The difficulty is that it does not assess the materiality of these risks as against any potential benefits of its proposals. In fairness, this is probably not part of its remit, but it does raise the possibility that the reader may cherry pick ideas from the report without considering the materiality of any downside risks, or ignoring them altogether.
The report identifies a number of areas for attention:
- multiple CGT rates;
- boundary issues (i.e. where it thinks income can be disguised as capital);
- business reliefs and losses (in particular whether business asset disposal relief and investors relief should be retained);
- exempt amounts; and
- the interaction between CGT and IHT.
Alignment of rates
Unsurprisingly the headlines have been grabbed by the possibility of income tax and CGT rates being aligned (presumably at up to 45%) and the impact this will have. Anecdotal evidence suggests that some taxpayers are already arranging their affairs on the basis that this will become a reality.
Of course, this will make things simpler, moving from five potential rates (0%, 10%, 18%, 20% and 28%) down to as few as one. By doing so it would also potentially raise tax revenues although as explained below, this is likely to come at a high cost. According to data cited in the paper, CGT paid by individuals raised £8.3bn on just under £59bn of gains in 2017/18. Even if there was no behavioural impact of alignment, the amount raised would still be insignificant when set against the £180bn raised by income tax (and also well below the amounts raised through VAT and NIC).
In 2017/18 CGT was paid by 265,000 taxpayers. However, the vast bulk of this was made up of a relatively small number (2,000 taxpayers accounting for over a third of the gains). Also, almost half of 2017/18 gains is through the sale of unlisted securities. Therefore, the reality is that there are a small number of individuals making very large gains, most likely through entrepreneurship.
It is impossible to say with certainty what the behavioural impact would be of aligning rates as this will very much depend on the personal viewpoint of the individuals concerned. Given the small population of very high CGT payers, individual behaviours could have a material impact on the overall position.
The report suggests that investors do not base their investment decisions on the tax rate but look at gross returns. Where this is true, it is more likely in the case of professional investors who would be unlikely to determine investment decisions based solely on the basis of the tax position.
For entrepreneurs, this position seems much less tenable; certainly, our experience is that they will be influenced by the tax outcome. It is rare to have a conversation with an entrepreneur setting up a business where tax doesn’t come up at all. Of course, a higher tax exposure is not likely to deter an entrepreneur from pursuing a business opportunity; it could however impact where they do it. Certainly a great many tech entrepreneurs are internationally mobile and could decide to leave the UK with minimal disruption to their lives or businesses. Likewise, they could easily choose to set up elsewhere. If the exodus starts, then it is likely that others could follow reducing the attractiveness of the UK as a tech hub which could be disastrous for economic recovery.
If the alignment of rates causes even a few of these individuals to move from the UK and set up elsewhere then the effect on receipts could be material, even ignoring the collateral adverse impact on jobs creation and income tax/NIC receipts. Without concrete evidence as to the behavioural impacts, aligning income tax and CGT seems like far too big a risk at the current time.
There is quite significant discussion around boundaries between income tax and CGT and the distorting behaviour this produces. It focuses on two areas: employee share schemes and retained earnings in personal companies.
Employee share schemes
In the former case, the OTS tries to distinguish between reward for employment endeavours and investment return without really proposing a viable basis for this distinction. Indeed, the OTS recognises (para 3.47) that trying to create an acceptable boundary between employment and investment returns from shares “would bring its own complexities”!
Based on the commentary in Chapter 3, the OTS seems to be under the impression that growth shares are economically equivalent to market value non-tax advantaged share options, with the former invariably giving a better tax result. In one place (para 3.46), it appears to conflate share awards with salary and bonus. This is misleading in (at least) two respects
- It gives an example of growth shares where the employee pays £500 for shares that then sold for £100,000, then illustrates the tax treatment in this situation and shows how much better off she is than if she had paid income tax. Although 200x returns are not unheard of, in reality they are very rare and policy decisions should not be based on outliers, particularly when a company that has produced this return has likely delivered massive collateral benefits to the economy.
- The vast majority of arrangements will involve much greater investment than £500 and much lower returns than 200x money. In many cases, where the business does not succeed as hoped, the employee could be in a worse position than if they had received a share option as any up-front tax liability or investment would not be recoverable. This is largely ignored in the report. The report also doesn’t address the value of “skin in the game” and suggests that a share option where any risk is purely notional will incentivise the same behaviours as an individual who has put material cash at risk. Our experience doesn’t reflect this.
The report purports to identify instances where retained earnings in personal companies are being taken as capital gains on a liquidation rather than dividend. The OTS suggests that this should be addressed and that the best way to do this is to provide that these “retained earnings” are taxed as dividends. The report recognises that it will be essential to target any legislative change accurately. We can only hope that this will be achieved and not adversely impact “innocent” arrangements, although experience tells us that this is not always the case!
Reliefs and losses
The paper proposes replacing business asset disposal relief with a form of retirement relief, based on the pension age. In our view this may be some consolation to the owner managed business owner who has run a business for many years but is unlikely to placate the serial entrepreneurs who are likely to generate material growth and jobs. There is also mention of an indexation allowance to exempt gains arising merely from “inflation”. Both of these reliefs have appeared in the CGT legislation in the past and could easily end up more complex than the regime they are replacing. There is also recognition that the restrictions on ability to use capital losses should be relaxed. Again, this is likely to add complexity rather than simplicity.
The report contains some interesting data in relation to behaviours around the annual CGT exemption (currently £12,500). In 2017/18, there was a huge spike of reported gains around the annual exemption for that year (25,000 taxpayers compared to 1 or 2,000 at other levels up to £15,000). This indicates that there is a non-negligible number of people locking in tax free gains each year, probably mostly through listed share portfolios. It’s not difficult to see this as an easy political win, although it won’t raise much in immediate revenue (people will keep hold of their assets) and does have the impact of bringing more people into self-assessment.
CGT and IHT
There is concern that the tax free uplift of CGT base cost on death can give some illogical outcomes depending on the nature of the assets disposed of and the timing of the disposal. In some case, IHT and CGT can both be payable. In others it can be neither. There are proposals to remove this potential inequity by tweaking the CGT rules to prevent a base cost uplift when the asset is exempt from IHT. It is possible that this may gain some favour, but again, it may be that it creates additional complexity and is unlikely to raise material revenues.
CGT and Trusts
The report expressly ignores CGT that is paid by trusts, presumably as this was outside the remit set out by Mr Sunak. However, if any changes are ultimately proposed, it will be very important to ensure that any knock-on impact of the change in relation to trusts is considered. In at least one case, a simple rise in the headline CGT rate to income tax levels could lead to a trust being taxed at rates up to 72%. These knock-on implications will need to be addressed.
The report is very detailed and covers a lot of ground. There is no doubt that the CGT rules are complex but this is not a reason to opt for simplicity at any price. Although there are some relatively minor tweaks which could be adopted without major disruption, in our view the headline grabbing recommendations, in particular the alignment of rates with income tax come with material downside risks. If these risks materialise the damage that could be done to the economic recovery will far outweigh any benefit from simplification.
For more information please contact James Paul.