Pre Budget Report 2007 - read our analysis

Pre-Budget Report Overview
9 October 2007

Comment
Alistair Darling delivered his first Pre-Budget Report on Tuesday 9 October 2007 and focussed primarily upon personal tax.

The most dramatic proposed reform is the introduction of a new 18% flat rate of capital gains tax (replacing the current 10-40% effective rates) and the abolition of taper relief. This reform will mean bigger tax bills for wealthy private equity bosses who have recently been the subject of great criticism for paying much reduced levels of tax. However, the reform will be more far-reaching than this and will affect many other individuals such as company employees, as well as trusts.
There has also been a move to allow married couples to pass on unused inheritance tax allowances and the introduction of a flat rate charge of £30,000 on non-domiciled individuals who have been resident in the UK for 7 years. Coupled with these changes is a tightening up of loopholes and anomalies, which have previously allowed non domiciliaries to manipulate the rules.

We will need to wait for the publication of the relevant legislation to assess the precise impact of many of the changes being introduced. However, it is safe to assume that the impact of the 2008 Budget is likely to be significant.

1. Capital Gains Tax

Abolition of Taper Relief

Change
Currently, capital gains can be reduced by indexation relief and taper relief, which reduce any gain chargeable to tax (thereby reducing the effective rate of tax). Taper relief is particularly valuable. It was introduced in 1998 and meant that a percentage of gains dropped out of charge and only a residual percentage was subject to tax. For business assets in particular, an effective tax rate of 10% could be achieved after holding business assets for two years. Business assets included not just assets used in a trade, but also shares in unquoted companies and shares in quoted companies where the shareholder was employed by that company. Gains on non-business assets were also reduced by taper relief but not at such an accelerated rate; the effective tax rate could reach only as low as 24%, but only after holding the asset for 10 years.

The introduction of new legislation in the Finance Act 2008 means that taper relief will be completely abolished and there will now be a single rate of capital gains tax set at 18 per cent.

This new rate will apply to individuals, trustees and personal representatives but will not affect companies paying corporation tax on chargeable gains.

The 18 per cent rate of CGT does not affect the income tax rates.

Effective Date
The measure will have effect for disposals made on or after 6 April 2008 and held over gains coming into charge on or after 6 April 2008 (even if assets were held before this date).

The current CGT rules continue to apply for disposals made up to 5 April 2008.

Comment
The changes to taper relief appear motivated by the heightened focus on private equity, and it seems that the Chancellor has removed the regime put in place by Gordon Brown less than 10 years ago as a political reaction to the attacks in the press on private equity managers who, it has been alleged, earn significantly more money but pay less tax than their cleaners.

However, the announced measures seem to miss their target, with private equity managers reported to be expressing relief that the Chancellor has not introduced more targeted measures aimed at them. Instead, the Chancellor has abolished taper relief, and this represents a huge change to the capital tax system as we know it, and arguably threatens to undermine the existing entrepreneurial culture of the UK.

As the new proposals will not take effect until 6 April 2008, we are likely to see commercial decisions distorted by this impending change, especially in light of the apparent absence of any "grandfathering" provisions to reflect (and protect) any current accrual of entitlement to taper relief.

In particular, those holding assets, such as shares in a private trading company, that currently benefit from full business asset taper relief may prefer to trigger a disposal of shares before 5 April so that they benefit from an effective 10% rate of CGT. Whilst this might trigger a short term boom in M&A transactions, the current market conditions are less than ideal and it could result in owner/managers achieving a lower exit value. Conversely, those holding assets that have no accrued business asset taper relief may wish to wait and trigger disposals only after 5 April, triggering a flurry of disposals after this date.

Taper relief does not just apply to private equity and M&A transactions, and the changes will increase the rate of tax paid by many employees of companies which have share incentive arrangements. For example, for disposals after 6 April 2008, the benefit of the 10% tax rate on a disposal of EMI option shares after holding the options for two years has come to an end, with gains now being taxed at 18%. This represents an 80% increase for such individuals as against the old tax rate.

On a more positive note, the change is seen as a huge tax boost for owners of second homes, who will now pay tax at 18% rather than 40% on disposal of properties made after 6 April 2006.

2. Inheritance Tax ("IHT")

Nil-Rate Band

Change
Under current law, when someone dies, their "nil rate band" (£300,000 for the tax year 2007/08) passes free of IHT and any residual value in their estate above this level is charged at 40%.

However, transfers of property between spouses or civil partners are generally exempt from IHT which means that if someone who dies leaving some or all of their property to their spouse or civil partner, this may result in all or part of their nil rate band being unused. This problem has historically been dealt with by simple estate planning with each spouse entering into a will ensuring that their nil rate bands have, in fact, been used.

Legislation will be introduced in the Finance Bill 2008 to allow any unused IHT nil-rate band from a deceased's spouse or civil partner's estate (regardless of the date of their death) to be transferred to the estate of their surviving spouse or civil partner.

The additional amount of nil rate band available to the surviving spouse will be the percentage of unused nil-rate band at the first death, with the maximum nil-rate band which can be transferred to the surviving spouse being the value of the nil-rate band in force at the time of the death of the surviving spouse.

Where the new rules have effect, personal representatives will not have to claim for the unused nil-rate band to be transferred at the time of the first death. Any claims for the transfer of the unused nil-rate band will be made by the personal representatives of the estate of the second spouse or civil partner to die, when they make an IHT return.

Effective Date
The new rules apply to situations where the surviving spouse or civil partner dies on or after 9 October 2007 (no matter what the date of death of the deceased spouse or civil partner).

Comment
Although the HMRC press releases state that the IHT nil-rate band has been increased to £600,000, this is actually a mere consolidation of two individuals' nil-rate bands. The key benefit of this change is simply that married couples and registered civil partners no longer need to carry out basic estate planning to ensure the full use of both of their nil rate bands.

Notwithstanding this, married couples may be better off as a result of the proposed change to the extent that the allowable nil rate band increases between the death of the first and second spouse. This will potentially increase a couple's aggregate nil rate band compared to the position if the first spouse to die uses their nil rate band in full (i.e. the nil rate band in force at the date of the death of the first spouse). For this reason, couples who currently use "nil rate band trusts" to take advantage of the nil rate band in force when they die may wish to reconsider whether it would be preferable to unwind such trust arrangements in light of the new rules. Having said this, the property in an individual's estate may still increase in value beyond the levels of increases in the nil rate band, so this potential benefit may be negated. Moreover, the precise details of the changes will not be known until the publication of draft legislation, so it may be prudent to await these details before making any changes to existing tax planning.

Individuals who are neither married nor registered civil partners will not be affected by this change.

3. Attack on the Residence & Domicile Rules

Remittance Rules

Change
UK residents who are not domiciled in the UK or who are not ordinarily resident in the UK are taxed on a remittance basis - that is, they are only taxed on foreign income and gains if (and only to the extent that) such income and gains are remitted to the UK.

New legislation will be introduced in the Finance Bill 2008 so that after a non-domiciled individual has been resident in the UK for seven years, they will only be able to benefit from the remittance basis of taxation if they pay an additional tax charge of £30,000 a year. Where individuals decide not to use the remittance basis of taxation (and therefore not pay the £30,000 charge), they will be taxed on their worldwide income whether remitted or not.

Effective Date
The changes apply on or after 6 April 2008 to all non-domiciled individuals who have been resident in the UK for seven years, and all previous years of residence will count from that day.

Comment
The laws of residence and domicile have been up for review for many years. Faced with the unpopular option of leaving the rules unchanged or taxing resident non-domiciled individuals fully on their worldwide income, what HMRC have proposed is something of a 'halfway house', whereby the tax treatment of non-domiciliaries is a matter for them to choose.

The unintended effect of these changes will be that long term foreign workers in the UK will have to pay tax on all of their worldwide income and there may also be implications for those working under dual-employment contracts. Details of these proposed changes are not yet available, but draft legislation is expected by the end of 2007.

4. Closing Tax Planning Opportunities

Change
Anomalies in the current rules mean that individuals using the remittance basis of taxation can avoid paying UK tax on their foreign income and gains effectively brought into the UK. These anomalies have been exploited by tax advisors in recent years in order to mitigate tax for those clients who can benefit from them.

A number of changes are being made to ensure that where foreign income and gains are remitted to the UK, tax is charged on those remittances. There will be consultation on the changes, based on draft legislation due to be published later in the year and the changes proposed include:

changing the current claims mechanism which allows income arising in one year to be remitted tax free the following year by claiming the remittance basis in the first year but not in the second;
reducing the scope for the alienation of income and gains through the use of offshore structures, such as companies and trusts, which convert taxable income and gains into non-taxable payments;
extending those existing anti-avoidance measures which currently do not apply to remittance basis tax payers so that in future they do;
extending the definition of remittance in relevant foreign income; and
removing the 'cease the source' rule.

Effective Date
6 April 2008.

Comment
After many years of threatening to shake up the domicile and residence rules, the government have now decided to launch an attack on the tax planning opportunities which were widely used by non-domiciliaries.

5. Residence Tests

Change
When deciding if an individual is resident in the UK for tax purposes, HMRC does not currently count the days they arrive into or depart from the UK.
Days of arrival and departure will now be counted as days of presence in the UK for residence test purposes.

Effective Date
6 April 2008.

Comment
There has been much confusion recently about the correct basis of day counting for non residents.

By concession, HMRC has historically allowed days of arrival and departure in the UK to be ignored when calculating the number of days an individual has been present in the UK in any tax year for UK residence purposes. However, recent case law has cast doubt over whether this concessionary treatment still applied.

Putting these new rules into statute should clear up any confusion surrounding the practice of day counting when determining individuals' residence as it is now clear that arrival and departure days must be brought into account.
This signals the end of freedom to effectively spend three days in the UK for the price of one, typically enjoyed by so-called Monaco commuters.