Key changes to Capital Gains Tax from April 2008

The Chancellor finally revealed some of the details yesterday of the Government's proposed "simplification" of the capital gains tax ("CGT") regime that he announced as part of his 2007 Pre-Budget Report.

As expected, the main changes are as follows:

the current system that effectively treats capital gains as the top slice of income will be replaced with a single rate of CGT at 18%; and
the abolition of taper relief.

In addition, as a consequence of rigorous lobbying from various disgruntled groups, the Chancellor also outlined a new "entrepreneurs' relief" yesterday. This aim of the relief is to reduce the effective rate of CGT from 18% to 10% on the first £1million of capital gains in respect of disposals of what could be broadly described as business interests.

This series of changes will take effect from 6 April 2008. Importantly, the changes only apply to CGT, so the corporation tax rules in respect of chargeable gains are unaffected by yesterday's announcement.

A broad overview of the impact of the changes is set out below.

18% flat rate of CGT

CGT is paid by individuals and trustees and is charged at the point of disposal of certain assets if they have increased in value.

Individuals have a tax-free annual exempt amount of £9,200 for the 2007/08 tax year, and gains made up to this limit are exempt from CGT. There are also other exemptions from CGT for the disposal of certain assets, for example an individual's main residence.

An individual's capital gains for a tax year are currently calculated after the deduction of allowable losses, indexation, taper relief, and the annual exempt amount. The remaining capital gain is charged to CGT as though it were the top slice of the individual's income for that year. As a result, they could be liable to CGT at 10%, 20% or 40% (or a combination of those rates) depending upon the individual's total income and gains for the year.

The changes announced replace this interaction with income tax with a single rate of CGT of 18%. This single rate applies not only to individuals, but also to the trustees of settlements and the personal representatives of deceased persons, whose capital gains are currently charged to CGT at 40%.

On this basis, the rate of CGT payable on a disposal will either increase or decrease depending upon whether the taxpayer would currently pay CGT at 10%, 20% or 40%. At a first glance, it appears that a higher rate taxpayer will be subject to CGT at 18% rather than 40% on disposals after 6 April 2008. However, this ignores the significant impact that taper relief currently has on the "effective" rate of CGT that is currently payable.

Abolition of Taper Relief

Taper relief has the effect of reducing the effective rate at which CGT is paid. It operates by reducing the amount of a gain which is charged to CGT. The amount of the reduction is determined by reference to whether the asset was a "business" or a "non-business" asset, and the length of time that it had been owned before the disposal. One of the most common examples of a business asset is an unlisted share in a trading company.

For example, if a business asset is sold more than a year after it was acquired, any gain is reduced (or "tapered") by 50% and, if it is held for two years, any gain is reduced by 75%. The tapered gain is then subject to CGT as the top slice of income or gains as described above.

As a consequence, an individual who is currently liable to income tax (and, therefore, to CGT) at the higher rate of 40% can benefit from taper relief to reduce their effective rate of CGT to 10% on a gain arising on the disposal of a business asset which has been held for at least two years. This is because they would pay CGT at the rate of 40% on 25% of the capital gain. The same individual can reduce their effective rate of CGT to 20% on a gain arising on the disposal of a business asset which has been held for more than one year, but less than two years. This is because they would pay CGT at the usual rate of 40%, but on only 50% of the capital gain. In respect of non-business assets (such as a buy-to-let residential property) an individual's effective rate of CGT in respect of the disposal of such assets can be reduced to 24% if the asset was held for ten years.

From 6 April 2008, taper relief will be abolished and all capital gains will be charged to CGT at the new flat rate of 18%. There are undoubtedly those who will benefit from this change. For example, individuals disposing of business assets before they have been held for two years (as such individuals will now pay CGT at the new flat rate of 18% as opposed to 40% or an effective rate of 20%) or non-business assets (irrespective of how long they have been held) will be better off under the new regime. Similarly, higher rate taxpayers with second homes which do not qualify for principle private residence relief will pay CGT at 18% as opposed to 40% on any gain realised upon their disposal.

Notwithstanding this, there are numerous individuals who will have anticipated obtaining an effective 10% rate of CGT on a future disposal of their business assets who will lose out. Following lobbying from entrepreneurs and bodies representing them, the Chancellor has effectively been forced to provide a concession for entrepreneurs. This "entrepreneurs' relief" is summarised below.

The fear is that the increase in the rate of CGT from an effective rate of 10% now (with full business asset taper relief) to 18% after April 2008 will discourage such entrepreneurs from investing in unlisted trading companies (including those whose shares are traded on the Alternative Investment Market ("AIM")) in the UK.

Entrepreneurs' relief

The full details of the proposed entrepreneurs' relief have yet to be announced. However, it appears that the relief will be available in respect of gains made on disposals:

of all or part of a business; or
of assets following the cessation of a business; or
by certain individuals who were involved in running or working for the business.

The first £1million of capital gains that qualify for the relief will be charged to CGT at an effective rate of 10%. Gains in excess of £1million will be charged at the 18% rate. An individual will be able to make claims for relief on more than one occasion, up to a lifetime total of £1million of capital gains qualifying for the relief. However, as stated above the full details of the relief have not yet been made available, and it is not clear whether the clock for calculating this £1million maximum for the relief starts from 6 April 2008, or whether previous disposals at a gain also need to be taken into account in calculating the relevant £1million maximum capital gains qualifying for the relief.

The relief will apply to gains on disposals of shares and securities (which should include loan notes issued in respect of earn-out rights relating to a prior disposal of shares) in a trading company (or the holding company of a trading group) provided that the individual making the disposal:

has been a director or employee of the company, or of a company in the same group of companies;
owns at least 5% of the ordinary share capital of the company and that holding enables the individual to exercise at least 5% of the voting rights in that company; and
has held the shares or securities for at least one year.

Whilst this will be a welcome concession to many (including employees who acquire shares from existing option schemes who can satisfy the 5% tests), at current tax rates (ie. 18% post 6 April 2008) individuals will only benefit from a maximum lifetime tax saving of £80,000 (i.e. 8% of £1million).

Serial entrepreneurs will quickly exceed the £1million threshold and will then be subject to CGT at the flat 18% rate and, as we are yet to see the draft legislation in respect of entrepreneurial relief, it is not even clear if the clock in this regard starts on 6 April 2008 or whether previous disposals also need to be taken into account in calculating the relevant £1million capital gains. Clearly, the answer to this will impact significantly upon how useful this new entrepreneurial relief is to entrepreneurs.

Conclusion

There will undoubtedly be winners and losers as a result of the changes to the CGT regime announced by the Chancellor yesterday.

The winners include second home owners and higher rate taxpayers who sell business assets before they have been held for two years or who sell non-business assets however long they have been held.

The change has no real effect for higher rate taxpayers selling business assets and realising a capital gain of up to £1million where those assets are held for at least two years before the sale.

The main losers will be higher rate taxpayers selling business assets and realising a capital gain in excess of £1million where those assets are held for at least two years before the sale. For those individuals, their effective rate of CGT upon a disposal of such assets will increase by 80% from April 2008.

What does seem clear though is that this package of changes is unlikely to amount to the "simplification" of the CGT system that the Chancellor intended after all.

The information and comments contained in this Note are for general information purposes only, and are neither intended as nor constitute advice or opinions to be relied upon in relation to any particular circumstances. This is a very complex area and there remain a number of uncertainties. As always, bespoke professional advice should be sought in respect of the application of the law to any specific situations.

Harbottle & Lewis LLP
24 January 2008