In the 2007 Pre-Budget Report, the Chancellor announced radical changes to the rules governing UK capital gains tax (CGT). The changes – billed as simplification as well as revenue raising – include the removal of taper relief and indexation allowance, as well as the introduction of a flat 18 per cent tax rate. The new rules will apply to all disposals after 5 April 2008. Despite fierce opposition from much of the business community, the changes have neither been delayed nor fundamentally changed. The one concession to intense lobbying has been the announcement of a new ‘entrepreneurs’ relief’, which will be available for up to an aggregate of £1m of certain limited types of gain.
These changes will have significant implications for all taxpayers who are subject to CGT, including individuals and trusts. They do not directly affect companies, but in many cases may indirectly do so due to the behavioural effect of the changes on shareholders.
This guide outlines the principal changes, highlights how different categories of taxpayer could be affected and suggests action that may be taken in anticipation of the changes. It also includes some comments about loan note alternatives. The Appendices go into more detail on some of the issues and includes some numerical examples.
This discussion is intended only as a general guide to the reforms and is not intended to provide legal advice. It is based on what we understand of the proposed changes as at 12 February 2008. It is not a comprehensive description of the changes and does not cover all categories of investor or all the situations that could be affected by the changes. For example, it does not consider investors who have acquired shares under employee share schemes or shares that qualify for Enterprise Investment Scheme (EIS) tax reliefs. In addition, major changes to the CGT treatment of individuals not domiciled in the UK (non-doms) will take effect from 6 April 2008. These changes are outside the scope of this guide, but it is worth noting that non-doms may have additional reasons to make disposals before the new rules come into force.
The changes: summary
The following changes apply to all disposals after 5 April 2008.
- Taper relief, which could reduce the effective tax rate from 40 per cent to as low as 10 per cent for business assets, is wholly withdrawn.
- Similarly indexation relief, which provided an inflation allowance for assets held between March 1982 and April 1998, is also withdrawn (together with the ‘halving relief’ and ‘kink test’, which were relevant in some cases for periods before April 1982).
- Instead of tax rates of up to 40 per cent (in line with income tax rates), there will be a flat CGT rate of 18 per cent.
- The CGT identification rules will be amended, so that instead of the current last in, first out (LIFO) rule, which generally deems the most recently acquired shares to be sold first, shares of a single class will be treated as a single asset or ‘pool’. This is subject to the retention of specific rules for transactions on a single day, and the 30 day anti ‘bed and breakfasting’ rule.
- A new entrepreneurs’ relief will allow the first £1m of qualifying lifetime gains to be taxed at an effective rate of 10 per cent. This will be available only in respect of interests in trading businesses, companies or groups, in circumstances where the individual concerned has been an officer or employee and (for shareholdings) holds at least 5 per cent of the share capital and voting rights. See Appendix 2 for more detail.
- Some further simplification changes are to be made, including the removal of rules that attribute gains of ‘settlor interested’ trusts to the person establishing the trust, or settlor.
Rules that remain unchanged include the annual exempt amount (AEA), currently £9,200; relief for capital losses; the exemption for principal private residences; CGT rollover/holdover reliefs; individual savings account (ISA) arrangements; the Enterprise Investment Scheme; and the Venture Capital Trust rules. The basic territorial scope of CGT also remains unchanged, so non resident individuals generally remain outside the scope of the tax.
How different tax payers are affected
In very broad terms, taxpayers are affected as follows.
- Most shareholders in Alternative Investment Market (AIM) listed and unlisted trading companies, and most employee shareholders in other companies, currently qualify for business asset taper relief and could well lose out by an increase in tax rate of up to 80 per cent, or even more in some cases. Each such shareholder should consider his own position and the actual effective rate applicable to him under the current rules but, if such a shareholder has held his shares for at least two years and the new entrepreneurs’ relief either will not apply or is of limited value, he may wish to consider triggering a disposal before 6 April.
- Management and ‘carry’ investors in private equity structures are a particular example of shareholders who are likely to lose out. The restricted scope of the new entrepreneurs’ relief means it is likely to be of little or no benefit to these investors.
- Non-employee shareholders in listed companies or in non-trading unlisted companies will in many cases benefit from a reduction in headline tax rate for disposals after 5 April. However, whether this produces a real tax saving could well be affected by the removal of indexation relief and, for small gains, both the availability of the AEA (which is more valuable where taper relief applies) and (for those without significant income) the absence of progressive rates.
- Holders of loan notes with rolled over or held over gains that are qualifying or have qualified for full business asset taper relief will generally wish to redeem or otherwise dispose of their notes before the new rules take effect. Other loan note holders may wish to defer disposal: see further below on this.
- Owners of business assets (eg offices or other commercial buildings, or farmland) that qualify for business asset taper relief are likely to benefit from triggering a disposal before 6 April. The tax saving may be very significant if the asset currently qualifies for a substantial amount of indexation relief.
- Second home and buy to let owners will generally benefit from deferring disposals until after 5 April.
Action before 6 April
- he first, and critical, step is to compare the effect of the current regime and the proposed new regime in relation to the specific asset and taxpayer in question (Appendix 1 illustrates some of the likely winners and losers under the reforms in generic terms). While in many cases the answer is obvious, this is by no means always so. For example (and as illustrated in Appendix 3), indexation can in some cases have a material impact in reducing the effective tax rate, but in other cases has little impact. In addition, the effect of losses, the AEA and the current share identification rules – which generally deem more recently acquired shares to be sold first – will all need to be taken into account.
- Generally it is worth noting that HM Revenue & Customs (HMRC) have recognised that by pre-announcing the reforms taxpayers have an opportunity to arrange their affairs if they wish. No new statutory antiavoidance measures have been proposed to prevent taxpayers from taking action to either accelerate or delay disposals.
- If the conclusion is reached that action should be taken before 6 April, a number of alternatives may be available. Some of these may be appropriate to consider in combination, for example the following (this is not a complete list).
– Assets can be sold outright. If an unconditional contract is entered into before 6 April this will trigger a disposal for CGT purposes assuming the sale is completed, even if completion occurs after the deadline. Obviously, any such contract will need to be properly evidenced. It will be necessary to ensure that shares and securities sold in this way are not reacquired within 30 days, due to the anti ‘bed and breakfasting’ rules, although reacquisition by a spouse may be possible within that period1. A check will also be required to ensure the transaction does not qualify for any mandatory CGT deferral relief (for example, the rollover relief applicable to certain share and loan note exchanges). It is often possible to ensure, if desired, that one or more of the conditions for any such relief are failed.
– Assets can be transferred into a family trust, including a ‘settlor interested’ trust (ie one where the settlor is a beneficiary). Provided the trust is not an outright or ‘bare’ trust solely in favour of the settlor, a transfer into trust will normally trigger a CGT disposal for a deemed market value consideration, with the trustees obtaining a corresponding acquisition cost2. A typical trust would be a discretionary trust with a class of family beneficiaries, but in practice the settlor may be able to retain significant control as well as being a beneficiary, and may also act as a trustee. Subsequent distributions in favour of the settlor would also be a possibility, subject to possible recharacterisation concerns if this occurs within a short period and there is no realistic possibility that anyone else would benefit. Inheritance tax (IHT) would need to be considered, but it may be possible to fund the trust to buy the asset using a loan so that the effective ‘gift’ element on which IHT arises on establishing the trust is reduced, and/or to terminate the trust before any material IHT arises within the trust itself. Income tax would also be a consideration, but for settlor interested trusts (including where the settlor’s spouse, civil partner or minor children are beneficiaries) income will usually continue to be taxed on the settlor3. In addition, stamp duty costs would need to be taken into account for shares and land but would only be charged on any actual consideration for the transfer.
– Assets could be transferred to a family member who is not a cohabiting spouse or civil partner, by outright gift or by sale. Again, this would trigger a CGT disposal for a deemed market value price. IHT, income tax and stamp duty would again need to be considered, but the IHT ‘potentially exempt transfer’ exemption for lifetime gifts may well assist.
– Assets could also be transferred to a company for a price left outstanding, or even for shares if care is taken to avoid the CGT rollover rules. This may sidestep IHT issues arising on transfers into trust, but may be less attractive as regards future gains (taxable at up to 28 per cent, albeit with indexation, in a UK company) and as regards the inherent double taxation exposure that introducing a corporate entity can involve. – Another possibility that may be available in some cases is a sale of assets to an existing SIPP (self-invested personal pension). Again, this would trigger an outright disposal.
– Alternatively, assets can be transferred to a (cohabiting) spouse or civil partner. Unlike the types of disposal referred to above, this will not trigger a gain and will not ‘bank’ any taper relief due to the ‘no gain, no loss’ rule applying on such transfers. However, in the view of HMRC this will have the effect of banking indexation relief. In some cases where assets were held between 1982 and 1998, this could be very valuable4.
– An initial inter-spousal transfer could again be considered if the LIFO share identification rules interfere with a desire to dispose of earlier, but not later, acquired shares – for example, where only some of the shares held qualify for full business asset taper relief. This would be a disposal of the more recently acquired shares but not a chargeable one. The remaining shares could then be the subject of a chargeable disposal, for example by sale or transfer into trust5.
– To minimise the economic exposure of an early disposal, hedging contracts such as options might be used to obtain the desired economic position in a period where the shares or other assets are not held.
- Conversely, the conclusion may be reached that any CGT disposal should be delayed until after 5 April, but in circumstances where there is a commercial desire or requirement to enter into a transaction before that date. In such a case, the following applies.
– If a share or loan note alternative is available on a takeover or similar, that may provide the solution – see further below on the latter.
– The disposal can also be delayed if the contract remains genuinely conditional until after 5 April. – Alternatively, the contract could be structured as an option that is not exercised until after 5 April. It may be possible to use both put and call options to protect both parties’ positions, subject to some possible recharacterisation concerns.
– It may be possible to make use of specific ‘no disposal’ rules applying to repos and stock loans, where shares or securities are sold or transferred under arrangements contemplating that they or similar assets may be reacquired.
– The economic exposure of a delayed disposal might be addressed through an appropriate hedging contract.
- For transactions involving earn-outs that will be entered into before 6 April 2008 with the earn-out payable after that date, it may be beneficial to structure the earn-out so that it is paid in cash rather than as usual by the issue of loan notes. This would mean that the current value of the earn-out right would be taxed at the point of sale.
Loan note alternatives: before and after 6 April
- On bids or schemes of arrangement where loan notes are issued before 6 April 2008, shareholders with full business asset taper relief may well wish to take cash, whereas those without full business asset taper relief may prefer to defer their gains until after 5 April by taking loan notes.
- In the past, it would often be preferable for loan notes not to be ‘qualifying corporate bonds’ (QCBs), as non QCBs allowed taper relief to continue to accrue. For any loan notes held after 5 April, taper relief will not apply and so there will often be no real advantage in structuring loan notes as non QCBs. (Non QCB loan notes would still allow the possibility of a capital loss if the loan notes were not repaid, but given the way many loan notes are guaranteed or secured this will generally be of limited interest.)6
- In contrast, if QCB loan notes are taken before 6 April, HMRC have confirmed that indexation relief will be ‘banked’ and will therefore effectively be available on a later redemption. This would not apply to non QCB loan notes. It follows that QCB loan notes may now be more attractive to those who acquired their shares before April 1998. In addition, some existing holders of non QCB loan notes may wish to seek to restructure those notes as QCBs before 6 April7 to benefit from both accrued indexation and the new 18 per cent tax rate. This benefit would only be available if the QCBs are acquired before 6 April.
- Existing holders of loan notes who wish to trigger their gains before 6 April, but who do not have a suitable redemption opportunity, will need to consider other methods of disposal, such as those described in ‘Action before 6 April’ above.
- For sales of companies from 6 April onwards, we expect loan notes will still be offered in at least some transactions. On public takeover bids and schemes of arrangement, this would primarily be to allow use of future years’ AEA for smaller shareholders. In other transactions, another reason may be to allow access to expected future capital losses. And importantly, in certain ‘earn-out’ situations a loan note structure will often remain necessary to avoid immediate taxation of the earn-out right. These situations most commonly arise in private mergers and acquisitions (M&A) transactions, but the technique has been used for some deferred consideration elements on public deals as well.
- Where loan notes are offered after 5 April, there will be no indexation or taper relief benefit available. We envisage that QCB loan notes will generally be favoured. It will not be possible to claim a capital loss in relation to QCB loan notes that fail to repay, but as already mentioned this will often not be a significant point given the guarantee or other security usually provided.
There are three Appendices to this guide. Appendix 1 illustrates some of the likely winners and losers under the reforms in general terms; Appendix 2 provides more detail on some of the points made in the introduction and in Appendix 1; and Appendix 3 features some numerical examples.