Capital gains tax taper relief is to be abolished, and a single rate of capital gains tax will be introduced from 6 April 2008.
These changes will increase the effective rate of UK capital gains tax from 10 per cent to 18 per cent for UK entrepreneurs who sell their businesses. These changes are relevant not just to private-equity investors, as they will apply to any UK individuals who sell business assets. Sale contracts which have yet to be completed could be affected, as will transactions which have been completed but where full cash payment has not been received before 6 April 2008.
Abolition of taper relief, and single rate of capital gains tax
The Government has announced a major change to capital gains tax, which will have effect from 6 April 2008. The three rates of capital gains tax which currently apply (10 per cent, 20 per cent, and 40 per cent) will be replaced with a single rate of 18 per cent. This change only applies to individuals and trustees.
Significantly, this will be accompanied by the abolition of a number of reliefs from capital gains tax - in particular, taper relief will be abolished (both business asset taper relief, and the less generous form of taper relief for non-business assets). Taper relief was introduced in 1998 by the then Chancellor of the Exchequer, Gordon Brown, in order that the capital taxation system “should better reward long term investment particularly in economically productive business assets.”. Currently, business asset taper relief reduces the effective rate of capital gains tax to 10 per cent but only in respect of business assets which have been held for at least two years. Business assets include (a) shares in unlisted companies (including those traded on AIM) and (b) shares in listed companies where the holder is an employee or director.
In recent months, questions about the generosity of this relief have been raised in the context of a public debate about the private equity industry. However, the abolition of this relief will have much wider effects; it will remove an incentive for any UK resident individual to invest in unlisted trading companies (e.g., private companies and companies on AIM), rather than shares in FTSE 100 companies or other investments (e.g., second homes/buy-to-let properties).
The loss of business asset taper relief will increase the effective rate of capital gains tax payable by individuals who sell shares after 6 April 2008, including those who acquired shares in the expectation that business asset taper relief had become an established part of the UK’s tax regime. This change will also have an impact upon any sale where a conditional contract has been exchanged, if the condition is not expected to be satisfied (i.e., completion is not scheduled to occur) until after 5 April 2008. Individuals who disposed of their shareholdings prior to this announcement may also be impacted, if the terms of sale included an earn-out or other forms of deferred consideration (e.g., loan notes). The changes announced today could result in the capital gains tax payable on the earn-out/deferred consideration rising from 10 per cent to 18 per cent This rate of tax of 18 per cent contrasts with a tax rate of 25 per cent for dividends from UK companies; while previously there had been a differential of 15 per cent, this has narrowed considerably.
As the changes are to have effect from 6 April 2008, there may be some opportunity to restructure the terms of current, and past transactions to mitigate the additional tax cost, but there may be commercial constraints on what can be achieved in terms of (for example) commuting earn-outs or redeeming loan notes. Individuals will have to consider whether it is better to crystallise the tax charge at a rate of 10 per cent now (assuming that full business asset taper relief has been obtained) or defer it but suffer tax at a rate of 18 per cent or a higher rate for assets owned since before 1998 because of the removal of indexation allowance. A disadvantage of crystallising the tax charge at a rate of 10 per cent rather than 18 per cent is that the date on which the capital gains tax must be paid is advanced by at least a year, to 31 January 2009. One difficulty is the absence of draft legislation, which would clarify some of the uncertainties surrounding the proposals. The Government has announced that it will immediately begin discussion with interested parties on the technical detail and implementation.
Holders of EMI options will also be adversely affected by the abolition of business asset taper relief, if the terms of the option scheme do not allow options to be exercised, and shares disposed of, prior to 6 April 2008.