With Brexit negotiations stalling and the COVID-19 pandemic continuing, the economic outlook in the UK is far from rosy. The Bank of England and the Office for Budget Responsibility have both predicted that the UK economy will contract close to 11 per cent in 2020, which is the worst annual performance for more than 300 years. Against this backdrop and the government having ruled out austerity, it seems inevitable that taxes will have to increase, and a prime target is capital gains tax ('CGT').
On 11 November 2020, the Office of Tax Simplification ('OTS') published a report on CGT in response to the Chancellor’s request in July 2020. The Chancellor asked the OTS, in particular, to 'identify opportunities relating to administrative and technical issues as well as areas where the present rules can distort behaviour or do not meet their policy intent'. The report is the first of two, with this one focussing on the policy design and principles underpinning CGT and the second, which will follow in early 2021, exploring technical and administrative issues.
While it is not within the OTS’s remit to determine the principles and role of CGT, the report discusses possible policy reasons for various parts of the tax and sets out recommendations to achieve those policies, concluding that as things stand the current rules are 'counter-intuitive' and create 'odd incentives' in a range of areas. The recommendations cover four interlinked areas: rates and boundaries; the annual exempt amount; interaction with lifetime gifts and inheritance tax; and business reliefs.
The OTS report is lengthy and contains recommendations with varying degrees of likelihood of adoption. We have already published a blog with some initial reactions to the OTS report. In this article, we focus on the technical aspects of the recommendations, with a further article on how we consider the government is likely to respond to the report to follow shortly.
Rates and boundaries
The recommendation that has received the most media attention (and caused the most alarm!) is the proposal that CGT rates should more closely align with rates of income tax. The OTS considers that, if the government’s priority for this review is, as the Chancellor stated, to reduce behavioural distortions, a closer alignment would remove some of the incentive for people to seek to characterise certain receipts as capital gains rather than income and to favour activities and investments that generate capital gains rather than income. It could also simplify the tax rules, as (in theory) it would reduce the need for complex anti-avoidance rules to police the boundary between income and gains.
However, if CGT and income tax rates are more closely aligned, the OTS further recommends that the government should consider other related changes:
- reintroducing a form of relief for inflationary gains (e.g. indexation);
- addressing interactions with the tax position of companies (as higher CGT rates could incentivise holding investments through a company to access lower corporation tax rates); and
- allowing more flexible use of capital losses.
It is worth noting that the OTS stops short of recommending the full alignment of CGT and income tax rates, recognising that there are possible policy objectives, such as to reward risk taking and promote enterprise, which may justify lower CGT rates. Absent full alignment, if the government’s objective is to simplify CGT, the OTS also recommends the government consider reducing the number of CGT rates (there are currently four) and the extent to which CGT liability depends on a taxpayer’s income.
In the context of the boundary between CGT and income tax, the OTS singles out two areas where the boundary is under particular pressure:
- share-based remuneration; and
- retained earnings in smaller owner-managed companies.
The pressure in these two areas could be reduced if the rates were more closely aligned.
On share-based remuneration, the OTS recognises the desirability of certain employee share schemes, but specifically draws attention to growth shares, where any profit on the sale of the shares is subject to CGT rather than income tax, whereas profits from other conceptually similar arrangements such as share options are taxed as income. The report recommends the government consider whether the boundary is currently in the correct place.
On retained earnings in companies, the OTS draws attention to the different tax outcomes between:
- realising those earnings on sale or liquidation - chargeable to CGT, subject to certain anti-avoidance rules; and
- withdrawing profits as dividends or salary - chargeable to income tax.
The thesis is that, for small owner-managed companies, all profits relate to the individual’s labour and so should, in principle, be subject to income tax. The OTS recommends that the government consider whether this inconsistency can be justified.
Annual exempt amount
The OTS concludes that, if the purpose of the annual exemption is to operate as a de minimis to simplify administration, then it should be reduced to somewhere between £2,000 - £4,000 (from its current level of £12,300). The OTS estimates that this would result in 300,000 - 400,000 new people having to file self-assessment tax returns and pay CGT. To reduce the administrative burden on these new taxpayers and HMRC, the OTS recommends that the government should consider:
- extending the current chattels exemption;
- formalising real time capital gains reporting, linking these to the Personal Tax Account; and
- requiring investment managers to report CGT information to taxpayers and HMRC.
Interaction with lifetime gifts and Inheritance Tax
The OTS considers that the way CGT and inheritance tax ('IHT') currently interact is incoherent and distortionary, and discourages lifetime transfers. As in its IHT report in 2019, the OTS again recommends abolishing the capital gains uplift on death. It suggests that the uplift be abolished where no IHT is payable due to a relief applying. However, the latest report goes further than the previous IHT report, in suggesting that there is also a good case to consider whether the CGT uplift be abolished for all assets. This measure, the OTS suggests, could decrease the ‘lock in effect’ which discourages people from disposing of assets before they die so they benefit from the uplift. The beneficiary would instead be treated as acquiring the asset at the same base cost as the deceased, with CGT paid when the beneficiary disposes of the asset.
If the government decides to remove the capital gains uplift more widely, the OTS recommends it consider:
- rebasing all assets, perhaps to the year 2000; and
- extending gift holdover relief to a broader range of assets.
The OTS recommends that gains on main residences continue to be exempt from CGT and that if the CGT uplift on death is abolished, a beneficiary receiving the main or only home would benefit from the tax-free status of the period of occupation by the deceased.
The OTS recommends that business asset disposal relief ('BADR') (which is the new name for entrepreneurs’ relief) and investors’ relief both be abolished.
In the case of BADR, the OTS recommends that it be replaced with a relief more focussed on retirement and suggests the government consider:
- increasing the minimum investment to perhaps 25 per cent;
- increasing the holding period to perhaps 10 years; and
- reintroducing an age limit, perhaps linked to age limits in pension freedoms (noting the lock in effect this could have).
In the case of investors’ relief, the OTS considers that there is little evidence of people using, or wanting to use, this relief and recommends that it be abolished, to be replaced with something better targeted if the government considers necessary. It should be noted that this relief was only introduced in 2016 and the first year in which qualifying disposals might have taken place is the 2019/2020 tax year, and so it is unsurprising the relief has been little used.
The above provides a summary of the recommendations made in the OTS report and we will consider in a forthcoming article the extent to which we consider any changes are likely.