The Office of Tax Simplification (OTS) is recommending aligning capital gains tax (CGT) rates with income tax and sharply reducing the annual exempt amount in order to increase tax revenues and create a more equitable tax regime
The independent body’s first report on CGT, commissioned by the Chancellor in July, described the current approach as one which is ‘counter-intuitive, creates odd incentives, or creates opportunities for tax avoidance’.
To address these distortions, the OTS outlines four broad policy choices.
Rates and boundaries
Firstly, the OTS says the disparity in rates between CGT and income tax can distort business and family decision-making and creates an incentive for taxpayers to arrange their affairs in ways that effectively re-characterise income as capital gains.
Most gains are concentrated among relatively few taxpayers, who also tend to have more flexibility about when they dispose of their assets. This can mean that they pay proportionately less tax on their overall income and gains than others.
A greater alignment of rates would reduce the need for complex rules to police the boundary between income and gains, as the way income is classified would not affect the tax position. Alternatively, the issues arising from the disparity in rates could be addressed at the boundary between income and gains.
The two key areas where the OTS considers the boundary is under pressure are the use of share-based remuneration, and the accumulation of retained earnings in smaller owner-managed companies.
A rough static costing suggests that alignment of CGT rates with income tax rates could theoretically raise an additional £14bn a year for the Exchequer, given that the vast majority of CGT by value comes from higher and additional rate taxpayers.
However, the OTS says it is clear that nothing like this amount would be raised in practice, due to behavioural effects (such as people delaying disposals) and other changes that might be made in parallel (such as allowing for inflation)
Annual exempt amount
Secondly, the OTS said the relatively high level of the annual exempt amount (£12,300 in tax year 2020-21) can distort investment decisions. In tax year 2017-18, around 50,000 people reported net gains just below the threshold and so ‘use up’ the allowance which is straightforward for holders of listed share portfolios
The report suggests that if the government’s policy is that the annual exempt amount is intended mainly to operate as an administrative de minimis, it should consider reducing its level.
If taxpayer behaviour did not change, the number of taxpayers required to pay CGT in 2021-22 would double if the annual exempt amount were reduced to around £5,000, and would nearly triple if it was cut to around £1,000.
However, any reduction would need to take into account the increased administrative costs and burden, for taxpayers and HMRC. The OTS considers it would be essential, at the same time, to improve the administrative arrangements for real time CGT reporting, simplify the rules about personal effects and review the threshold for reporting transactions if no gain arises.
The OTS also argues that the way CGT interacts with inheritance tax (IHT) is ‘incoherent and distortionary’, and says CGT incentivises owners to transfer business and personal assets to others on death rather than during their lifetime.
The OTS , which has previously reviewed the operation of IHT, continues to recommend that a taxpayer should not get both an IHT exemption and a CGT death uplift.
A less distortive alternative to the death uplift could be a ‘no gain no loss’ approach, where (except in relation to a person’s main or only home) the recipient is treated as acquiring the assets at the historic base cost of the person who has died.
This approach would make transfers in life and on death more neutral. The OTS considers there is also a case for going further, as there would still be an incentive to hang onto some assets until death in a range of other situations, in particular in relation to gifts.
Finally the OTS report says there is a policy judgement for government to make about the extent to which CGT reliefs should be used to seek to stimulate business investment and risk-taking.
It argues that business asset disposal relief is mistargeted if this is its objective, and that incentives for investment, if required, should apply at the time the investment decision is made.
Instead, business asset disposal relief has long been understood as having another objective – as a specific relief when business owners retire.
The OTS argues the government could consider meeting this objective by increasing the minimum shareholding to perhaps 25%, so that the relief goes to owner-managers rather than to a broader class of employees; increasing the holding period to perhaps 10 years, to ensure the relief only goes to people who have built up their businesses over time; and reintroducing an age limit, perhaps linked to the age limits in pension freedoms, to reflect the intention that it mainly benefit those who are retiring.
The report is scathing about the impact of investors’ relief, which investors have been able to claim only in relation to investments made from April 2016 and disposed of from April 2019, saying the evidence indicated almost no-one has shown any interest in this relief or is using it.
John Cullinane, CIOT’s tax policy director, said: ‘The OTS report benefits from the extensive consultation that lies behind it and we urge the government to continue a consultative approach in weighing up the issues it raises, which go beyond simplification, important as that is.
‘There are fundamental issues of fairness between different types of taxpayer, of how to most effectively encourage enterprise, and of what pragmatically raises the most revenue, and these do not all necessarily pull in the same direction.
‘There are also interactions with the taxation of companies and trusts which need to be worked through.
‘A diet of piecemeal Budget surprises would be unlikely to lead to a more coherent system or to achieve the best balance between these factors.’
Helen Jones, partner in private client tax services at BDO, argued that changes to CGT should go hand-in-hand with reforming IHT.
‘Obsolete exemptions and legislation that is no longer fit for purpose should be removed. Only then will we be able to understand if significant changes to the rates of these capital taxes would be appropriate.
‘Whilst simplicity is to be welcomed, some will say it causes more unfairness. It is hard for governments to balance simplicity with fairness: a flat tax rate is simple, but whether it is fair that the wealthy pay the same rate of tax as those less well-off is a highly charged question.
‘We agree that higher rates of CGT could distort behaviour as people choose to retain assets rather than trigger a tax charge. In order to enable the economy to thrive, it is essential that CGT rates remain lower than income tax rates so that we incentivise individuals and businesses to keep investing into the UK.’
Jones also pointed out that some of the OTS recommendations, if implemented, would mean taxpayers had new record keeping obligations and in some cases faced greater complexity, particularly if assets were rebased to their year 2000 value, which was one proposal if the suggested removal of capital gains uplift on death went ahead.
‘Simplifying CGT rates is certainly a good start, but we remain far away from a simplified tax system suitable for the globalised 21st century,’ she said.
According to HMRC statistics, in the 2017-18 tax year £8.3bn of CGT was paid and £55.4bn of net gains (after deduction of losses) reported by a total of 265,000 individual UK taxpayers.
This compares with the £180bn of income tax paid in 2017-18 by 31.2m individual taxpayers.
Most people do not need to pay CGT very often, but those who do often pay large amounts - income tax raises over 20 times as much overall, but the average (mean) amount of CGT paid by those who are liable to the tax is £32,000, which is more than five times the equivalent figure for income tax.