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  • Stuart Fowler

Anticipating regressive CGT changes


As financial advisers, should we laugh or cry? Labour’s ‘flat tax’ experiment with Capital Gains Tax is being unwound by the coalition government, a victim of the horse-trading between a party with well-thought through tax policies and a minority party with fantasy tax plans that never needed to pass tests of practicality or optimality. We are moved to tears by the inefficiency and complexity that will once again be introduced into household financial management, for no good purpose. We could laugh because complexity makes work for advisers. But, hey, this is No Monkey Business so we do actually know that there is no integrity in rejoicing at governments’ inability to see that simpler, flatter tax regimes are more efficient for everyone.

the devil in the detail

We do not know yet what changes will be agreed between the Conservatives and the Lib-Dems, only that they ‘agree to seek a detailed agreement on taxing non-business capital gains at rates similar or close to those applied to income’. The devil will be in the detail of that agreement. If the rate increases to close to 40% without relief for either time (taper relief as a function of the holding period) or inflation (indexation uplift of the cost base), the changes will be a bad backwards step in both principle and practice and will probably shrink rather than increase the tax the Government raises (which isn’t very much anyway). If the rate increases, but with reliefs based on time or inflation, the tax will be fairer in principle and more honest, to the extent the government does not then tax historical general inflation in capital values. But it will still be impractical and expensive to operate and will distort decision making. It will probably still reduce the tax take, for the same reason people believe in simpler, lower, flat taxes with no reliefs.

guessing the detail

Look for the way in which the Emergency Budget on 22nd June deal with time and/or inflation.

  • Indexation has more integrity than taper but taper is simpler to account for.

  • The policy could revert to the position prior to 1998 and apply full RPI uplift to the cost base, starting at 1982 values.

  • It could rebase the start level from 1982 to a date more recent (requiring ‘backward revaluation’ of assets – simple for listed securities, more expensive and arbitrary for property) and apply either indexation or taper relief from that new date.

  • It could apply taper to the existing base costs, all the way back to 1982 if held for longer, so a much more gradual rate of taper than the regime post 1998 and one which bring the effective benefit more closely into line with the small size of the annual uplifts with indexation relief.

  • It could give less weight to inflation and more to a politically-correct notion that gains realised after short holding periods are less worthy than gains after long holding periods, as was the case with the 1998 regime (no taper for three years).

How individuals view each option depends on their own vested interests, as a function of their known base costs and actual holding periods and their expected future gains and holding periods.

  • On economic grounds, the danger is greatest from any option that treats as a public windfall CGT resulting from the more than doubling of the general price level from 1982.

  • This bears hardest on real property, as the gains cannot be ‘worked out’ gradually using annual exemptions, unlike securities.

  • Taper looks arbitrary and inefficient for new investment decisions.

  • But if combined with a recent new base date taper may not be too harmful for old investments.

Watch too for changes to the annual ‘small gains’ allowance. The Lib-Dems wanted to cut this from £10,100 to £1,000 – a clear demonstration of fantasy politics as it would massively increase the number of tax returns being filed each year in an HMRC already struggling. If the Conservatives don’t scotch this proposal they will deserve the derision it will attract from both left and right.

guessing the effective date

What price principle? The rate of CGT is known at the point a decision is made to sell. It is chargeable at the rate effective at the point of sale. So if the Government were to make the regime changes retrospective to 6th April 2010 it would be an historic breach of principle. However, there must be some probability assigned to this scenario, enough to consider making sales in haste and certainly enough to warrant considering bringing forward sales that would be made for good reason anyway.

In practice most individuals will already have made the sales that ‘would be made anyway’, before 5th April 2010 and possibly even well before the election speculation included a possible increase in CGT rates. The flat rate of 18% was an effective rate lower than at almost any stage in the past, and (in the days of indexation) higher only than assets whose peak rates of growth were earned in the 1980s. Many of our clients were willing to pay tax at that rate but would have otherwise avoided the transactions had the tax charge been much higher. That is why we think around 20% is the optimal rate for revenue generation.

It is unusual for the rate of CGT or reliefs to change part way through the tax year, hence the most probable scenario could look like a change effective at the end of this year. But there is another reason for making it effective later. If the revenue effects are largely illusory or speculative, and this is really gesture politics, some hard benefit could be derived by incentivising the bringing forward of realisations into a one-off nine-month window.

What probability you assign to the changes being effective from 22nd June depends in large measure on your view of its practicality and cost for HMRC. Our own accountants think it leaves plenty of time for HMRC to adjust its own self-assessment software, at no great cost. However, this may depend partly on the new form of taper or indexation relief and, particularly, the need for new valuations if the base date changes. For decision making, note, this scenario makes little effective difference as it is only the chance of bagging the 18% rate in the current window that affects decisions about sale of assets prior to the Budget.

If it is left to year end, however, there is then every reason to assess the merit of bringing forward realisations, particularly of property holdings, into 2010/11. This is not just a tax exercise but a call to action to review the ‘capital efficiency’ of household balance sheets, given realistic risks and returns but also whether needs for liquidity and certainty dominate your financial planning. You do not need to wait for the Budget to do that. Just pick up the phone.

implications for efficient investment

1. Tax management in portfolio management

  • Tax matters. It is a cost of investing but often discretionary. Budget for it like all other costs.

  • Only lazy clients let investment managers get away with saying they will ignore tax in their decision making.

  • As a general rule, it is over-confidence about gross returns, whether by manager or customer, that leads to capital management that is wasteful of the tax budget. Watch for this. Humility in the face of market uncertainty is more likely to be associated with good tax housekeeping.

2. The importance of index linked gilts

  • In the absence of proper indexation (not taper relief, which may or may not be as effective), it will be inefficient to receive ‘inflation compensation’ via increases in nominal capital values that are then chargeable to CGT. This has nothing to do with making sales in the course of efficient management of portfolios but rather a long-term view of the after-tax risk and reward of capital that at some point will be turned into consumption, such as to support spending or to make lifetime gifts.

  • The higher the taxation of gains that are really only inflation compensation, the more efficient it is to hold index linked gilts as the hedging assets for future consumption. Most of the return will be inflation compensation and will be received tax free. If you are not already using horizon-matched index linked gilts to manage the uncertainty about long-term wealth or spending outcomes, you certainly should be now.

3. A boost for ‘bond wrappers’

  • One reason why higher rates of CGT, even in the presence of time or inflation relief, are likely to reduce the tax revenue raised is because people like us will use offshore bonds as a holding vehicle for the assets we think we need to rebalance from time to time as part of efficient capital management.

  • Bonds defer the tax on realisation although they also provide scope for reducing the overall tax rate if realised when the policyholder’s income tax rate is lower then the CGT rate, or if death occurs before gains have been taken and the policy has been ‘written in trust’ to beenfit the next generation.

  • Except when the realisation of gains is unavoidable to to convert a stock of capital to a stream of spending money, or to make gifts, making sales to ‘rebalance’ a portfolio is an option, not a necessity. In any case, good professional management will minimise the frequency of transactions, and their attendant frictional costs, such as by opting out of active management and adopting ‘horizon matching’ when allocating assets.

  • ISAs and SIPPs may provide capacity enough for the rebalancing stock of assets that would otherwise be within the CGT regime but where this capacity is restricted, for any reason, a low-cost bond wrapper is a good alternative holding vehicle.

  • Watch out for commisison-driven sales of expensive investment bonds. The increase in CGT rates provides one last hurrah for IFAs promoting these expensive products before the Retail Distribution Review crunches the excessive margins. If you are paying a fee for advice there is no reason why the right wrapper should not be very cheap (and a flat rate).

4. Offshore funds

  • Ironically, narrowing the gap between income tax and CGT effective rates will reduce the current regime’s heavy penalty on unregulated, unauthorised funds, with both gains and losses currently subject to income tax.

  • Regardless of the tax change, however, the market in the UK for alternative investent strategies will mainly be shaped by the legislation coming from Europe that will allow hedge-fund like strategies in ‘passportable’ fund structures. This is something to monitor, not act on now.

5. Investment properties vs securities

  • High effective CGT rates penalise against property and in favour of securities or funds investing in public-market securities. This is because holdings can be subdivided and realised in tranches, maximising allowances in the form of realised losses (themselves generated from partial sales to create the contingent asset of a loss carry forward) and the annual exempt amount.

  • Buy-to-let property is the obvious candidate for review for possible replacement if a window is created in the Budget up to year end. Let property is an investment strategy where we see one of the greatest gaps between perception and reality so a review is a good idea anyway.

6. Home ownership

  • As our recent paper on the economics of home ownership explains, owner-occupied (as opposed to investment) property relies for most of its benefit on the enjoyment of the asset as a form of ‘consumption’. If financed by debt, actual financial gains depend on the cumulative real cost of the debt over the life of the loan. If the opportunity cost in the form of financial asset returns is higher, actual financial wealth is reduced below that resulting from renting property. Real financial gain is never to be taken for granted, least of all in today’s post-credit crisis world. I fear that higher CGT rates will be used to trump these economic arguments and validate a largely partial and emotive bias to property on the grounds the main residence is free of CGT.

7. Business assets

  • The one-paragraph coalition statement makes a clear distinction between the regime for business and for non-business assets. But we have no basis for speculating about the detail in respect of business assets and see no actions that can be taken in any event between now and the Budget.

  • We should not confuse the private equity industry, whose business model was dominated by the leveraged buy-out or buy-in, with entrepreneurship in general. The industry will be lobbying hard to ensure the changes do not hurt the ‘carried interest’ of partners but this is not obviously of any economic consequence. The economics of private equity have been upended by the credit crisis which has undermined the theories of capital efficiency, leverage and value added that private equity built on. Until these are replaced with a different and more robust basis of assessment, we cannot even begin to think about the role of tax incentives on enterprise in the future.

  • But there is a more important debate to be had about the appropriate sharing of risk between business creators and intellectual property developers on the one hand (whom we need much more than private equity owners) and the tax payers on the other. This should not be policy made (or unmade) in haste.

8. Trusts

  • There seems no obvious reason to expect changes to the existing regime which gives only half the annual allowance.

  • A higher rate will return us to the penal regime applicable to stored-up gains in offshore trusts with UK beneficiaries.

  • It would be nice to think both the parties to the coalition share the view that trusts are not just or primarily about tax mitigation and that the excessive tax burden indiscriminately imposed on trusts will be reformed at some point.

9. The Tax Reform Bill of 20..

  • This goes for tax reform generally. The credit crisis probably put paid to any realistic chance of an incoming government reforming the tax code to reduce inefficiencies in decison making, cut the need for and cost of advice and increase the after-cost revenues collected by flatter taxes: lower rates across a broader base with fewer allowances and reliefs. It might reduce the fees from our financial planning activity but we will celebrate nonetheless. Meanwhile, we dream on.

#budget #capitalgainstax #economics #investmentbonds #property

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