Cathy Russell: Are your clients sitting on a portfolio with substantial capital gains?

Canada Life's Cathy Russell asks if clients could be sitting on a portfolio with substantial capital gains in this technical article for Retirement Planner

As we contemplate how the government will repay the debt accumulated during the Covid-19 crisis, many people think this will lead to an increase in taxes.

So let’s consider how you could help your clients in these strange times. This window of opportunity may be small, so don’t think about it for too long before you act. Any changes made by the government may come into effect on the day they are announced and by then, it could be too late.

The current rates of income tax vary from 0% to 45% in England and Wales (0% to 46% in Scotland). Whereas the current rates of capital gains tax (CGT) on investment portfolios are 0% (annual exemption), 10% (non-taxpayers and basic rate taxpayers) or 20% (higher rate/additional rate taxpayers, trustees of discretionary trusts and personal representatives).

The 0% rate applies to the first £12,300 of gains in the current 2020/21 tax year for individuals or a maximum of £6,150 for trustees of discretionary trusts. I say maximum of £6,150 because this will be shared equally among ALL discretionary trusts a settlor has created – down to a minimum of one fifth (£1,230) – even if one or more of those trusts can’t use a CGT exemption.

Therefore, one option to repay some of the debt may be to increase the rates of CGT, or decrease the annual exemption, or perhaps do both!

Think about your wealthy clients – Are they sitting on gains within their portfolio? I appreciate that some clients’ values will have dropped during the lockdown period and this may have reduced the gains to a more manageable level, plus not all clients will want to remain invested until they have made up those losses.

Have they already used their annual exemption for this tax year? As we are just through the first quarter there is a possibility they haven’t crystallised any gains yet. And they may have some losses that could be crystallised at the moment.

Remember that losses can be offset against gains which arise in the same tax year and, if the client has any unused losses leftover, these can be banked with HM Revenue & Customs (HMRC) and carried forward indefinitely.  On that point don’t forget to check if your clients have already banked losses with HMRC – as they could be used to reduce any CGT payable on withdrawals made this tax year.

The opportunity is to take advantage of the current low rates for CGT – encash sufficient of their portfolio to use up their annual exemption – and thereafter the gains will either be taxed at 10% or 20% and, on top of that, there will also be some original capital returned to them.

Don’t forget that when someone takes a partial surrender from a collective there is a formula that works out how much of the withdrawal is original capital, so that you can see how much is actually gains. It’s called the A/A+B formula. You take the original purchase price and you multiply that by A, where A is the amount you are withdrawing, then you divide that by (A+B) where B is the amount left in the collective after the withdrawal.

For example, a client could have invested £300,000 into fund X and this is now worth £400,000.  If they wanted to withdraw, say, £250,000 the calculation is:

£300,000 {purchase price} x (£250,000 {A}/£400,000 {A+B}) = £187,500 {return of capital}

The gain is £62,500, and from this they can deduct £12,300 annual exemption leaving taxable gains of £50,200. If the client was a higher rate taxpayer they have £10,040 tax on the gain (£50,200 x 20%). That leaves them with £239,960 available to invest.

Having fully utilised their CGT annual exemption (preferably before the government decide to lower this exemption and/or increase the tax rates) and paid tax at 20% on the gain (for a higher rate/additional rate taxpayer), they could then invest the proceeds into an international investment bond.

Therefore, using my example, if the client invested say, £240,000 – and this is placed inside an international investment bond wrapper – they have the following potential advantages:

  • it can benefit from gross roll-up
  • it is a non-income producing asset – so there will be no ongoing tax charge each year while it remains invested
  • if the client needs to take money out they could benefit from the 5% tax deferred yearly allowance (which is cumulative) and based on £240,000 investment this would equate to £12,000 each policy year
  • the client could maximise the number of segments inside the bond (we allow up to 99,999) so that if they did need to take a withdrawal they could choose to fully surrender individual segments rather than take the 5% tax deferred allowance across all segments
  • there is the opportunity to assign segments, in the future, if the client wanted to pass some of this wealth onto, say, children or grandchildren
  • it can benefit from open architecture
  • it can be managed by a DFM or held on over 50 platforms
  • the funds can be switched as often as they want without any tax consequences
  • the bond could be placed under trust with no immediate tax consequences

And he would still have the balance of his portfolio invested in collectives where the advantages could be :

  • the annual dividend allowance is just £2,000 – tax-free, irrespective of marginal income tax rates. The collectives may produce up to £2,000 of dividends to make use of the full allowance rather than having excess dividends being taxable at 32.5% (higher rate)
  • there could be an annual exemption in future tax years (even if it doesn’t remain the same, or increase by inflation) to help rebase his acquisition cost on an annual basis
  • there may be losses, which have been banked with HMRC, to help reduce future gains on subsequent withdrawals
  • on future withdrawals he can use the A/A+B formula – but in this instance you need to remember to rebase the ‘purchase price’. Although it started at £300,000, using my example, he had a return of £187,500 capital, so on the next withdrawal his ‘purchase price’ is rebased to £112,500, and will be further rebased each time he makes a withdrawal.

Not every client will want to encash some of their portfolio at this time, but some clients may be willing to do so in the hope that they are getting the maximum current annual exemption and a substantially lower rate of tax on the capital gains while these are still available.

And by investing the withdrawal into an international investment bond they are increasing their flexibility going forward and can decide whether to take future withdrawals from the remaining collectives, or from the investment bond, or perhaps a combination of both for maximum tax efficiency.

Cathy Russell is tax and estate planning consultant at Canada Life