Neil MacGillivray: Business owners beware of potential CGT changes

The OTS recommendations put forward in its review of capital gains tax, published on 11 November, has created quite a stir. Neil MacGillivray warns that, if the key proposals are adopted, current CGT planning opportunities may be lost, particularly for owner-managed businesses

The Office of Tax Simplification (OTS) report highlights how the capital gains tax (CGT) rules can distort behaviour and do not meet policy intent, in particular, their interaction with income tax and inheritance tax (IHT).

For example, the lower rates of CGT can act as a motivator for owner-managed companies to retain accrued income within their company in the hope they can benefit from lower CGT rates on selling or winding up the business.

What grabbed the headlines was the key recommendation that CGT rates should be aligned with income tax rates. The closer alignment of rates would reduce the complex rules needed to police the boundary between income and gains, but correspondingly remove the tax rate advantage of capital gains. This change, and the recommendation to reduce the annual exemption to between £2,000 and £4,000, would of course lead to much higher tax bills for some.

On the upside, if rates were aligned, the OTS envisages a case for considering a more flexible use of capital losses, in particular, an extension of the range of situations in which they can be offset against income.

If the Government chooses not to support this option, then the OTS has a plan B, as it feels strongly that at least some of the distortions between CGT and income tax need to be addressed.

The thinking behind this is that part of the value of the shares in a trading company derives from work carried out by its employees or by owner-managers. The OTS therefore proposes taxing share-based rewards arising from employment and accumulated retained earnings in smaller companies at income tax rates. There’s little doubt that this course of action would result in more complexity than simply aligning rates.

In relation to the interaction between CGT and IHT, the OTS has previously touted the view that where a relief, or exemption (for businesses, farming businesses, and assets passing to a surviving spouse) from IHT applies, the capital gains uplift on death should be removed. This would mean the recipient is treated as acquiring the assets at the historic base cost of the person who has died (a no gain no loss basis), as opposed to the current regime, whereby gains are wiped out on death. The OTS has now gone further by advocating the removal of the capital gains uplift on death even where IHT is payable.

The reasoning is that similar scenarios can have different outcomes where either one, both or neither of the taxes arise. This again can distort behaviours. For example, an individual may defer passing a business down the family line until death as it avoids CGT and IHT. This delay is driven by tax consequences, and not necessarily by what’s best for the future of the business. So, if there’s no CGT advantage in deferring the gift till death, it may make the decision to pass the business on earlier more straightforward.

Also urged in the proposals is that Business Asset Disposal Relief (BADR) and Investors Relief should be scrapped, with a return to a relief more focussed on retirement proposed to replace BADR. The OTS suggests increasing the minimum shareholding requirement to something like 25%, in order that the relief goes to owner-managers rather than more passive investors.

Also, that the period the shares need to be held should be increased to, for example, 10 years. This is to ensure the relief only goes to people who have built up their businesses over time, with the addition of an age limit, similar to those for pension freedoms, to reflect the intention that it should mainly benefit those who are retiring.

In relation to Investors Relief, which was introduced in April 2016, there’s strong evidence that the relief is simply not being used and therefore is not achieving its goal of enabling unlisted trading companies in securing investment.

It’s important to remember that none, or only some, of these changes may come into play and there is of course the question of when changes could happen. The key steps for advisers with business clients that may be impacted, is that they make their clients aware of the changes and initiate a rational discussion on what action, if any, needs to be considered.

This will particularly be the case where the client has been considering, or even dithering about, taking advantage of the current tax rules.

Neil MacGillivray is head of technical support at James Hay