In July last year, the Chancellor requested that the Office of Tax Simplification (OTS) undertake a review of capital gains tax (CGT) 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”.
In November last year, the OTS published its first report on this review: “Simplifying by design” (the Report).
The Report makes the following recommendations that are of particular significance to those who have share based remuneration schemes for their employees, and those considering a disposal.
The current rates of CGT are lower than standard Income Tax rates (20% compared to 45%). The report considers this disparity to be one of the main sources of complexity in tax affairs, and suggests that it can incentivise taxpayers to arrange their affairs in ways that effectively re-characterise income as capital gains.
The Report recommends that the government should consider more closely aligning CGT rates with Income Tax rates. It suggest, however, that if the Government chooses to do so, it should also consider reintroducing a form of relief for inflationary gains, consider the interactions with the tax position of companies, and consider allowing a more flexible use of capital losses.
Growth shares are designed to allow employees to benefit from future increases in their employing company’s value. Due to the growth shares only be entitled to future value, they will typically have little value at the time they are acquired but may, dependent on the relevant company’s performance and growth be worth significantly more value when they are sold.
The Report considers that capital gains tax should only apply where investors are on risk i.e. they invest meaningful capital in return for the prospect of a future return. It notes that growth shares are often acquired at relatively low value so do not carry this risk vs reward characteristic. As a result, the Report recommends that the Government consider taxing more of the return from these type of share-based rewards arising from employment at Income Tax rates.
After corporation tax has been paid, a trading company’s net profits can either be distributed as dividends or accumulated as retained earnings.
Earnings paid out as on dividends may be taxed at rates as high as 38.1% for additional rate taxpayers. If earnings are retained, however, then at the time the company is wound up or sold, those retained earnings are sold as surplus assets on a £ for £ basis and will form part of the sale proceeds taxed at the more preferential capital gains tax rates. This may be as low as 10% where Business Asset Disposal Relief applies.
The Report is concerned that this distorts behaviour, encouraging people to store up cash in their company. It recommends that the government consider taxing more of the accumulated retained earnings in smaller companies, at Income Tax rates.
Business Asset Disposal Relief (BADR) is targeted at owner managers and employee shareholders, and reduces the capital gains tax payable on a disposal of qualifying business assets to 10%.
If the intention of BADR is to encourage investment then it is, in the Report’s view, mistargeted. This is because the person receives the benefit when they dispose of the asset. If the objective is to encourage investment, then the person should receive the benefit at the time they make the investment decision.
Another objective of BADR is to provide a relief when business owners retire. If this is the objective of BADR, then the Report recommends that the government should consider replacing it with a relief more focused on retirement. To achieve this focus, the Report recommends the Government should consider increasing the minimum shareholding to 25%, increasing the holding period to 10 years and reintroducing an age limit.
Investors’ Relief is targeted at external investors and, as with BADR, reduces the capital gains tax rate payable on a disposal of qualifying business assets to 10%.
Though noting that Investors’ Relief is a relatively new relief and that evidence about its use is limited, the Report stated that based on the responses to the OTS’s consultation the emerging evidence was clear: almost no one has shown interest in using Investor’s Relief, and it therefore recommends that Investors’ Relief should be abolished.
The above recommendations are, at this stage, only that. As the Report states, there are wider policy trade-offs for the government to make in taking any of the recommendations forward. This would need further detailed work.
The Report concerns the policy design and principles underpinning CGT, and the OTS expects to publish a second report exploring key technical and administrative issues early this year. We may need to wait until this second report is published before we receive further clarity.
As many people are aware, the Report is already influencing behaviour. In particular, business owners are considering disposals of assets ahead of the Budget on March 3rd to secure the current rates of CGT.
Although we await sight of the second report, in our view the suggested reforms create a number of challenges. In particular, they seek to change the goalposts applying to existing commercial arrangements which not only creates uncertainty but also unfairness for tax payers. In addition, in respect of arrangements such as growth shares, they seek to fundamentally change the principle that if a person acquires an asset for market value then, regardless of gearing or otherwise, if that person later sells an asset for market value the return should be classified as a capital gain. Employee share ownership is used to align the mid to long term interests of employees and business owners (as well as encourage growth in the UK economy) and the Government will, no doubt, be wary of disturbing that balance.
At the same time, clearly the Government has to consider whether the tax system is fair and to address the deficit arising as a result of Covid-19. A potential increase in the rates of capital gains tax may be a reasonable approach (given rates are at a historically low level) and that certain assets are already taxed at the higher rate of 28%. In addition, ensuring that reliefs to the main rate of capital gains tax are tailored to longer-term ownership seems sensible public policy and reflects an approach in the 1990s and early 2000s.
Whatever the Government decides to do it is hoped that it will take a balanced approach, to avoid unintended and adverse consequences for UK businesses already struggling with Brexit and Covid-19.
This publication is intended for general guidance and represents our understanding of the relevant law and practice as at January 2021. Specific advice should be sought for specific cases. For more information see our terms & conditions.
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