for financial advisers only
This article sets out the rules relating to capital gains tax (CGT) and some of the major planning considerations.
The 2007 Pre-Budget Report proposed changes to the UK CGT regime. These changes were confirmed in the 2008 Budget and subsequent Finance Act. Further changes were contained in the Finance Bill following the Emergency Budget on the 22 June 2010.
In additional to the previous changes a new rate of 28% was introduced for those individuals where the gain (after utilising their annual exempt amount (AEA)), when added to their total taxable income, exceeds the basic rate income tax threshold. The new rate is applied to the amount of gain above the threshold (in part or full). The rate applicable to trusts and to rate for executors of deceased individuals’ estates increase from a flat rate of 18% to a flat rate of 28% on the entire gain.
Any gains realised prior to 23 June 2010 are disregarded for the purposes of assessing which rate of tax is due – they will be taxed at 18%.
For individuals, the AEA remained at £10,100 for 2010/11 and will increase year on year in line with the retail price index (RPI). The AEA can be used to offset pre and post 22 June 2010 gains although where tax is levied at 28% it would appear to make sense to offset the AEA against the higher rate of tax.
When disposing of an asset (eg encashment or switch of a fund) you need to know the true acquisition cost and consider any costs relating to the disposal. In calculating the cost of both the acquisition and the disposal of an asset the calculation below can be used as a guide.
Gains and losses are calculated in exactly the same way. Any loss made in 1996/97 or later tax years must be claimed within five years after 31 January following the end of the tax year in which the loss arose and can be carried forward. Losses will not be allowable unless the taxpayer advises the Tax Inspector of the amount of the loss. The taxpayer can claim a loss via their tax return, or by writing to the local Inspector of Taxes.
For tax years before 1996/97 losses do not have to be claimed in this way. Pre 1996/97 losses can still be carried forward and there is no time limit on using these losses.
For part disposals, the principle is that allowable expenditure incurred must be apportioned between the part disposed and the part retained. However, the actual costs incurred when disposing of the ‘part interest’ are deducted at this time and applied in full.
£10,100 for 2010/11
This will increase each year with inflation and is deducted from the gain, not the tax liability, for example: £100,000 gain - £10,100 = £89,900 x 18% = £16,182 and not £100,000 x 18% = £18,000 - £10,100 = £7,900.
If the gain, when added to the individuals income was liable to tax at 28% the calculation would be: £100,000 gain - £10,100 = £89,900 x 28% = £25,172.
Allowable losses arising in the tax year are deducted from the total chargeable gains for the same year.
To ensure maximum use of the AEA, it can be advisable to create losses and gains in separate tax years. If a loss and gain are created in the same tax year you cannot choose to offset part of the loss arising in the same year as the gain. In other words all the allowable losses for the tax year must be deducted up to the amount of the gain even if this results in chargeable gains after losses below the level of the AEA.
Offsetting all carried forward losses may mean that some or all of the AEA is wasted in a tax year, whereas if only part of the losses are used and the AEA is used to the full, then any remaining losses can be carried forward into another year. Losses brought forward from 1996/97 or later must be deducted before losses brought forward from earlier years.
The Part Disposal Formula is extremely important when calculating any tax liability where only a proportion of the investment is disposed of. Let’s consider a £500,000 investment where the client wishes to receive £25,000 per annum of capital, ie 5%.
The formula is expressed as PP x A/A + B
PP = original investment value (adjusted each year for amount of original cost ‘used up’)A = value disposedB = value retained
It is this fraction of the original cost that needs to be compared to the capital disposal of £25,000 being made to arrive at the capital gain. If in both year one and year two the investments grew by 7%, the calculation would be:
£25,000 - £23,364.49 = £1,635.51 (gain) - CGT AEA
Clearly this shows that the client, although disposing of more than £10,100, is only utilising part of their AEA.
It is worth remembering that a partial or full switch will give rise to a CGT calculation for full or part disposal.
If we consider an investment holding multiple funds, such as the Collective Investment Account (CIA), the calculation is at fund and not product level, ie five funds means five calculations if withdrawals are taken across each investment.
In both cases, whether new units are allocated to the investment following a distribution via interest or dividend (income units) or existing units are increased in value after the distribution (accumulation units), the distribution is potentially liable to an income tax charge. From 6 April 2008, where identical assets have been acquired at different times, the existing last in first out (LIFO) rule does not apply and has been replaced by a simplified approach. Principally the assets will be pooled (known as a Section 104 holding) and these assets will have a single acquisition value based on the average cost of all the assets purchased within the pool.
Gains in excess of the AEA (£10,100) or where total proceeds (not gain) exceed four times this amount, £40,400, for the tax year 2010/11, need to be filed with the client’s normal tax return.
The additional changes to the CGT regime further underline the need for good record keeping and also potentially managing other income in the year that gains are going to be realised to ensure tax is reduced where possible. Although a slightly more complex calculation is required than previously, the ability to utilise the AEA should mean many clients pay capital gains tax at a rate lower than their income tax rate.
This article is based on Skandia’s interpretation of the law and HM Revenue & Customs practice as at August 2010. We believe this interpretation is correct, but cannot guarantee it. Tax relief and the tax treatment of investment funds may change.
This site is designed for and directed at financial advisers and must not be relied on by anyone else.
THIS WEBSITE IS FOR FINANCIAL ADVISERS ONLY
The content of this site is approved for use by financial advisers only. It hasn't
been approved for customers to view.
If you are NOT a financial adviser, please click
here to return to Skandia's homepage.