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Recommendations by the Office of Tax Simplification (OTS) on the future shape of capital gains tax (CGT) could have a significant impact on investment and wealth transfer advice.

The Government requested the OTS to undertake a review of CGT in July with a particular focus on areas where the existing rules can distort taxpayer behaviour. The OTS report asks the Government to consider making changes which will have a significant impact on advice if they eventually become law.

It is therefore important for advisers to understand what changes could be on the horizon and how it could affect your clients.

The key proposals

• CGT rates to be more closely aligned to income tax rates
• Annual CGT exemption reduced from £12,300 to between £2,000 and £4,000
• CGT losses to be used in a more flexible way
• On death beneficiaries would be deemed to have acquired inherited assets at the historic base cost of the deceased rather their value at the date of death
• Lifetime gifts of assets to be on a no gain no loss basis

Aligning CGT rates with income tax rates

One of the drivers for more closely aligning CGT rates with income tax is to prevent arrangements which attempt to treat returns which are income like in nature as capital gains to benefit from lower rates of tax. But the impact will be felt across the board, not just by tax avoidance schemes.

We have previously seen gains taxed at the same rate as income tax when taper relief and indexation relief were available to reduce the amount of gain subject to tax. And these latest proposals recommend that there are similar measures put in place so that only the gain above inflation will be taxed.

The OTS was only asked to look at CGT in the context of individual taxpayers and not companies. Aligning CGT to income tax rates creates disparity between the income tax rates on higher rate taxpayers and the 19% rate paid by corporate investors.

The OTS has recognised that this may prompt growth in the family investment company market with investors able to take advantage of the lower tax rates. The OTS have suggested that HMRC put measures in place to prevent higher and additional rate taxpayers using this route to convert gains which could be taxable at 40% or 45% to 19% by setting up a company to hold the investments.

Reduced annual exemption

In addition to the CGT rate increase there is a proposal to cut to the annual exempt amount. The OTS deemed that the current £12,300 exemption is overly generous. They believe the original policy intention was to keep small occasional gains out of the need to report or pay tax.

What they found was that the exemption was being treated as an allowance whereby gains up to the exempt amount were realised each year. In their view cutting the annual exempt amount to between £2,000 and £4,000 would be a suitable de-minimis limit which would still keep most gains free of CGT.

Flexible use of losses

Currently capital losses can be carried forward indefinitely and used to offset future capital gains. But for those who infrequently realise capital gains, relief for capital losses is limited. Aligning CGT rates with income tax offers scope to open up allowing capital losses to be offset against income. And the report also suggests the possibility of allowing losses to be carried back to allow tax to be reclaimed against capital gains from earlier tax years.

CGT on death

There's no CGT payable on death and the deceased's beneficiaries are deemed to have acquired the assets they inherit at their value at the date of death. This CGT free uplift could disappear under the OTS proposals and be replaced with a transfer on a no gain no loss basis.

This would mean that there is still no CGT paid on death but the beneficiaries base cost for future disposals would be the deceased's historic acquisition cost. This could create an administrative issue for some beneficiaries in identifying the original base cost. To help it has been suggested that base costs are revalued to the year 2000.

CGT on lifetime gifts

The CGT free uplift on death was also deemed to act as a deterrent to lifetime gifting with the possibility of a double tax charge. This is because CGT could be payable at the time of the gift and potentially IHT too if the donor failed to survive for seven years from the date of the gift.

The OTS report suggests that the lifetime gift of assets is also moved to a no gain no loss basis to encourage the transfer of wealth between generations. This would see gains deferred until the donee disposes of the asset, something which is only currently possible where the gift is of unquoted shares or gifts into relevant property trusts where holdover relief can be claimed.

Impact on saving

These changes will undoubtedly affect savings and wealth transfer behaviour. But it is important to look beyond the headline changes to understand the true impact.

An increase to the rate of tax payable on capital gains combined with a cut to the annual exemption is not good news for savers. Savings in unit trusts and OEICs could see the rate payable on gains double. But remember that under these proposals only the gain above inflation would be taxed.

Reducing the annual exempt amount would reduce the benefit of crystallising gains up to the exemption at the end of each year. Currently using the exemption in this way is worth up to £2,460 a year for a higher rate taxpayer but if it is cut to £4,000 combined with a move to income tax rates the annual tax saving is reduced to £1,600.

The reduction would also leave little room for larger portfolios which are actively managed to rebalance assets without triggering a CGT liability. Could this increase the popularity of passive and multi-manager type funds by removing the necessity to make regular disposals to maintain the target asset class mix?

Bonds v OEICs

The proposed changes will narrow the tax gap between investment bonds and OEICS/unit trusts. OEICs are currently taxed at 10% or 20% on their capital growth, rather than income tax rates that investment bonds pay.

Income and capital gains within a bond are rolled up and no tax is payable until there is a chargeable event such as the surrender of the policy. Top slicing relief acts as a mechanism to limit tax paid at higher rates on rolled up bond gains arising in a single tax year.

This ability to defer tax can be beneficial especially if gains can be timed to coincide with a tax year when the bondholder has little or no income in the tax year. However, it can also mean that dividend income is not only rolled up with no opportunity to utilise the dividend allowance each year but also becomes taxable at 20% or 40% compared to the dividend rates of 7.5% or 32.5%.

In addition bonds can be assigned without triggering a chargeable event, creating an opportunity to pass the bond to another family member who may pay less tax on the gain.

This has made bonds flexible when looking to transfer wealth as a similar change of ownership for an OEIC/UT is a disposal for CGT and tax could be payable unless it is a spousal transfer. But a move to a no gain no loss basis for lifetime gifts brings OEICs in line with bonds in terms of giving assets away without creating a tax charge.

There is no relief for economic losses within an investment bond but the added flexibility to carry back capital losses or to offset them against income would be welcome new feature for OEICs.

Summary

These suggested changes will clearly have an impact on both investment wrapper choice and the transfer of wealth if they become law. And if it the tax gap between bonds and OEICs is set to narrow, advice when selecting the right tax wrapper will increasingly be determined by understanding a client's circumstances and objectives.

While there are no guarantees the Government will adopt these recommendations they do address the specific points raised by the Chancellor in his letter to the OTS. It is important that advisers understand the current thinking in this area and the possible direction of future CGT rules.