While the OTS does not advise on policy, this first report considers areas where the current rules do not meet the original policy intent or can distort taxpayer behaviour. A second report is due to be published early next year, exploring key technical and administrative issues.
Some of the key recommendations in the OTS report include:
More closely aligning tax rates on income and capital gains
The lower rates of tax on capital gains were noted as distorting taxpayer behaviour, by encouraging conversion of income to capital. The OTS recommends aligning the rates more closely, to allow taxpayers to make choices depending on business and personal needs rather than tax considerations. This would also reduce the need to police the boundary between income and gains, but it would not remove it altogether as the way income is classified would still affect the National Insurance Contributions position.
Problems noted with this approach were the effect of inflation, having to pay a large amount of tax in one year on disposal, which could cause reluctance to sell, and issues with differing tax treatment for assets held personally or in an investment company. The OTS therefore proposes that closer alignment should go hand in hand with other changes, including reintroducing relief for inflationary gains, allowing more flexible use of capital losses, and considering the position for assets held in companies. It is difficult to see how these proposals fall within the OTS’s remit of simplification.
The report discusses the tax benefits afforded to family investment companies (FICs), and we are aware that these are already under scrutiny by HMRC. While change is not necessarily imminent, their attractiveness may mean that the Government considers FICs further as part of more general reform.
Addressing ‘boundary issues’
The OTS suggests that an alternative to closer alignment of rates is to address ‘boundary issues’, and goes on to focus on taxing share-based rewards from employment and the accumulated retained earnings in smaller companies.
The OTS recommends that the Government should consider taxing more of the share-based awards arising from employment at income tax rates. It also comments on the tax advantages that arise from growth shares when compared to share options or a cash bonus, and notes that the returns on growth shares may look more like rewards from labour than from capital investment.
Retained earnings within a small company are also discussed in the report, and the ability of a taxpayer to pay tax at a much lower rate by incorporating and retaining profit within the company until it is sold or wound up. The OTS recommends considering that when a ‘small’ company is sold or liquidated, some or all of the retained earnings remaining in the business should be taxed at dividend rates.
Reducing the annual exempt amount (AEA)
The OTS notes that the AEA distorts taxpayer behaviour, with many reporting net gains close to the threshold. It found that if it is intended simply to prevent taxpayers with small occasional gains from having onerous reporting obligations it should be set at a lower level, with amounts from £2,000 upto £5,000 referred to in the report. This would of course increase the administrative burden, bringing more taxpayers into self-assessment.
The OTS suggests that the Government should at the same time introduce a broader exemption for personal effects, improve the online service to report capital gains in real time, and require investment managers to report client gains to HMRC directly.
Gifts in lifetime and on death
At present, there is a CGT uplift on death meaning that assets can be sold shortly after death without any CGT being due. If an asset is exempted or relieved from IHT, this means that no tax will arise in respect of that asset on death.
The OTS is concerned about the distortion this creates, encouraging taxpayers not to make lifetime gifts that may otherwise be more suitable for their personal circumstances, particularly in relation to passing down businesses. These rules are entwined with the IHT regime, but the OTS recommends that where an IHT relief or exemption applies, such as the spouse exemption or business or agricultural relief, the recipient should receive the assets at the historic base cost.
The OTS suggests the Government could go further and consider removing the capital gains uplift on death altogether, with all assets, other than a main residence, to be inherited at their historic base cost. This would cause an administrative challenge in calculating historic base costs. The OTS’s proposed solution is to consider a general rebasing of all assets to the year 2000, on the basis that valuations of land and property became easier from around this time.
The OTS also suggests that if the CGT uplift is removed, holdover relief on lifetime gifts should be extended to a much wider class of assets. Currently, CGT holdover relief broadly allows some business assets to be given away with no CGT payable at the time of the gift. Instead, the recipient receives the asset with the donor’s base cost.
The proposal to remove the CGT uplift on death for assets exempt from IHT was also made in the OTS’s recent report on IHT simplification. This is likely to prove an attractive idea to the Government in some form, potentially as part of a wider reform.
The OTS also considered two CGT reliefs: Business Asset Disposal Relief (BADR) and Investors’ Relief.
Although BADR was heavily amended in March, the OTS considers that it does not meet the presumed aim of simulating business investment, which requires an incentive at the time of the decision to invest. The OTS recommends an increase in the minimum shareholding to qualify to 25%, an increase in the holding period to 10 years, and perhaps an age limit to link BADR to retirement.
The report did not comment on how this proposal would interact with the separate proposal to tax retained earnings in small companies to income tax.
The OTS recommends removing investors’ relief altogether, as the near unanimous evidence was that it was not being used, and taxpayers had almost no interest in it. This is an unusual proposal given it is a relatively new relief and can only apply to disposals made after 5 April 2019, and it would be a surprise to see it abolished without consultation.
While CGT is not a huge revenue raiser for the exchequer, the Conservative manifesto commitment not to raise income tax, National Insurance Contributions, or VAT, does leave CGT a likely target for change, and an increase in the rate of CGT would be an unsurprising outcome. There have been calls to defer any tax increases for the time being, given the impact increasing taxes now could have on economic recovery, but the Government may choose to make some changes as early as the next Budget, expected in March 2021.
This CGT review follows the OTS report on IHT, published in two parts in 2018 and 2019. A Wealth Tax Commission report on the feasibility of a wealth tax is also due to be published in December. While it is impossible to predict what changes will be made and when, it may be an appropriate time for individuals and small businesses to consider how they may be affected by these potential changes and to start to discuss this with their advisers.
Our previous article, covering tax changes on the horizon and what taxpayers could consider doing to put themselves in the best tax position, can be found here.
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.