The use of indirect taxes to reward or punish consumer behaviour is an accepted part of government policy. Hence booze'n'fags, plane journeys and landfill have special duties attached to them, while food and children's clothing are free from VAT. On the direct tax side, the position is less clear. In the seventies, a special surtax was imposed on unearned income, intended to penalise those who lived off investments or rents rather than by the sweat of their brow. Nowadays, partly to assuage pensioners, national insurance ("NICs") has been expanded so that wages are taxed more heavily than interest or dividends.
The history of CGT v income tax is perplexing
The history of capital gains versus income tax rates is similarly perplexing. Unlike many EU states, the UK does not impose NICs on capital gains. CGT has at times been paid at a higher or lower rate than income, or sometimes at the marginal rate, depending in part on whether the government of the day is trying to clamp down on speculators and second-home owners (bad) or reward those who build up and sell businesses (good). In an unreported case dating back to the days of taper relief , HMRC tried to classify a termination payment as an untapered capital gain (taxed at 40%) rather than income, so bypassing the £30,000 exemption. If the same events happened today, it is hard to imagine that the case would be pursued so vigorously.
The introduction of the 50% rate for high-earners has increased the difference between CGT and income tax rates to 32%, and even this figure is an underestimate, as it fails to take into account the annual exemption for CGT or the NICs generally payable along with income tax. Unsurprisingly, taxpayers and their advisers are doing their best to organise their affairs to ensure CGT treatment. To the surprise of some, the April budget did not increase the CGT rate, but stopped a couple of rarely-used employee share schemes and announced that:
There will be a review and consultation, during 2010, on taxation of geared growth arrangements used in connection with employment related securities, to ensure employment income is subject to correct tax and NICs.
The reference to geared growth arrangements is no doubt deliberately vague. At its widest, it could cover any ordinary shares held in a company with debt above a certain level - this would of course affect buyout companies, which generally have layers of preference shares with varying security and coupon, and a small strip of "sweet" equity. At its narrowest, it might affect only shares that accrue rights above a specified corporate value, so allowing managers to invest a relatively small amount up front in their acquisition and benefit from CGT treatment on what may be a substantial multiple if an exit is achieved.
The new coalition government did not explicitly mention the review, but did say in the Queen's speech that CGT for non-business assets would be raised to "closer to" income tax rates. This raises a number of questions:
- What will constitute a business asset? Will it include shares in an individual's employing company, as it did under the old taper regime, or will it require a substantial shareholding, similar to the current rules for entrepreneurs' relief?
- Does the proposed increase in CGT rates render the review and consultation irrelevant?
- Will the Budget on 22 June change the tax rates for disposals in the current tax year?
- What will happen to the CGT exemption? There has been speculation that it may be lowered to as low as £2,500.
The answers to these questions may of course be linked - if business taper relief is construed narrowly, the CGT rate increased to the marginal income tax rate, and the CGT exemption significantly reduced as well, the main reason to realise gains as capital rather than income would be avoiding NICs, which for most executives is a cost for the employer, rather than the shareholder. By contrast, if the new business taper rules are generous to taxpayers, the government may consider the review and consultation to be vital in order to preserve revenues. Indeed, the anti-avoidance provisions may be publicised by the government as proof that they are going after the executive rather than the cleaner, to borrow from a once popular catchphrase.
Even if tax rates are equalised CGT will still be relatively attractive
Even if the tax rates are equalised, CGT treatment will be attractive because the timing of the charge can generally be chosen, neither PAYE nor NICs applies, and losses may be set against any gains. For those who can become non-resident in the future, there are obvious planning possibilities, although the courts have been clamping down on those who purport to emigrate while keeping close family and other ties to the UK. Enterprise management incentives and CSOP options will therefore remain attractive, as will more exotic schemes, to the extent that they are not rendered ineffective by the review on geared growth arrangements.
It would be complicated but not impossible to amend the CGT rate mid-year
The rate of CGT has never been amended with effect from the middle of a tax year. It would be complicated but not impossible to do so. Changing the rate with effect from 6 April 2011 may encourage taxpayers to realise gains before then in order to benefit from the lower rate, but the government may see this as positive, on the basis that gains will at least be crystallised and tax revenue collected. If the government is concerned about accelerated sales, it may, by analogy with the anti-forestalling rules for pension contributions, permit shareholders to realise no more than a specified maximum gain at the 18% rate, with any excess charged at a new rate.
Proceed with caution
Holders of shares or other assets looking to sell in any case may consider ensuring that sales take place before Budget day. Others may take their chances that any material changes will have effect only from the next tax year, so leaving plenty of time to organise disposals in the interim. All should bear in mind the fate of many of the taxpayers who created artificial sales to trusts and the like in order to benefit from the 10% CGT rate before the increase in rates to 18% for most shareholders in 2008. Many had to pay CGT in January this year without any genuine proceeds of sale and on gains well above what could now be achieved, albeit at a ten percent rate.
