Capital Gains Tax:
Take Advantage of Low Rate
Planned CGT Increases: Take Action Now
MOST COMMENTATORS agree that taxes will increase after the forthcoming General Election, regardless of who wins. What is less certain is which taxes will rise and when. However, with its low rate of 18%, many people see Capital Gains Tax (CGT) as a likely candidate.
We at Taxcafe have no idea whether CGT will be increased or not. We also have no idea whether any increase will take the form of a simple rate increase, a withdrawal of existing reliefs, or a combination of both.
However, if YOU believe CGT will rise, and have capital gains from a business, property, or other assets, what we can do is show you how to ‘make hay while the sun shines’ and ‘cash in’ those gains under the current low tax regime.
How to Trigger a Gain
There are four main methods for creating a capital gain:
- An arm’s length sale to an unconnected third party
- A transfer to another individual (e.g. your adult child)
- A transfer to a trust
- A transfer to a company
Note that a transfer to your spouse or civil partner is deemed to take place on a ‘no gain/no loss’ basis for CGT purposes and will not trigger a capital gain. (For the rest of this article ‘spouse’ also means a civil partner.)
Arm’s Length Sales
Simply selling the asset will, of course, trigger a capital gain and doing so before any rate increase will ensure that the current CGT rate applies. For quoted investments this is simple enough. The same investments can even be repurchased, if desired. It is important to wait at least 31 days before making the repurchase, however. Alternatively, the repurchase can be made by your spouse or partner, or through your ISA.
For property, or business assets (such as a sole trader business, a partnership share, or private company shares), the selling process is a little more complex and it will therefore be essential to allow a reasonable amount of time in order to be able to arrange a sale at a good price. Here it is important to remember that the date of sale for CGT purposes is the date on which there is an unconditional sales contract.
In most cases, a repurchase of business assets or property will not be possible so, unless you’re happy to part with the asset permanently, you will need to look to another method for triggering your capital gain.
Transfers to Connected Persons
For tax purposes, each of us is deemed to be ‘connected’ to certain other people including our children, our parents, our siblings. We are also connected to the spouses of all these relatives. If you are married you are also connected to your spouse’s parents, siblings and children.
Any transfer of an asset to a connected person other than your spouse is treated for CGT purposes as if it were a sale of that asset for its open market value. Normally, this presents a bit of a problem but if you’re actually trying to trigger a capital gain, it’s really useful.
Colin has an investment property which he bought some years ago for £100,000 and which is now worth £300,000. He would like to be able to benefit from the current 18% rate of CGT on his existing gain but he also wants to keep the property in the family for a few more years.
Colin therefore transfers the property to his adult daughter Bonnie. This is treated as a sale of the property for its market value of £300,000, giving Colin a capital gain of £200,000. After deducting his annual exemption of £10,100, he is subject to CGT at 18% on £189,900, giving him a tax bill of £34,182.
Some years later the CGT rate has increased to 30% and Bonnie sells the property for £400,000. Her capital gain is £100,000 from which she can deduct her annual exemption of, say, £12,000, leaving her with a CGT bill of £26,400 (£88,000 x 30%).
Between them, Colin and Bonnie have paid a total of £60,582 in CGT. If, however, Colin had retained the property himself until the time of sale, he would have had a CGT liability of £86,400 (the £300,000 gain, less the estimated annual exemption of £12,000 taxed at 30%).
In this way, the family has saved almost £26,000; most of it (£24,000) by ensuring that the first £200,000 of the gain on the property is taxed at the current 18% rate. A further ‘added bonus’ saving is also achieved because Colin and Bonnie are each able to use an annual exemption.
There are two major drawbacks to the method used in this example. Firstly, Colin faces a tax bill of £34,182 without any sale proceeds to pay it from. In other words, the long-term saving is achieved at a severe cashflow disadvantage. Secondly, the saving generated is dependent on a purely speculative future increase in the CGT rate. In short: it’s a gamble!
Transfers to Other People
You might also wish to consider transferring an asset to another individual not officially ‘connected’ to you, such as an unmarried partner or close friend. Gifts and sales at undervalue to such people are generally treated in much the same way as a transfer to a connected person. As the transfer is not a ‘sale at arm’s length’, it is again deemed to take place at market value for CGT purposes, producing much the same result as we saw in the example above.
This is particularly helpful for unmarried couples wishing to trigger a capital gain to be taxed at the current low rate. A transfer to your unmarried partner will have the desired result (unlike a transfer to your spouse).
Gains arising on the transfer of qualifying business assets (such as shares in your own private company or your own trading premises) may be ‘held over’ so that CGT is only paid on the ultimate sale by the transferee. This is normally seen as a very useful relief but, for our current purposes, it rather defeats the object of the transfer!
What is useful, however, is the fact that it is possible to claim a form of partial holdover relief by selling qualifying assets for less than their market value. This can be used as a form of compromise by limiting the tax charge on the transfer.
Leila runs a successful trading business through her company, Jameson Limited. Her shares in the company originally cost just £1,000 and qualify for entrepreneurs’ relief (allowing the first £1 million of gains to be taxed at just 10%).
Although the company is worth £7 million, Leila sells her shares to her son Navin for £1,001,000. For CGT purposes, Leila has a gain, based on the market value of her shares, of almost £7 million, but she and Navin can jointly elect to hold over the part of the gain in excess of the actual sale price. This leaves Leila with a taxable gain of just £1 million which, because she is entitled to entrepreneurs’ relief, will be taxed at an effective rate of just 10%.
As we can see, the partial holdover relief claim has enabled Leila to benefit from the current beneficial 10% rate on the first £1 million of gains qualifying for entrepreneurs’ relief without having to pay any further tax at this stage. The drawback, however, is that when Navin sells the shares, he will have a deductible cost of just £1,006,005 rather than the £7 million which he would have had in the absence of a holdover relief claim.
Note that Navin does not need to pay Leila in cash: the sale price can be left outstanding as a loan, if desired.
Direct transfers to other individuals have three major limitations: you cannot retain control of the asset yourself, you cannot trigger a gain by transferring it to your spouse, and you generally cannot transfer an asset directly to a minor child. One possible answer to these limitations is to use a trust.
A lifetime transfer of assets into trust will trigger a capital gain in much the same way as a transfer to a connected person. This continues to apply even if you, your spouse, or one of your minor children are a beneficiary of the trust – known as a ‘self-interested trust’. In this case, you personally will be taxed on any future capital gains or income arising in the trust, but the objective of triggering a capital gain to be taxed at the current low rate will have been achieved.
If Colin (in our first example) had transferred his property into a trust for his own benefit, he personally would have paid CGT on both the transfer into trust and the ultimate sale, but the same overall saving would have been achieved.
A trust is also often useful where you wish to pass assets to adult children but do not yet want them to have full control over those assets. It is possible to claim holdover relief on a transfer of any asset into a trust from which you, your spouse and your minor children are excluded from benefitting but you don’t need to make any such claim if you wish to trigger a capital gain. Alternatively, you could limit the tax charge arising on the transfer by selling an asset to the trust for less than its market value in much the same way as we looked at for business assets.
Transferring residential property into a trust without making any holdover relief claim has the added benefit that it may be possible to avoid CGT on any future capital gain on the property by allowing a beneficiary of the trust to use it as their principal private residence.
Transferring Assets into a Company
Our final method for triggering a capital gain is to transfer assets into a company. This is particularly useful as a means of creating a CGT ‘disposal’ of a business – often known as ‘incorporation’.
Whilst it is generally possible to hold over the capital gain arising when a business is transferred into a company, this is not compulsory and incorporation can therefore be used as a means to create capital gains to be taxed at the current low rate. In most cases, the effective CGT rate on the first £1 million of capital gain arising on the transfer of a business into a company will be just 10% (due to entrepreneurs’ relief). Once again, a sale at less than market value can be used as a means to obtain partial holdover relief.
It is also possible to trigger capital gains on other assets by transferring them to a company. In the case of property, however, there is the major drawback that the company has to pay Stamp Duty Land Tax based on the market value of the property, regardless of whether any actual consideration is paid. This may create a total tax cost for the transfer of up to 22%. This could still produce long-term savings if the CGT rate is increased significantly in the future but it increases the risk that the gamble might backfire.
The company will pay Corporation Tax on any future capital gains on the transferred assets at its usual rate – generally 21% for a small trading or property investment company, or 28% for a large company or other type of investment company. It will, however, be able to deduct indexation relief, which is designed to exempt the purely inflationary element of capital gains, based on movements in the Retail Prices Index.
The company’s future taxable gains will of course be increased if a partial holdover relief claim has been made on the original transfer.
One major point to watch out for is that, depending on how the original transfers are carried out, a future sale of the company may give rise to a taxable capital gain for the company’s owner almost equal to the full sale proceeds, with no deduction for the gains arising on those original transfers. A similar result may also arise if the company is wound up.
This outcome can be avoided by transferring assets to the company in exchange for shares rather than gifting them or selling them for cash consideration (even if left outstanding as a loan). There are many other issues to consider, however, including the fact that this may preclude the possibility of a partial holdover relief claim.
Other Tax Consequences
It is important to remember that gifts or sales of assets at below market value to another individual or a trust may have Inheritance Tax consequences. In the case of transfers to another individual, however, there will not usually be any problem as long as the transferee survives at least seven years after the transfer and does not retain any interest in the transferred asset.
Transfers to a trust may have both immediate and long-term Inheritance Tax consequences. These can often be avoided by limiting the value of the transfers to no more than £325,000 (or £650,000 for a couple transferring jointly owned assets) and winding up the trust within ten years.
Some types of trust are also subject to high rates of Income Tax on the income derived from their assets – currently 40%, rising to 50% from 6th April 2010. These high tax rates apply to all trust income in excess of £1,000 per year but can sometimes be avoided by using an ‘interest in possession trust’ or a ‘self-interested trust’.
If making sales of property at below market value to another individual or a trust, Stamp Duty Land Tax will apply to the actual sale price in the usual way. Any mortgage liabilities assumed by the transferee will need to be included in the sale price for this purpose (as well as for any partial holdover relief calculation).
For transfers of shares, Stamp Duty at 0.5% (rounded up to the nearest £5) will be payable on any actual consideration greater than £1,000. For Navin in our second example this would amount to £5,005 (which, added to his purchase price of £1,001,000, gives him his deductible cost of £1,006,005).
Any transfer of a sole trader business or the whole of your share in a trading partnership, whether to a company, another individual, or a trust, is treated as a cessation of business on your part. This has numerous further tax consequences with many benefits, but also many pitfalls to be aware of, so professional advice is essential.Finally, take care not to transfer an asset standing at a loss. Unless it’s an arm’s length sale to an unconnected person, the loss arising can only be set off against future gains on transfers to the same person, so it could be very difficult to get any relief for it.