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LAWS08130 Capital Gains Tax Study Guide
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Capital Gains Tax 1.1. Capital Gains Tax – Introduction to CGT 1.2. Capital Gains Tax – The Charging of Capital Gains Tax 1.3. Capital Gains Tax – Tax Exempt Assets 1.4. Capital Gains Tax – Calculation of the Chargeable Gain 1.5. Capital Gains Tax – Deemed Disposals 1.6. Capital Gains Tax – Underlying Assets 1.7. Capital Gains Tax – Entrepreneur’s Relief Capital Gains Tax 1
Capital Gains Tax (“CGT”) is in principle a very simple tax – the value of what is sold is compared with the buying price and the taxable amount derived from that figure. Capital gains tax was previously extremely complex and incurred a high collection cost. CGT is complicated by a number of special rules of which it is necessary to be aware. Contrast Inheritance Tax, which has a complex structure but which has fewer instantiated rules. In relation to CGT it is necessary to do some additional private study, given the complexity of the subject. 4.1 Capital Gains Tax – Introduction to CGT A chargeable gain is found by deducting from the proceeds of sale the consideration for a particular asset. All of the chargeable gains for each year are added together and from this is subtracted the annual exemption of £11,000. Note – There are computation examples in the back of the handout. Note that CGT used to determine an ‘index gain’, to take account of inflation. This would place CGT as if income, with the CTG added to income. A simplification was brought in that tax is only paid on the ‘paper gain’ with the quid pro quo being that tax is paid at lower rates than income tax. o After the annual exemption, the main rates for CGT are 18% and 28% Once the yearly chargeable gain is determined (less the exemption) then the following structure is applied thereto: 2
Note that spouses and civil purposes are treated as mostly separate to CGT purposes. But transfers between spouses or civil partners are treated as compulsory holdovers – the receiving spouse gets the acquisition cost of the disposing spouse. o Thus where one spouse gives another a gold bar worth £30,000 but with an acquisition cost of £10,000. The spouse would be deemed to acquire the asset at the price which the donor spouse acquired the asset (£10,000). However, if the gold bar was given to a child, then conventional CGT is paid. Executors are deemed to acquire the assets of the deceased at the market value at the date of death. Thus the executors are treated as persons for CGT purposes. Executors do two things with assets – they transfer them directly to a beneficiary or they sell assets as part of the administration of the estate in order to make cash legacies. o Thus the gold bar above is transferred to the executors at £40,000 (and therefore there is not CGT applicable). HOWEVER , where an asset is transferred or sold by the executor to a beneficiary the relevant value is the market value at the date of death and not the date of transfer. o Therefore, where the gold bar above which increased in value to £42,000 and then it was transferred by the executor, CGT is chargeable at £2,000 (disposal cost [market value at transfer or sale] – acquisition cost [market value at death]). o Thus executors must decide whether or not an asset is transferred or sold to a beneficiary. This will depend on the existence of an 18% band or other annual exemptions. Companies pay corporation tax on their capital gains (at corporation tax rates) rather than at CGT rates. Companies do not receive an annual allowance but do receive an indexation allowance. When a company disposes of an asset 4.3 Capital Gains Tax – Tax Exempt Assets The disposal of an exempt asset will give rise to neither a gain nor a loss – thus in particular instances particular exempt assets will assist the taxpayer and others will assist the exchequer. o Thus e.g. exempting cars protects revenue as losses would often be made thereupon. o One of the major protections for the taxpayer, however, is the private residence exception. o It is necessary to know well the following reliefs: 1. Private residences 2. Tangible moveables which are wasting assets 3. Tangible moveables sold for no more than £ o Note that interest received from money in an ISA is not taxed. Gains through capital growth are also free from CGT. 2. Tangible moveables are tangible corporeal property (not shares or options etc.) Moveable property excludes houses or land. o Most tangible moveables are wasting assets (i.e. they have a life expectancy of less than 50 years). Thus excluded from this are jewellery, expensive paintings and heirlooms. o Thus CGT is mainly a tax on heritable and incorporeal property. 3. This exemption excludes a great many other assets, reducing further still the amount of assets in relation to which tax may be applied. But note – this only applies to tangible moveables. Debts are exempt from CGT in the hands of the original creditor. The values of debts fluctuate. An example is the follows:
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o A “debt on security” is not exempt. Case law has interpreted a debt on security as being a debt which is generally marketable, eg most company loan stock. 4.4 Capital Gains Tax – Calculation of the Chargeable Gain Consideration is normally the proceeds of sale. Market value (read s 272(1)-(3)) is substituted in the following situations: o Disposal of asset otherwise than by way of bargain made at arm’s length, eg outright gift, or transfer into trust, or sale at deliberate undervalue s.17(1)(a). However, bad bargains are generally not subject to the market value rule. o Disposal for a consideration which cannot be valued or in return for services s.17(1)(b) o Disposals between connected persons s.18 (for which see s.286):
o Where market value is substituted and the disposal is a market value disposal, the market value becomes the acquisition cost for the person receiving the asset:
o If, as a result of a disposal between connected persons, a loss arises, that loss can only be set off against gains on other disposals to the same connected person s.18(3). 5
o Expenditure in valuing the asset for the purposes of filing the tax return o Expenditure to establish title to the asset (e.g. legal expenses in the event of a dispute over ownership). o The expenditure must actually be incurred - in Oram v Johnston , a DIY enthusiast was not allowed to charge his time in the computation of the gain on the disposal of a renovated cottage. o Expenditure expressly disallowed: Interest payments on a loan to acquire the asset s 38(3) Expenditure deductible for the purposes of income tax (ie repair type expenditure) s 39 Expenditure reimbursed out of public money s 50 (e.g. solar panels, energy efficient heating systems) Insurance premiums s 205. Indexation allowance was previously used in relation to individuals to mitigate the effect of interest. Although abolished entirely for individuals, trusts and executors from 2008, it continues to operate in relation to capital disposals by companies. o The relief is to deal with the effect of inflation since any relevant expenditure on the asset. The allowance is given as a deduction from proceeds of sale, in similar (but not identical) fashion to the cost of the asset. o All allowable expenditure is potentially eligible for indexation, not just the acquisition cost of the asset, so the cost of defending title to the asset must be indexed, as must the cost of, say, adding an extension to a factory. Expenses of disposal are not normally indexed as they often take place too close to the disposal for inflation to have devalued the expenditure. o The allowance is calculated by working out the "indexation factor" (IF)- the shift in the RPI between the incurring of the expenditure and the disposal of the asset, and applying the indexation factor to the expenditure. The allowance is then given as a deduction in the calculation of any gain. o To find the IF for a particular expenditure, you first find the set of tables which relate to the month of disposal. You then look up in this set the date of acquisition and you will see a figure to three decimal places – eg 1.302. This is the IF. (An IF of 1 means that something which originally cost £100 would cost £200 at the date of disposal.) (Note in previous years, calculation of the IF was required – no longer – you will be given it where necessary in exams.) o The present relief dovetails with the rule you have already come across - the rebasing of assets to their 1982 value if they were acquired before that date. In such a case, the indexation factor is always calculated using March 1982 as the RI figure. Example 1 Asset acquired by a company in 1980 for £700,000, worth £1,000,000 in March 1982, disposed of for £5,600,000 in April 2014. CGT computation: Proceeds of Sale £ 5,600, Less Acquistion cost (Mar 1982 value) £ 1,000, Unindexed gain £ 4,600, 7
Less Indexation £1,000,000 x 2.219 £ 2,219, Indexed Gain £ 2,381, Continuing from the above example, assume that the asset was a building, and that £200,000 was spent on building an extension in June 1997. The calculation would now look like this: o Note that the IF is always applied to the acquisition cost. o Indexation allowance is only permitted to the extent it is necessary to reduce a gain to nil. It cannot turn a gain into a loss or increase a loss (Read s 53(1) and (2A) TCGA 1992) o This is why it is necessary to calculate the unindexed gain before giving effect to indexation allowance (see examples above). Assume the facts are as in Eg 1 on previous page, except that the proceeds of sale were only £3,000,000. The calculation would now look like this: o This is treated for CGT purposes as a disposal at no gain no loss - ie no chargeable gain, and no allowable loss. In other words, no effect can be given to the full indexation relief and part of it is lost. (This is clearly unfair.) Annual exemption o Individuals and executors are entitled to an annual exempt amount (similar to the income tax personal allowance) of £11,000 in 2014-15 (s 3) normally up-rated each year in line with the consumer price index (CPI). A body of trustees gets one annual exemption of half the exempt amount, ie £5,500 in 2014-15. o The annual exemption cannot be carried forward or back if unused, and cannot be used to reduce income, only capital gains. o A misapprehension which has become apparent in previous exam scripts is that an annual exemption is available in respect of each transaction. This is not the case - only one exemption is available each year, irrespective of the number of disposals in the year. 8
o This section deals with compensation for loss or damage to an asset. Take an example – a person has a valuable Ming vase, which is smashed. The wrongdoer is sued and the owner receives compensation for the value of the Ming vase. The vase cost £50,000 and £60,000 is received in compensation. This is a disposal because a capital sum is received for the loss or disposal of an asset. There has been a gain of £10, Similarly, under (b) above, an insurance payment of £60,000 gives the same result. Recall that in relation to capital gains tax two pieces of information are critical – i) the initial value of the asset (the acquisition cost) ii) the consideration given therefore. Complete destruction of the asset is relatively straightforward. Section 22 applies to money payments. Also of importance here is section 24 which provides:
o There is some overlap here between ss.22 and 24. Section 24 applies, however, irrespective of whether or not a capital sum is received. Thus damaging a Ming vase constitutes a disposal of the asset upon which CGT is chargeable. The reason for this is loss relief. o The effect of s.24(2) is xyz. If a ming vase is destroyed in a situation where no compensation is received, the individual is treated as having disposed of it for market value(?). This is most often used in relation to shares – asset retained but treated as having made a loss. This means also that if the shares increase in value and they are sold 5 years later, the new acquisition cost is the value when the deemed disposal is made. This will result in a larger later capital gain. Section 23 states: 10
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o Example – there is a ring and the diamond thereof is lost. The whole of an insurance payment is spent fixing a ring. Tax is not charged. Thus where compensation is received and the money is spent entirely on restoring the asset, there is no disposal. Note – Date of disposal 4.6 Capital Gains Tax – Underlying Assets All forms of property are assets for the purposes of the TCGA (s.21(1)). Some forms of property are straightforwardly such. However, the definition of property has expanded greatly as a result of precedents. o S.21 then goes on to specify three inclusions under the asset umbrella, but otherwise the concept is not defined in the legislation. The concept of an asset is much wider than corporeal property, and incorporeal property is clearly included. o Incorporeal property includes rights of all kinds, not just rights over particular kinds of property such as leases and intellectual property, as the following cases show: It includes the right of a company to services under a contract of employment. In O'Brien v Benson's Hosiery a director paid a company £50,000 to release him from his contract of employment. The HL held that the contract was an asset of the employer and therefore there was a taxable capital sum derived from an asset (s.22 equivalent), capable of being turned into account, and the fact that the rights under the contract were not capable of assignation, or of transfer in any normal way, did not prevent them from being assets. This decision might seem out of place, especially given the contract could not be sold or assigned (because employment is a contract delectus personae ). There were, however, limited ways in which the asset could be converted into money. Thus there could be a claim for the diminution of the value. in Zim Properties v Proctor [1985] STC 90, a right to sue was considered to be an asset. The taxpayer had contracted to sell property. As a result of his solicitor’s negligence the sale fell through. He sued them and received damages of £60,000. It was held that the damages were received from an asset, that asset being the right to sue. The money was not derived from the real property, so the receipt could not be read back to that. The taxpayers argued that, even if the sum was derived from an asset, it derives from the heritable properties. The sum was not right to sue the solicitors in negligence (which, they argued, was not an asset). They would wish to do this because it would be treated as a part disposal. They would receive a percentage of the acquisition cost to set against the receipt. If the right derived from the right to sue, the acquisition cost of the right to sue would have to be valued. Subsequent legislation stated that the acquisition cost of a right to sue is £0, leaving the whole receipt taxable. The judge ruled that it would be inconsistent with O’Brian to say that the right to sue was not an asset.
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This decision was controversial – all rights to sue were notionally taxable. The result of the controversy was ESC D 33 (which should be read). Note paragraph 9:
But the concession here in relation to the total destruction of an asset, s. would apply and therefore concessionary treatment is not required. The problem with the Zim case was that no damage was done to the property. The Zim concession covers the Zim case. Under this concession, the compensation is treated as deriving from the underlying asset. The most significant part of the ESC is that which treats situations as in the Zim case. There is property and a separate right of action. The right of action is settled. The concession allows the settlement to be treated as deriving from the original asset, allowing it therefore to be treated as a part disposal. If in Zim the property was a principal private residence. The house is sold and the sale fails. Compensation of £60,000 is paid. This is tax free because it is derived from an asset which is tax exempt. Recall – The notion in CGT that tax is paid on an asset whether or not a profit is actually paid. Giving up the right to sue on the settlement of an action results in a disposal. The sum derived from the settlement. But this is problematic – can an exception be made? This will depend on the underlying asset. With a right to sue there is no underlying asset – nothing behind that right which is an underlying asset for CGT purposes. The Zim concession deals with when there i) is and ii) is not an underlying asset. Under i) the concession states that the right to sue is not treated as an independent right (this may not truly be concessionary treatment, but may simply describe the legal position under s.22). 14
4.7 Capital Gains Tax – Entrepreneur’s Relief Entrepreneur’s relief applies to individuals, partnerships and trustees (but not companies). It is an encouragement to engage in enterprise, which lowers the rate of tax which paid on disposals. o If this relief applies, the tax rate on qualifying business assets is 10%. (s 169N(3) as amended.) Lifetime limit of £10 million of gains at reduced rate: s 169N(4A). Capital Gains Tax applies to taxable disposal of gains on assets. Selling a business requires for tax purposes a breakdown – e.g. trading stock (not a CGT asset), heritable property (a CGT asset), intellectual property and goodwill (CGT assets). o Thus finding out how much is attributable to each particular asset is important. It is helpful to realise that the process is a disaggregated one. In order to qualify for entrepreneur’s relief, it is necessary to have a principal disposal which is a material disposal: “A disposal of business assets s 169I(2) is (a) a disposal of the whole or part of a business, 16
o In Gilbert t/a United Foods it was asked whether when a taxpayer sold part of his business, did this qualify for entrepreneur’s relief or was it the disposal of an asset? Here the taxpayer had 7 clients whose food he sold on commission. One of his largest clients decided to take the job in-house. A deal was done and the taxpayer was paid around £300,000 for giving up that part of the business. He transferred to them the customer database on termination. He also sold the goodwill, trademarks, business information and contracts. He carried on as normal with the rest of the customers. HMRC argued that the above disposals were the disposals of an asset, not the sale of part of a business. The First Tier tribunal decided that what was relevant was the part being sold. Was this, on its own, a viable business. In this case, it was. (b) a disposal of (or of interests in) one or more assets in use, at the time at which a business ceases to be carried on , for the purposes of the business, or o There are two possible interpretations here. Does the business need to cease altogether, or does it simply need to cease being carried on by the particular person who previously carried it on? o Note that this paragraph applies to assets (c) a disposal of one or more assets consisting of (or of interests in) shares in or securities of a company.” o This applies to shareholders in unquoted trading companies. Disposal of shares and securities is material disposal if throughout the period of 1 year ending with the date of the disposal– 1. The company is the individual's personal company (ie that individual owns at least 5% of the shares) and is either a trading company or the holding company of a trading group, and 2. The individual is an officer or employee of the company or (if the company is a member of a trading group) of one or more companies which are members of the trading group. Associated disposals apply when the business in which an individual owns assets is carried on not by the individual personally, but where it is carried on by a partnership (in which the individual is a partner) or where it is carried on by a company (in which the individual is a shareholder). o Thus where assets are owned personally by an individual but are used by a business run by a partnership or a company, the disposal of such assets by the individual can qualify for ER if he is also getting out of the partnership or company at the same time. o The disposal of the ASSET must be made as part of the withdrawal of the individual from participation in the business carried on by the partnership or by the company AND throughout the period of 1 year ending with the earlier of– (a) the date of the material disposal of business assets, and (b) the cessation of the business of the partnership or company, (c)? o (e.g. Pippa is a shareholder in Grapefruit Ltd. She owns the building in which the business of Grapefruit is carried out. She sells her shares (this is the “material disposal”) and then sells the building (this is the “associated disposal”)). 17
