This article sets out the main rules relating to capital gains tax (CGT).
What is capital gains tax?
Capital gains tax is a tax on gains made when directly held assets are disposed of by the investor. The disposal of assets covers many situations such as where assets are given away, sold, transferred or exchanged, and even extends to compensation payments received for an asset.
Does capital gains tax apply to all assets?
Most assets are liable to capital gains tax whether they are in the UK or abroad. This includes investments such as stocks and shares, units in a unit trust and debentures.
Some assets are exempt from capital gains tax. This includes investments such as ISAs, gilts, premium bonds, national savings certificates and most qualifying corporate bonds.
What are the rates for capital gains tax?
From 6 April 2016 a 20% rate applies for those individuals where the gain (after utilising their annual exempt amount (AEA)), when added to their total taxable income, exceeds the basic rate income tax threshold. The 20% rate is applied to the amount of gain above the threshold (in part or full).
A 10% rate applies for those individuals where the gain (after utilising their AEA), when added to their total taxable income, remains below the higher rate income tax band.
The rate applicable to trusts and the rate for executors of deceased individuals’ estates is 20% on the entire gain above the trustee annual exempt amount.
A 10% rate applies for gains qualifying for Entrepreneurs’ Relief.
How is capital gains tax calculated?
Acquisition and disposal cost – calculating the gain or loss
When disposing of an asset (e.g. encashment or switch of a fund) you need to know the true acquisition cost and consider any costs relating to the disposal. In calculating the cost of both the acquisition and the disposal of an asset the calculation below can be used as a guide.
Gains and losses
Gains and losses are calculated in exactly the same way. Any loss made in 1996/97 or later tax years must be claimed within five years after 31 January following the end of the tax year in which the loss arose and can be carried forward. Losses will not be allowable unless the taxpayer advises the Tax Inspector of the amount of the loss. The taxpayer can claim a loss via their tax return, or by writing to the local Inspector of Taxes.
For tax years before 1996/97 losses do not have to be claimed in this way. Pre 1996/97 losses can still be carried forward and there is no time limit on using these losses.
For part disposals, the principle is that allowable expenditure incurred must be apportioned between the part disposed and the part retained. However, the actual costs incurred when disposing of the ‘part interest’ are deducted at this time and applied in full.
Annual exempt amount (AEA)
£11,100 for individuals, personal representatives and trustees for disabled people in 2016/17
£5,550* for other trustees in 2016/17
This is deducted from the gain, not the tax liability. For example: £100,000 gain - £11,100 = £88,900 liable to tax.
If the investor is a basic rate tax payer the gain will be liable to tax at 10% for the part that falls in their available basic rate tax band and the balance will be liable at 20%.
*However, where the settlor has created more than one trust the exempt amount is shared between the trusts down to a minimum of onefifth. So five or more trusts would each have an annual exempt amount of £1,110.
Losses and the AEA
Allowable losses arising in the tax year are deducted from the total chargeable gains for the same year.
To ensure maximum use of the AEA, it can be advisable to create losses and gains in separate tax years. If a loss and gain are created in the same tax year you cannot choose to offset part of the loss arising in the same year as the gain. In other words allthe allowable losses for the tax year must be deducted up to the amount of the gain even if this results in chargeable gains after losses below the level of the AEA.
Offsetting all carried forward losses may mean that some or all of the AEA is wasted in a tax year, whereas if only part of the losses are used and the AEA is used to the full, then any remaining losses can be carried forward into another year. Losses brought forward from 1996/97 or later must be deducted before losses brought forward from earlier years.
Part disposal formula
The Part Disposal Formula is extremely important when calculating any tax liability where only a proportion of the investment is disposed of. Let’s consider a £500,000 investment where the client wishes to receive £25,000 per annum of capital, ie 5%.
The formula is expressed as PP x A/A + B
PP = original investment value (adjusted each year for amount of original cost ‘used up’)
A = value disposed
B = value retained
It is this fraction of the original cost that needs to be compared to the capital disposal of
£25,000 being made to arrive at the capital gain. If in both year one and year two the investments grew by 7%, the calculation would be:
|Year one = £500,000 x 1.07 = £535,000 - £25,000
|So if capital is taken at the end of year one
|(PP) £500,000 x (A) £25,000/(A) £25,000 + (B) £510,000
|£500,000 x 0.046728972
|£25,000 - £23,364.49 = £1,635.51 (gain) - CGT AEA
||= £0 tax
|Year two = £510,000 x 1.07 = £545,700 - £25,000
|(£500,000 - £23,364.49)
|(PP) £476,635.51 x £25,000/(A) £25,000 + (B) £520,700
|£476,635.51 x 0.045812718
|£25,000 - £21,835.97 = £3,164.03 (gain) - CGT AEA
||= £0 tax
Clearly this shows that the client, although disposing of more than £11,100, is only utilising part of their AEA.
It is worth remembering that a partial or full switch will give rise to a CGT calculation for full or part disposal.
If we consider an investment holding multiple funds, such as the Collective Investment Account (CIA), the calculation is at fund and not product level, i.e. five funds means five calculations if withdrawals are taken across each investment.
Income units and accumulation units
In both cases, whether new units are allocated to the investment following a distribution via interest or dividend (income units) or existing units are increased in value after the distribution (accumulation units), the distribution is potentially liable to an income tax charge. From 6 April 2008, where identical assets have been acquired at different times, the existing last in first out (LIFO) rule does not apply and has been replaced by a simplified approach. Principally the assets will be pooled (known as a Section 104 holding) and these assets will have a single acquisition value based on the average cost of all the assets purchased within the pool.
Transfers between spouses or civil partners
The disposal of assets between spouses or civil partners who live together is on a “no gain, no loss” basis. This means that the transferring party passes on their gain to the other party.
Such transfers can be used where one party has used their annual exempt amount and the other party hasn’t, where one party has losses that can be set against the gains of the other party or where one party pays CGT at a lower rate.
The disposal of assets on the death of an individual is not subject to CGT. The beneficiaries of the estate acquire the assets at their market value on the date of death.
Gains in excess of the AEA (£11,100) or where total proceeds (not gain) exceed four times this amount, £44,400, for the tax year 2016/17, need to be filed with the client’s normal tax return.
Good record keeping is important to support the client’s tax return. Potentially managing other income in the year that gains are going to be realised to ensure tax is reduced where possible is another planning consideration.
This article is based on Old Mutual Wealth’s interpretation of the law and HM Revenue & Customs practice as at April 2016. We believe this interpretation is correct, but cannot guarantee it. Tax relief and the tax treatment of investment funds may change.