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. The disposal of assets covers many situations for example 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?
The applicable rate for capital gains tax is calculated by reference to income tax bands. Capital gains, less any available annual exemption and losses are added on top of an individual’s gross income (note, where income includes chargeable event gains, the top sliced gain is used for the purpose of calculating CGT).The rate of tax will depend on which income tax band the gain falls. For the 2017/18 tax year the rates are as follows:
Gains within the basic rate band (£0-£33,500) - 10%.
Gains within the higher / additional rate bands (amounts over £33,500) – 20%
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.
Capital gains relating to residential property sales, which are not otherwise covered by the primary residence relief, are taxed at 18% (basic rate) and 28% (higher/ additional rate).
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 HMRC of the amount of the loss.
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)
£11,300 for individuals, personal representatives and trustees for disabled people in 2017/18
£5,650* for other trustees in 2017/18
This is deducted from the gain, not the tax liability. For example: £100,000 gain - £11,300 = £88,700 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 income 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 £1,130.
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 could 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, i.e. 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 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
|(A) £25,000/(A) £25,000 + (B) £510,000
|(PP) £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) = £476,635.51
|£25,000/((A) £25,000 + (B) £520,700)
|(PP) £476,635.51 x 0.045812718
|£25,000 - £21,835.97 = £3,164.03 (gain) - CGT AEA
||= £0 tax
This example shows that the client, although disposing of more than £11,300, 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.
Taxation of shares
Shares in a collective investment which have been bought at different times are now treated as a single asset, known as a Section 104 holding. When the holding is sold, the aggregate purchase price is used to calculate any gains or losses. We have an article which explains the methodology further detail.
The types of units held will also have an effect on the capital gains calculation;
Income units - fund managers distribute income to the fund holder, where this income is paid directly to the fund holder, the income has no baring of the calculation for gains. If the distributions are instead used to purchase additional units in the fund, these will need to be considered part of the section 104 calculation, as detailed above.
Accumulation units – income distributions are not paid out of the fund, instead the income increases the share value. There is no additional unit purchase. The value of income received does serve to increase the capital investment into the shareholding; it therefore increases the purchase cost for the shares, or the aggregated cost in the case of a section 104 holding.
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 (£11,300) must be reported via Self-assessment and the tax paid within the usual deadlines.
In addition, total proceeds (not gain) exceeding four times the AEA (I.e. £45,200 for the tax year 2017/18) should be reported via self-assessment.
This article is based on Old Mutual Wealth’s interpretation of the law and HM Revenue & Customs practice as at June 2017. We believe this interpretation is correct, but cannot guarantee it. Tax relief and the tax treatment of investment funds may change.