Last week the Office of Tax Simplification (OTS) announced a review of Capital Gains Tax. They have invited evidence and there is a simple on-line survey you can complete on the subject (see link below). As someone who occasionally pays capital gains tax, I give you my views on the subject below.
It is of course a horribly complex tax with several different rates and numerous exemptions. I need to employ an accountant to work out my self-assessment tax returns when I don’t consider my affairs particularly complex – I am mainly invested in listed shares, although I do have a few EIS and VCT investments. My accountants use specialist software to do the calculations, not generally available to retail investors and even that seems to be prone to complex misunderstandings.
This also puts a great burden on HMRC in terms of administration when it brings in less than 1% of tax revenues. Plus there is an enormous amount of effort put in by investors and their advisors to avoid paying the tax (there are lots of ways to do so). Indeed one could argue that the current Capital Gains tax regime was invented by accountants as a “make work” project due to the complexity of the rules.
Should the tax be scrapped altogether as some people have suggested? I don’t think so for the following reason: It is very easy to convert income into capital gains, or vice versa. I recall this was done many years ago by the Beatles when instead of receiving royalties they sold the revenue stream from music royalties as an asset. But even private investors can do this – for example by investing in investment trusts that roll up the income and don’t pay it out in dividends. Another example is that of Venture Capital Trusts which are often effectively converting capital gains into tax free dividends. Or of course investors can simply avoid trading in individual shares and invest in trusts or funds which are not taxed on their individual holdings and realisations thereof.
CGT Rates and Indexation
It is therefore irrational to have different rates for capital gains and income which is currently the arrangement. That’s clearly one simplification that could be made, although investors will be furious if they have to pay more tax as a result.
But one big problem is the lack of indexation of capital gains which was scrapped some years ago by Gordon Brown and replaced by allowances. This means that you pay tax not on the real change in the value of a share, but on that created simply by inflation when the shares are worth no more in reality. This may not seem a major issue in a period of low inflation, but with money being printed like it is going out of fashion by Governments, high inflation might well return. Even a low rate of inflation over many years can result in a very large tax bill, and even worse, you may not have the option to retain the holding. A takeover bid for a company can effectively force a sale. Indexation should be reinstated as it was not difficult to take it into account in your tax returns.
Tax Tail Wagging the Investment Dog
Capital Gains Tax also distorts investment decisions. For example, you might hold on to a shareholding longer than you otherwise would because you know a large tax bill will result. So your portfolio may end up containing a lot of companies with poor prospects and their market share prices might remain higher than they otherwise would be, i.e. the market in the shares is distorted.
It also causes sales of shares to take place when they might not be best timed, simply to use up capital gains tax allowances in the current tax year. Or even to anticipate changes to tax rates and allowances by decisions from new Chancellors or new Governments.
The existing arrangements encourage the use of investment trusts and funds rather than personal investors holding individual shares. This has had a negative impact on the stock market as investment decisions are now made by fund managers rather than real owners. It has also meant that much of the profits generated by public companies end up in the hands of the fund manager rather than the end investor who rake off 1%, 2% or more per annum which can often be a very high proportion of the real return generated by companies. It also has a negative influence on corporate governance as fund managers have little interest in controlling the pay of directors for example. In effect we have a lot of absentee owners.
These defects might be considered an argument for scrapping CGT altogether but that is unlikely. However, an alternative proposal would be to reform it so that a rollover of investments did not incur tax. In other words, if you reinvested the proceeds from a sale of shares or other assets into new assets within a period of time then no tax would be payable. If no net profit is actually realised, why should investors pay tax?
Interaction Between CGT and IHT
Do people even care about paying tax on their profits when they die? Capital gains tax liability currently disappears on death and that might need to be changed if rollover was permitted but there is also interaction with Inheritance Tax here which would also need to be reconsidered.
CGT on Property
Property is taxed at different rates, although the property you live in is exempt. This has of course encouraged people to invest in a home as an asset for their retirement. This has powered the house price bonanza in recent years and encouraged people to occupy bigger houses than they need. Although encouraging home ownership is meritorious, it is not clear why gains from owning a home should be tax free. Reforming this could be a political hot potato although a “roll-over” provision and other exemptions could mitigate the adverse consequences.
Capital Gains Tax has always had a negative impact on business creators although there are allowances that reduce their liability when a business is sold. Much tax planning activity is prompted by such outcomes which typically undermines the tax take. Another related issue is that high capital gains tax rates encourage wealthy entrepreneurs to move to countries where capital gains taxes are lower or even zero. We lose their expertise and also they spend their money in other countries as a result.
Conclusions and Recommendations
In summary Capital Gains Tax is ineffective, generates relatively little in tax from very few individuals and is a disincentive to entrepreneurial activity. It can result in tax being paid on purely inflated share prices and when no actual cash is realised as the profits are soon reinvested. It does of course discourage therefore new investment and distorts the stock market.
In my opinion, capital gains tax needs a complete overhaul. If you agree, or disagree, please add some comments to this article. I’ll ponder those before making a full submission to the OTS review.
OTS Capital Gains Tax Review: https://www.gov.uk/government/consultations/ots-capital-gains-tax-review-call-for-evidence-and-survey
You might also want to participate in this Equity Development webinar on taxation and the AIM market.
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )