Budget CGT hike fails to deter avoidance opportunities

The lower-than-expected rise in capital gains tax in the Budget could herald a review of how the taxman defines capital gains and income, in order to clamp down on avoidance.

While CGT for higher rate taxpayers increased to 28% from 18%, the increase was less painful than expected by many tax experts.

Most had predicted Chancellor George Osborne would raise CGT to 40% on non-business assets such as shares and second homes, in order to help reduce the UK’s £156bn budget deficit.

However, the more mod­erate increase could still encourage tax avoidance. Individuals could still be tempted to reclassify income as a capital gain or use artificial tax schemes to create losses to minimise the amount of CGT due, experts said.

With these issues in mind, HM Revenue & Customs is likely to look at strengthening the rules to pevent reclassification of profits from income to capital.

John Whiting, tax policy director at the Chartered Institute of Taxation and veteran observer of the UK tax system, said that the 28% CGT rate was a “sensible and pragmatic move”. But, he added that HMRC may decide to clarify and update the definition of a capital gain under the tax system in order to make it harder for people to pay less tax by reclassifying income as a capital gain.

“For very high earners you will get people trying to make a capital gain rather than an income,” he said.

Employees at private equity firms often receive a large proportion of their pay through the “realisation of carried interest” – taking a share of the profits from the sale of investments, which is treated as a capital gain.

Andrew Greenwood, man­aging director at profressional services firm Alvarez & Marsal Taxand, said that the increase in CGT, although less than feared, would still likely mean an increase in the number of people using artificial tax schemes that create or buy tax losses to reduce the amount of CGT owed.

Capital gains made by basic rate taxpayers will continue to be taxed at the 18% rate up to £37,400, as will gains made prior to 23 June.

The annual exemption band for CGT will remain at £10,100 for 2010/2011 and increase in line with inflation in future years.

The chancellor has also extended the 10% CGT tax band for entrepreneurs from a lifetime allowance of £2m to £5m for business assets, including shares in qualifying companies.

In his first Budget speech to the House of Commons Osborne ruled out re-introducing both indexation for CGT, which strips out the impact of inflation from profits on sales, and re-introducing taper relief, which cuts the CGT rate for assets held over a longer period of time.

Osborne said that the Treasury had calculated that a 40% CGT rate would yield less tax receipts than 28%, probably based on the assumption that a higher CGT rate would encourage people to hang on to their assets.

Richard Mannion, national tax director of accountancy and financial services group Smith & Williamson, said the increase in CGT indicated that the tax was not a “big money spinner” and was part of a “defensive shield to protect the tax base”.

Leonie Kerswill, personal tax partner at PwC, said that the introduction of a new CGT rate during the tax year will cause complications for people completing their tax returns for 2010/2011.

The Treasury’s calculation that a 28% CGT rate would rake in more tax receipts than a higher 40% rate, in line with income tax appears to follow the “Laffer Curve” theory – a graph curve showing tax rates increasing over a certain level would result in people not working as hard or not at all, thereby reducing tax revenue.

IN OUR VIEW

The lower-than-expected increase in the CGT rate has been broadly welcomed amid hikes in other taxes and big cuts in public spending. The success of the 28% CGT rate can be partly judged on how much tax it nets the government compared to the old 18% rate. Meanwhile, a clarification of the definition of capital gains and income tax by the taxman would be welcomed by tax advisers and their clients.