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Growing against the gain

Much has been written about the introduction of the flat rate of capital gains tax announced in the October 2007 pre-Budget report.

Several months on, it is clear that some of the changes made, although appearing to be minor and under the banner of simplification, will clearly have an impact on the advice that financial advisers give clients.

One such area that will be affected is the annual exemption. This increased by over 4 per cent from £9,200 to £9,600 for the current tax year, which at the time was above inflation but now looks to be in line with current inflation rates.

This 4 per cent increase, along with the new flat rate of capital gains tax of 18 per cent could give the impression that investors might pay less tax than in previous years but this impression could be false and the reality may be very different.

The removal of taper relief and the reduction of relief on the £9,600 to 18 per cent means that tax may be payable where it was not previously.

The annual strategy of crystallising gains by using the annual exemption and then reinvesting may also have reduced appeal. Let us consider why.

Consider an investment which would have previously benefited from taper relief which would have reduced the amount of gain taxable.

Managing the gain alongside the annual exemption meant that gains above the annual exemption could be realised annually without incurring a tax liability.

In 2007, if an asset had been held for 10 years, then taxable gains of £15,330 would have been reduced by taper relief by 40 per cent to £9,200. This meant there was no tax to pay as the gain would have fallen within the £9,200 annual exemption limit.

Working from the same figures, assuming that the same gain has been made, a taxpayer from April 2008 will now have to pay £1,031 in tax.As taper relief no longer applies, the annual exemption reduces the taxable amount by £9,600 to £5,730 (£15,330-£9,600=£5,730). When this value is taxed at the CGT rate of 18 per cent, the tax would be £1,031.

A common strategy for clients investing in collectives has been to realise sufficient gains to use their exemption and then reinvest the proceeds with an uplifted base value.

There are two common mistakes made by investors when doing this.

Often, clients only release an amount equal to the annual exemption as opposed to “gains” equal to the annual exemption and then proceed to reinvest in the same funds immediately.

The bed and breakfast rules were not amended in the 2008 Finance Bill so if reinvestment happens within 30 days, the CGT event would be ignored. Clearly, the need for advice in the area is easily demonstrated.

Having addressed the above, an ongoing strategy of realising gains to reinvest on an annual basis still needs careful consideration.

The maximum benefit which can be saved is 18 per cent of £9,600 or £1,728. If taper relief had remained at 40 per cent, it would be worth £3,840.

The issue is that, depending on the size of the portfolio and the amount which needs to be realised to maximise the annual exemption, the costs in doing this could seriously erode the overall benefit achieved.

Let us look at a £100,000 portfolio and assume all gain is growth-orientated:

For simplicity, if the £100,000 portfolio grows by 9.6 per cent and the cost of portfolio reconstruction is 1 per cent (to cover advice and related investment and product charges), the gain would be £9,600.

This means the whole portfolio would need to be sold and repurchased to realise the benefit of the annual exemption. The maximum benefit would be £1,728 as highlighted above. However, in achieving this, the true cost to utilise the annual exemption for the investor was 1 per cent – that is, £1,000 – and therefore only a tax saving of £728 would actually be achieved.

This strategy may still work for investors with smaller portfolios but the bigger the portfolio the smaller the benefit for the investor as the real costs can erode the actual the tax saved.

However, as an exit strategy, the annual exemption offers an advantage. Combining the part-disposal formula, which is used in calculating the amount of gain chargeable to tax, alongside the annual exemption, can mean that withdrawals may always be tax-free.

Consider a £300,000 portfolio, growing at 5 per cent a year, taking a 5 per cent withdrawal and the annual exemption of £9,600 increasing year on year at 2 per cent.

The basis of the calculation will mean that the annual exemption will grow sufficiently to equal the level of withdrawals before any tax is payable using the combination of part-disposal formula and the annual exemption.

When compared with a single-premium investment bond 5 per cent withdrawal facility, then clearly, on this point, the collective could offer a more tax-efficient approach.

The changes in the rates for CGT are generally good news but the subtle changes introduced alongside these changes further demonstrate the need for quality advice and present further opportunities for the informed adviser.

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