The Budget introduced unexpected reductions to the rates of capital gains tax, bringing down the 28 per cent rate for higher and additional rate taxpayers to 20 per cent and the 18 per cent rate for basic rate taxpayers to 10 per cent. These reductions took effect from 6 April. The CGT annual exemption for 2016/17 remains at £11,100.
Add to this the commencement of the tax-free £5,000 dividend allowance and 7.5 per cent higher tax rates for dividends above the allowance and you have a material change to the taxation of the two main drivers of investment performance for equity-based portfolios: capital gains and dividend yield.
This will, of course, be relevant for individuals with amounts to invest outside of the two most favoured “wrapped” investments: pensions and Isas. As well as individuals, though, there are other investor types to consider, such as companies, charities and trustees.
I can deal with the first two relatively easily. Companies do not pay CGT. Capital gains realised by companies are subject to corporation tax so the reductions in the CGT rates have no impact on this aspect of investment decision-making for companies. It is, however, worth reminding that companies only bring gains after indexation into the tax computation. And it is the RPI that is used, not the CPI (not that either are exactly standing at all-time highs currently).
The eligibility for RPI-based indexation, by the way, also extends to UK life companies. However, they also have special rules applicable to them when they invest into collective investments. These rules broadly mean that, based on any yearly increase in the value of the collectives, the tax due on this deemed gain is effectively paid in seven annual instalments.
Back to ordinary company investing, though. The dividend allowance and higher tax rates for dividends in excess of this are irrelevant for investments held by a company. Dividends received from UK equities and collectives by a UK company will effectively be “franked” and will not be subject to any tax when received by the corporate investor. This holds true regardless of the amount of dividends received.
Tax-free dividends for companies, including UK life companies, is something that has been with us for some considerable time. It definitely has an impact on tax-based decision-making by individuals when considering the relative merits of UK investment bonds and offshore bonds as the most tax-efficient wrapper for reinvested dividends from an underlying portfolio of investments.
For corporate investors, however, investing in equity-based investments through the medium of investment bonds can rarely make tax sense given that, for most companies, the loan relationship rules will apply to remove the benefit of tax deferment, whereas direct investment into UK collectives will deliver tax-free dividends and corporation tax on real capital gains only (that is, after the application of the indexation allowance) and only on actual realisation. And remember that the corporation tax rate is falling to 19 per cent in financial year 2017 and to 17 per cent in 2020.
So we can reasonably conclude that, for corporate investors, the changes to the taxation of capital gains and dividends will have no direct impact on investment decision-making.
Anyone advising a company on investment will need to consider the current and prospective future working capital needs of the business before committing any money to longer-term investment. Competing uses for available funds will also need to be considered, such as debt reduction/repayment or pensions. If any investment is to be made, an appropriate risk level will also need to be ascertained from the directors.
Last but not least, consideration needs to be given to any impact that investment may have on the availability of entrepreneurs’ relief on a subsequent sale of the business. Broadly speaking, consideration will need to be seriously given if the amount to be invested exceeds 20 per cent of the capital assets of the company. There are other (potentially ameliorating) aspects to take into account but the stated 20 per cent test is definitely a starting point. Merely leaving cash generated from trading on deposit should not have any negative impact on the availability of entrepreneurs’ relief.
And what about charities? Well, capital gains realised and dividends received by registered charities will usually be tax-free so the changes to CGT and dividend taxation should have no impact on investment decision-making for them either. Next week I will take a look at the impact of the tax changes for trustees of private trusts.
Tony Wickenden is joint managing director of Technical Connection. You can find him Tweeting @tecconn