The Chancellor's pre-Budget statement contained two ann ouncements which will have an impact on capital gains tax.
The first of the proposals is that business taper relief will be extended to shareholdings by emp loyees in certain non-trading companies.
Bus in ess taper relief is very valuable as it reduces the maximum tax rate on relevant inv estments to 10 per cent after the assets have been owned for four years.
Under current rules, the relief is only available for trading companies where any non-trading activity is insig nif icant. This proposal will be help ful in removing uncertainty about what level of non-trading activity excludes a company from the provisions.
Extending the availability of business taper relief should also provide a boost in business for the life industry. This is because it will allow more companies to take adv antage of the tax planning opportunities offered by investing in offshore bonds without worrying about whe ther such an investment will cause tax problems for the shareholders.
While there will be anti-avoidance rules to ensure individuals cannot gain the benefit of business taper relief by forming companies to hold their investment assets, this change will be helpful in the sense that it will allow more individuals owning shares in the company they work for to dispose of those shares at very low CGT rates. This will allow them to diversify their investment portfolios.
The second announcement which will impact on CGT is the extension of the Enter prise Man agement Initiative to allow qualifying companies to issue options on shares worth up to £2.5m in total compared with the current limit of £1.5m.
Shares emerging from this type of option arrangement should again qualify for business taper relief. A further boost for employees comes from the fact that, in contrast to the older types of share option arrangement, taper rel ief on EMI shares runs from the grant of the option, not the later purchase of the shares.
The individual will be able to dispose of shares at very low CGT rates, which is imp or tant as EMI is designed to enc our age investment in risk ier companies. It may be that employees holding significant blocks of such shares will feel that diversification into less risky investments is appropriate.
Where the individual is hoping to diversify their inv estment portfolio, an obvious tax-efficient home for some of the capital will be an equity Isa. Another helpful ann oun ce ment in the pre-Budget report was the continuation of the £7,000 annual limit for Isa investments for five years. Realistically, however, this will absorb only the first slice of the proceeds of a disposal of EMI shares.
The individual may then want to consider investing in other vehicles and to debate the respective merits of direct investment into equities or collectives and investment into pooled funds via the wrapper of a life insurance bond.
In theory, there are tax benefits to investing in assets subject to CGT whether they are equities or collectives such as unit trusts. These are the availability of the annual CGT exe mption (£7,200 for 2000/01) and the availability of taper relief, which for non-business assets can reduce the rate of tax to 24 per cent after 10 years.
The availability of the ann ual exemption is important but, for the individual whose wealth is emerging from the employer company, it is likely that this relief will be needed to mitigate the gains arising on the shares which are being sold to facilitate diversification.
Looking then at the second benefit, the individual will want to bear in mind that taper relief on non-business assets is only available after the ass ets have been held for three years. Even then, the relief builds up at only 5 per cent a year. Therefore, this relief is mainly of use where the individual expects to hold a very passively managed portfolio.
The combination of these two factors means an individual making direct investments may well find that CGT acts as a bar to responding quickly to changes in the market and may result in a portfolio of assets which stagnates.
There are other drawbacks to direct investment. Assets subject to CGT are difficult to gift because a gift is trea ted for tax purposes as a disposal at market value. So, inh eritance tax planning can only be ach ie ved at a CGT cost.
Where direct investment is contemplated, there is no flexibility in the incidence of tax on any income stream. Inc ome will be taxed on the individual at the marginal rate applying in the year of receipt.
Using a bond wrapper for investment has the effect that the CGT advantages of the annual exemption and taper relief are lost. However, offshore bonds – particularly portfolio bonds – compensate for this in their greater flexibility. The individual can hold a range of collective investments, managed by their preferred investment manager, in an environment where tax can be deferred to a point that suits the individual.
One major advantage of the portfolio bond is that the underlying investments can be managed aggressively without the disposals giving rise to CGT liabilities.
Another significant advantage of a bond investment is that, with the exception of irrecoverable withholding tax on dividend income, income and gains on the underlying investments will roll up tax-free within the bond. As with onshore bonds and simple offshore investment bonds, the portfolio bond is subject to the chargeable events regime which allows withdrawals of up to 5 per cent a year of the amount invested to be taken from the bond without an immediate tax liability.
In effect, this is the reverse of direct investment where the investor is taxed annually, whe ther or not income is req uired.
In my opinion, a bond is the perfect asset for IHT planning. It lends itself to trust arrangements because there are no income tax liabilities on creation of the trust or annual self-assessment compliance considerations. This means that, as well as planning when to pay income tax, the individual will often find it possible to choose not to pay IHT.
The changing CGT regime makes it ever easier for individuals to realise their investment holdings, particularly in tax-favoured share schemes, at low CGT rates.
When deciding where the proceeds of such disposals should be inv ested, the CGT regime may not be favourable enough to encourage direct investment. Advisers whose clients have this type of emer ging wealth may find the offshore portfolio bond is an attractive solution to the tax planning dilemma.