Ahead of the March 2010 Budget, there was considerable speculation that the rate of capital gains tax would increase to make it more closely aligned to the higher rate of income tax. That fear was unfounded and the rate of CGT will remain at 18 per cent although this area is likely to be revisited in future Budgets.
The Chancellor also announced that there would be no inc-rease in the level of the annual CGT exemption which for this tax year remains at £10,100.
In a further unexpected move, a doubling in the threshold of entrepreneurs’ relief from £1m to £2m from April 6, 2010 was announced and this continues the trend of “treating businesses fairly” under the capital gains tax rules.
The Government introduced entrepreneurs’ relief in response to strong protests over the removal of business assets taper relief in April 2008. In brief terms, entrepreneurs’ relief applies so that in the event of the disposal of a qualifying business, a shareholding director/employee, partner or sole proprietor (as appropriate) will now benefit from an effective rate of CGT of 10 per cent on the first cumulative £2m of lifetime gains. Balance gains will be taxed at 18 per cent. I say “effective rate” because there actually is not a 10 per cent rate. The said “effective rate” is arrived at by taking the full gain and redu-cing it by four ninths. The normal CGT rate of 18 per cent is then applied to the remai-ning reduced gain and the resulting tax due will represent 10 per cent of the unreduced gain. Now you know why we say “an effective rate of 10 per cent …” it’s easier!
The relief only applies to businesses that are trades and, in certain cases, there are restrictions to the relief where the business holds non-trading assets/ investments. This is something that advisers should carefully bear in mind when considering investment for companies. The evidence is that merely retaining funds from profits earned through trading in cash, for example, on deposit/treasury reserve, should not give rise to any problem in this respect as no positive act of investment will have taken place.
The same benign outcome is unlikely if the funds are invested, say, into a collective or a capital investment bond. Either of these investments may, of themselves, be capable of being justified as appropriate on investment or “self-contained” tax grounds. However, it is essential that advisers take into account the possible wider implic-ations for entrepreneurs’ relief. It is, however, true to say that the one-year “qualification” period for entrepreneurs’ relief may make the adverse consequences of any investment a little easier to avoid. Employees/directors must own at least 5 per cent of the shares and voting rights and, for relief to apply, the conditions must be satisfied throughout the one-year period before disposal.
The relief is cumulative throughout the life of the businessowner and so the cumulative gains on disposals of all businesses are taken into account in determining the level of relief. This cumulation only took effect from the time that entrepreneurs’ relief was introduced to take over from business assets taper relief. Gains made before this time do not have to be taken into account in determining whether the £2m threshold has been breached.
The increase in the limit of the relief applies from April 6, 2010. This means that where qualifying gains are made above the previous £1m limit before April 6, 2010, no additional relief will be allowed for the excess above the old limit. But if further qualifying gains are made after April 5, 2010, it will only be possible to claim relief on up to a further £1m of those additional gains, giving relief on accumulated qualifying gains up to the new limit of £2m.
This will be a welcome announcement for many owners of qualifying businesses – particularly those who, in order to avoid high levels of income tax on remuneration from companies, may prefer to retain profits inside the company and suffer a lower rate of corporation tax. Subject to those retained profits being put to trading use, they will currently only suffer a further effective CGT rate of 10 per cent on sale/disposal of the company up to the £2m “lifetime” allowance for entrepreneurs’ relief.
This seems to make eminently good sense from a pure tax planning standpoint, that is, avoiding personal tax at, say, 50 per cent, retaining funds where they bear tax at a lower rate (possibly 21 per cent) and perhaps even using the funds to invest in capital equipment qualifying for the extended 100 per cent annual investment allowance (available for qualifying expenditure of up to £100,000) – the investment eventually being realised with tax on the gain at the low 10 per cent effective rate.
In pursuing this highly undiversified strategy, though, advisers should encourage their SME-owning clients to consider the risk they are assuming. How many owners have relied on their “business as their pension” and conseq-uently “come unstuck” when the business can’t be sold or does not deliver the necessary net of tax value to the owner? This is a subject I will return to in later articles.
In closing , it should not be forgotten (as explained above) that entrepreneurs’ relief operates as a reduction in the gains subject to charge. So if CGT rates go up, so will the rate that applies to gains eligible for entrepreneurs’ relief.