The Coalition Agreement made between the Liberal Democrats and Conservatives, published on 20 May 2010, together with the Queen’s Speech delivered on 25 May 2010, contained several proposals for tax reform, which in the government’s view are aimed at creating a fairer and simpler taxation system. The tax measures that have been proposed widely reflect most of the Conservative and Liberal Democrat manifesto pledges, though the scope of a few of the measures has been reduced.
This article provides a summary of the coalition government’s key proposals for taxation reform, which are widely expected to be introduced in the emergency budget. In addition, this article specifically focuses on the proposed changes to the capital gains tax (CGT) regime and considers the implications that these proposed changes may have on certain taxpayers.
It appears that the aim of the government’s tax proposals is to reform the tax system so that it is fairer to those taxpayers on lower and middle incomes. However, the coalition agreement clearly emphasises that the deficit reduction programme will take precedence over all other measures (including tax), so it remains to be seen whether there will be sufficient funding for some of the proposals in the emergency budget.
Changes to the CGT regime
The suggested change to the CGT rate for individuals has received the most press coverage (mainly negative) since the proposals were initially announced in the 11 May coalition agreement. It is proposed that the rate of CGT will increase from 18% to close to 40% (or even 50%) on gains on assets that do not qualify for the business activities exemptions. This suggestion was not in the Conservative manifesto, but the Liberal Democrat manifesto included a pledge to align CGT rates with income tax rates.
Unfortunately, the announcement relating to the reform of the CGT regime was very high level, and very few details regarding the new measure have been provided in the coalition agreement or subsequently. The scope of these exemptions is going to be crucial. At the moment, there are several uncertainties associated with the proposed new measure. This article sets out the key issues that require clarification:
- There is no indication of whether any kind of indexation will be reinstated for individuals.
- The government has not indicated which assets will be treated as business assets or non-business assets and, therefore, which assets will be subject to the proposed new regime. It seems likely that assets used in a trade will be treated as business assets. However, it is less clear how assets used in a business that does not amount to a trade (such as property rental) will be treated.
Prior to 6 April 2008 (ie the date taper relief was abolished), gains on rental properties (other than certain furnished holiday lettings) did not generally qualify for the 10% CGT rate under business asset taper relief, and were usually taxed at rates between 24% and 40%. Likewise, rental properties do not tend to qualify for the 10% CGT rate under entrepreneurial relief, unless they are used in a furnished holiday letting business carried on in the UK or elsewhere in the European Economic Area. However, both of these measures (ie taper relief and entrepreneurial relief) were introduced by the previous Labour government so there is no guarantee that the coalition government will follow these past practices, adding further uncertainty regarding the application of the proposed new rules.
If entrepreneurs’ relief does not apply, any gain is currently taxed at a flat rate of 18%. The current CGT rate of 18% on sales of most rental properties has been criticised as too generous in comparison to other European jurisdictions. It is therefore possible that property rental businesses will be excluded from the entrepreneurial business exemptions and will be subject to the higher rates of CGT. The Liberal Democrat manifesto indicated that the party’s CGT proposals would attempt to ensure that those who use second homes as speculative investments will pay tax on enhanced capital value at the same rate as on earned income. Given that this initiative was introduced at the instigation of the Liberal Democrats, it follows that it is likely that property rental investments will be included with the ambit of the new CGT measures.
- There was no mention in the coalition agreement on whether the proposed CGT measures will apply to executive’s carried interest in private equity transactions. Currently, private equity carried interests held by executives (broadly, the ‘super profit’ realised by private equity executives on the ultimate disposal of an investment) is subject to CGT, rather than income tax. This treatment has largely been criticised and it would not be surprising to see ‘carried interest’ subjected to income tax treatment.
The private equity industry has already commenced lobbying against the proposed new regime applying to an executive’s private equity carried interest and is arguing that this should be treated as a business asset.
- There has been no indication whether the exemptions may apply to company shares. Given that both taper relief and (currently) entrepreneurial relief apply to shares in a company, it would seem likely that this could be the case. However, as stated above, both taper relief and entrepreneurial relief were Labour government initiatives, and the coalition government may take this opportunity to overhaul the system with a view to increasing tax revenue for the government.
In the author’s view, the proposed exemptions will be restricted to shares in a trading company and the exemptions will not apply to investment companies. Accordingly, any gains derived from the sale of investment companies (or non-trading companies generally) may not qualify for any exemptions and therefore could be taxed at the new higher rates.
- It is not clear whether shares in listed companies and unlisted companies will be treated differently for the purposes of the exemption, or whether there will be a cap on the amount of the exemption.
- It is also not clear and will be interesting to see whether there will be a minimum holding period for a gain on an asset to qualify for the entrepreneurial business exemptions.
Implications: what should taxpayers do now?
There is no information about the timing of this change. In the author’s view, it is doubtful that the new measures will apply retrospectively and more likely that the new measures will apply from the date of the emergency budget. If this is the case, taxpayers will have little time and opportunity to enter into arrangements aimed at minimising the impact of these new rules.
Given the scarcity of information regarding the CGT proposals, it is difficult for taxpayers to determine whether they should take immediate action with regard to assets standing at a gain. Taxpayers who are unlikely to qualify for the entrepreneurial business activities exemption and who have assets standing at a gain may consider disposing of the asset before the change takes effect to obtain the benefit of the 18% gain (or 10% if entrepreneurial relief applies).
This decision will involve making a cost-benefit analysis, comparing the benefit of securing the current 18% tax rate, while funding and paying a CGT liability by 31 January 2012, with suffering a future CGT charge at rates of 40% or 50%. Possible planning opportunities could involve ‘bed and breakfasting’ the assets, or transferring them to a trust or to a spouse to preserve the 18% rate. Taxpayers, however, should be aware that anti-avoidance measures may be introduced in the emergency budget, prohibiting these types of arrangements.
Change in personal allowances
The coalition government has indicated that it intends to raise the personal allowance to £10,000 (currently £6,475) gradually, with the benefit focused on those on lower and middle incomes. Presumably, those taxpayers earning in excess of a set amount will not benefit from this proposal.
Corporate tax reform
The coalition agreement indicated that it intends to create the most competitive corporate tax regime within the G20, while at the same time protecting manufacturing industries in the UK. Again, little detail regarding this proposal has been released, but based on the Conservative and Liberal Democrat manifesto pledges, it is assumed that this will be achieved by simplifying relief and allowances, and tackling tax avoidance to reduce headline rates of tax.
The Chancellor is expected to announce a five-year programme of corporation tax reform in the emergency budget.
The coalition agreement does not refer to reform of the controlled foreign company (CFC) regime, which was initially mentioned in the Conservative manifesto. However, the Chancellor did mention this measure in a speech to the Confederation of British Industry’s on 19 May 2010. It is therefore anticipated that measures will be confirmed in the emergency budget regarding the reform of the CFC regime. There has also been no further confirmation from the coalition government on the proposals relating to a move towards a territorial corporate tax system that only taxes profits generated in the UK. However, it is possible that this may be addressed as part of the reform of the CFC regime.
National Insurance Contributions (NICs) changes
The 1% rise in employer and employee NICs planned by the previous government will go ahead from April 2011, but the employer NICs’ threshold will increase by £21 per week to reduce the impact of the increase for employers.
The coalition government has also confirmed that it intends to conduct a review of small businesses, which will also include a review of IR35. The IR35 rules attempt to counter those transactions where individuals seek to avoid paying income tax and NICs by providing their services through an intermediary company and receiving dividends that are taxed more favourably than employment income. Broadly, IR35 requires individuals who are in substance an employee to pay income tax and NICs while ignoring the existence of the intermediary company. The coalition government intends to replace IR35 with simpler measures that prevent tax avoidance but do not place undue administrative burdens or uncertainty on the self-employed or restrict labour flexibility. It is possible that the review will consider the Liberal Democrat manifesto pledge of allowing small businesses to choose to be taxed on a cash-flow basis.
Other key measures
Other key proposals include a possible refocusing of the research and development (R&D) tax credit on hi-tech companies, small firms and start-ups. This proposal may include reforming the taxation of intellectual property and to improve R&D tax credits in general.
Further, a review of the taxation of non-domiciled individuals was outlined in the coalition agreement. No further details were announced and, accordingly, it remains to be seen whether either of the Conservative or Liberal Democrat manifesto pledges (such as the introduction of a flat-rate levy on non-domiciled individuals and to allow non-domiciled individuals that status for seven years only) will be implemented.
Increase in other taxes
The coalition agreement makes no reference to possible increases in rates of VAT, stamp duty land tax or income tax. These may, however, be included in the emergency budget.
It is likely that many, if not all, of the tax measures in the coalition agreement will be released with the emergency budget. It is unfortunate that further clarity on some of the proposed changes has not been introduced beforehand, particularly with respect to the proposed CGT changes.
Although many elements of the tax system are over-complicated and must be simplified, given the recent reforms to the UK tax system and the need to stabilise the economy, the author questions whether these simplification changes are necessary or whether the proposals are more related to the new government trying to ‘put its mark’ on the UK tax system. Presumably the government will also seek to enact a Finance Bill containing some or all of the above measures (and possibly, some of the many technical tax changes stood over from the March 2010 budget) before Parliament’s summer recess. This does not allow long for these changes to be considered, and for new coherent and ‘simple’ legislation to be drafted.