The Tax That Lost Its Way

JOHN ENDACOTT BSc (Econ), ACA, ATII considers the case for reform of capital gains tax.

Gordon Brown made two announcements with regard to capital gains tax on 18 June. The first announcement reduced the period for maximum business asset taper relief from four to only two years and the second was to instigate a consultation process on the simplification of the tax. The two announcements do not sit easily together. This is because the changes to the taxation of capital gains over the last 40 years (since Schedule D, Case VII was introduced in 1962) have been numerous and we are left with no clear rationale as to why the tax exists or how it fits into any conceptual framework.

Different approaches?

If one adopts an accountancy framework, then it is possible to draft a balance sheet for an individual at each point. The movement from each balance sheet to another is growth (or deficiency). Growth could be either income or other gain and could be created by inflation. Other than adjusting for inflation, why should real growth be taxed at different rates? Nigel Lawson concluded that it should not, in the landmark Budget of 1988, and said:

'In principle, there is little economic difference between income and capital gains, and many people effectively have the option of choosing to a significant extent which to receive. And insofar as there is a difference, it is by no means clear why one should be taxed more heavily than the other. Taxing them at different rates distorts investment decisions and inevitably creates a major tax avoidance industry.'

Nigel Lawson had a clear conceptual framework and built upon it to achieve a cohesive system over a number of years. New Labour has pursued a less cohesive approach to the taxation system, although Gordon Brown's 1998 Budget speech did attempt to outline a conceptual framework and it was this Budget that introduced taper relief. In that speech he said:

'The capital gains tax régime we inherited rewards the short term speculator as much as the committed long term investor. So it is time also for a fundamental reform of capital gains tax. … I have decided to phase out complex allowances and instead will introduce a new structure of capital gains tax which will explicitly reward long term investment and is based on a downward taper and lower tax rates.'

The above is not entirely fair, as under the previous régime the most significant relief was retirement relief which was a clear incentive towards long term ownership of business assets.

Since 1998 the taper relief provisions have been amended by reducing the maximum taper relief period for business assets from ten to four and now to two years and by a shifting of the definition of what is a business asset. It was also stated at the time that reform of the taxation of capital gains of companies would follow. This has been dropped and the régime for companies remains exactly as devised by Nigel Lawson with relief for inflation and the same rate of tax applied to all income.

Questions to be answered

Against this background it is proposed to simplify capital gains tax within 'the existing policy framework'. If this is to be achieved, then it is necessary for large elements of the legislation to be repealed. Without a clear framework as to why the tax exists, it is hard to see how this can be achieved.

Some key considerations illustrate this.

From what date?

Currently the date from which the tax should be effective can be 1945, 1965 or 1982, with 1998 also being very significant. In reality simplification is only going to be achieved by full rebasing (to, say, 1998) and yet it is hard to imagine that 1982 will be departed from as the rebasing date. This is because of the precedents that have been established and because that was the year in which the re-rating in England and Wales was to be introduced.

Should only real gains be taxed?

Currently, for individuals inflation relief is available from 1982 to 1998. For companies it is available from 1982 onwards. While inflation is low, this is not a very significant issue but as a point of principle surely only real gains should be taxed.

Should business assets be favoured?

As far as business assets are concerned, we actually have a system designed to encourage short term speculation. Why stay invested for the medium to long term when you can exit quickly with a reasonable gain and a very low tax rate?

The distinction between business and non-business assets has become crucial and yet, as we all know, this can be a very grey area. If the current approach is to continue, then we need this distinction to be put at the heart of the tax system and the same definition to apply throughout. Currently the definitions used for section 165 'Holdover relief, business property relief and taper relief' are not the same.

The principal distinction between the quote from Nigel Lawson above, and that from Gordon Brown, is the desire to influence investment decisions. This Government is keen to use the tax system actively to influence investment decisions and specifically with regard to employees. Employees holding shares are positively encouraged, and yet is it not more prudent for those employees to invest outside of their employer's company in order to spread their risk? Also, if there is the desire to reward employees who wish to commit to building up the business of their employer, then why are share option arrangements so disadvantaged?

What holdover and rollover reliefs should be available?

Currently holdover relief is available on the gift of business assets. Should a general gift holdover relief be introduced and, if so, should spouse no gain/no loss transfers be abolished?

One of the most significant aspects of the change from April next year to a two-year taper relief period is for holdover and rollover relief claims. Inheritance tax planning is encouraged as a result of this as the revaluation of business assets on death ceases to be as significant if the beneficiary can achieve a ten per cent capital gains tax rate after only two years.

Why no capital gains tax charge on death?

Since 1992, when 100 per cent business property relief was introduced, there has been no inheritance tax on business assets but there is still a tax free uplift for such assets on death. This can lead to commercial decisions being distorted and the equity of this provision is hard to fathom. It also illustrates that capital gains tax cannot be simplified in isolation, which suggests that inheritance tax will also feature in the March 2002 Budget.

Proposed simplification

What is required is not a simplification of capital gains tax, but wholesale reform and that requires a wider remit, objectives to work towards and a clear framework to be established by the Government.

Views on the simplification of capital gains tax should be sent by 14 September to:

John Endacott is a tax partner at Winter Rule, chartered accountants and business advisers. The views given here are his own and are not necessarily those of his firm.

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