AF1 Capital Gains Tax. Part 1: Basic principles

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1 AF1 Capital Gains Tax. Part 1: Basic principles This is the first part of the CGT study material The milestones for this part are to understand: What does CGT seek to tax. Which assets are subject to CGT and which are exempt. Which transfers are exempt. How to calculate a CGT liability with and without losses CGT taxes the gain made on the disposal of an asset that is subject to CGT. The gain is the difference between its value at date of disposal and acquisition. A disposal occurs when an asset is sold but also when an asset is given away. Jo gives a share portfolio with a value of 100,000 to her daughter. The acquisition cost was 20,000. Jo has a made a gain of 80,000 even though she has not received any money. The disposal value is the asset s market value. There are no issues if the asset is sold at armslength to a third party. However, if Jo in the previous case sold the portfolio for 40,000, that is below market value, she would still have made a gain of 80,000. Not all property is subject to CGT. The study text gives a complete list but for the moment the following should be noted: Principle Private Residence Life Insurance Policies in the hands of the original owner ISAs Gilts and Corporate Bonds (but not Unit Trusts or OEICS investing in these) Assets with an expected lifespan of less than 50 years. These are known as wasting assets. In addition, some disposals are always exempt even if the asset is normally subject to CGT. These are: Transfers between spouses or civil partners. Transfers to a charity Transfers made on death through a will or intestacy Sam has an extensive art collection. He sells this whilst he is alive and realises a gain of 500,000. This would be subject to CGT If he doesn t sell but passes it to his children on death all the gain would be wiped out and there is no liability for CGT 1

2 Calculating the tax liability There are two stages in calculating a CGT liability: Calculate the total chargeable gains in a tax year Establishing the correct rate. The individual s liability is total chargeable gains multiplied by the correct rate. Calculating the gain The starting point is to calculate the difference between the disposal and acquisition value of the asset. You must always use market value even if it is sold for less than this. Jane bought 25,100 of shares in Acme Widgets in June She sells them in September 2017 for 42,400. There is a gain of 17,300. In practice, there are usually costs involved with both sale and purchase of an asset which need to be taken into account. A collector buys a painting for 10,000 at auction. If the auctioneer charges a 5% fee to the buyer the acquisition cost will be 10,500. Some years later it is sold for 20,000 and the auctioneer charges a 10% commission, he only receives 18,000 so the gain is 7,500. The key is to ask yourself what was the size of the cheque the individual wrote when they acquired the asset and how much was paid into their account when it was sold. A further deduction is the cost enhancing an asset. For example, the owner of a painting may spend money on having it cleaned as this will increase its value. This can be deducted when calculating the gain. On the other hand, the cost of insuring the painting could not be deducted. The test HMRC will apply is whether the expenditure enhances the value. Enhancement can be grey area particularly with residential property. The costs of renovating a property before it is let would be an expense against CGT. The cost of insuring the property and paying a managing agent would be an expense against income. Regular maintenance such as decorating the property every seven years falls into this grey area. It will probably be viewed as an income expense as it is something that must be done and doesn t directly enhance the value of the property. There is also the possibility of rebasing which applies if the asset was purchased prior to April 6 th Inflation was above 10% for a large part of the 70 s and early 80 s. This meant that real gains, i.e. over and above inflation were small and sometimes non-existent. To compensate for this the 1982 budget allowed investors to treat the acquisition value as the value March 31 st

3 Ian purchased shares in a company in 1970 for 1 a share and these were worth 4 a share at March , the purchase price for any future calculation would be 4 a share. Part Disposals Problems can arise where there is disposal of part of an asset. For example, someone may buy a set of figures and then decides to sell part of them. The disposal price will be known but at what price was this part acquired? When the remaining pieces are sold what will their acquisition price be? The solution is to apply this formula A A + B x original cost Where A is the proceeds of the part disposed and B is the market value of the retained part Sid buys an asset for 10,000 and sells part of it for 20,000, with the remainder being worth 60,000 The deemed cost of the part disposed of is 20,000/ 20, ,000 x 10,000 = 2,500 The gain on the part disposal is 20,000 less 2,500 = 17,500 The deemed cost of future disposal of the remainder will be 7,500 Having calculated all the gains these are totalled and the annual exemption of 11,700 is deducted to establish the chargeable gain. Applying the correct rate The rate is determined by adding the total of chargeable gains made in the tax year to the individual s income. For all assets other than residential property (buy to let) Any of the gain that is in the basic rate band is taxed at 10% Any of the gain in the higher rate band is taxed at 20% If the gain straddles the basic and higher rate band, then part is taxed at 10% and part at 20% Jane makes a taxable gain of 10,000. Her total income is 20,000 after deduction of her personal allowance so she still has 14,500 of her basic rate band left. She. The gain is all in the basic rate band so is taxed at 10% giving a tax charge of 1,000 If her income was 60,000 she would already be a higher rate tax payer so 20% would be charged giving a tax bill of 2,000. If Jane s income was 41,350 she would have 5,000 of her basic rate band left so 5,000 would be taxed at 10% with 5,000 taxed at 20% giving a total bill of 1,500 3

4 Note that additional rate tax payers also pay CGT at 20%. A non-tax payer would still have to pay CGT at 10% on the first 34,500 of any gain in over the annual exemption. The gain cannot be reduced by the income tax personal allowance. If the basic rate threshold has been increased by Personal Pension contributions or Gift Aid contributions, then the amended threshold will be used in calculating what rate of CGT is payable. Jenny has an income of 46,350. This is the point at which the next of income would be taxed at 40% ( 11, ,500) so if she makes a chargeable gain it will be taxed at 20% If she makes a PP contribution of 4,000, this will be grossed up to 5,000 and her basic rate band extended to 39,450. Now the first 5,000 of any chargeable gain will be charged at 10% So far it has been assumed that the disposal resulted in a gain but it is also possible that it could have resulted in a loss. Losses Since CGT taxes gains or profits on the disposal of an asset it follows that any losses can be offset against gains. As with gains, losses can only be offset when the loss is realised. There is an exemption for shares of negligible value. These are shares in companies that have either gone into liquidation or ceased trading and there is no market to trade them. HMRC publish an official list of these and a claim for disposal can be made without selling shares on this list. Losses made on assets exempt from CGT such as directly owned Gilts and Bonds cannot be offset. If a loss and a gain are made in the same tax year, the rule is that the total loss must be deducted from any gain before the annual exemption is deducted. Sandra has made a gain of 22,000 and a loss of 10,000 in the same tax year. This reduces the loss to 12,000. The annual exemption is then deducted. Gain 22,000 Loss 10,000 Gain 12,000 Less Annual Exemption 11,700 Chargeable gain 300 If the gain had been 15,000 the loss would have reduced this to 5,000 so no tax is payable. This is not efficient because it is below the annual exemption. Ideally she should just offset 3,300 of the 10,000 loss as this reduces the gain to the annual exemption. She could then carry forward 6,700 to a later year. Unfortunately, HMRC do not allow this. 4

5 However, if there is a loss from a previous year this can be carried forward to a future year. This can be created in two ways: Charles has made a gain of 12,000 and a loss of 20,000 in the same tax year. The loss wipes out the gain and the remaining 8,000 can be carried forward to another year. Anne made a loss of 20,000 without crystallising any gains in the same tax year so the whole amount can be carried forward If there is a carried forward loss the annual exemption is offset against a gain before the annual exemption. David has a gain of 15,700 in 2018/19 and has 10,000 losses from previous years Gain 15,700 Less Annual Exemption 11,700 Gain 4,000 Less carried forward loss 4,000 Gain 0 Remaining carried forward loss 6,000 Losses can be carried forward indefinitely but HMRC must be notified of a loss within 4 years of the loss occurring even though it is not claimed at that time. If there is a loss and a gain in the same tax year and losses to carry forward the process is as follows: The whole of the current year s loss must first be offset against that year s gain The annual exemption of 11,700 would be deducted. If there is still a taxable gain all or part of the carried forward loss can offset to further reduce the gain. In a calculation it should be set out like this: 5

6 Kate made a gain of 20,000 and a loss of 6,000 in 18/19. She also has a carried forward loss of 13,000. Gain 20,000 Loss (current year) 6,000 Adjusted gain 14,000 Less Annual Exemption 11,700 Adjusted gain 2,300 Less c/f loss 2,300 0 Previous loss 13,000 Less 2,300 Loss to be carried forward 10,700 Interaction of Residential Property and other gains. As noted earlier, CGT on residential property is charged at 18% and 28%. When an individual has disposed of residential and ordinary property in the same year this adds an additional layer of complexity. Look at this situation. Emil, a higher rate tax payer made a gain of 40,000 on some shares and a gain of 60,000 from residential property. Against which gain should the annual exemption be offset? HMRC allow the annual exemption to be offset against the property gain Residential Property Gain 60,000 Less annual exemption 11,700 Gain 48,300 Gain on shares 40,000 Total gain 88,300 This is beneficial because the amount that is taxed at 28% is reduced. Similarly, a loss on other assets can be offset against residential property. Tom makes a gain of 50,000 on the disposal of a residential property gain. He sold some shares for a gain of 15,000 but made a loss of 10,000 on some other shares. Property gain 50,000 Less share loss 10,000 40,000 Less annual exemption 11,700 Gain 18,300 Plus share gain 15,000 33,300 6

7 If Tom is a higher rate tax payer then 18,300 would be taxed at 28% and 15,000 at 20%. However, suppose Tom was retired and with a pension income of 28,000. He has 18,350 of his basic rate band left so is the lower rate of CGT applied to the property or share gain? The HMRC rule is that the lower rate is applied to the non-property gain. Share gain 10% 1,500 Remainder of basic rate band ( 3,300) Property Gain ( 40,000) % 10,262 12,365 To sum up these rules. Where both a property and non-property gains have been made: The annual exemption can be offset against the residential property gains. Losses on non-property gains can be offset against property gains If the individual s income has not used up all their basic rate band, the lower rate of CGT must first be charged on the non-property gain. That concludes this part so you should now understand: The basic principles of CGT Which assets are subject to CGT and which are exempt. Which transfers are exempt. How to calculate a CGT liability with and without losses 7