Shining light into the darkness
First of two articles on the Budget and Finance Bill explains the important changes in income tax, inheritance tax and capital gains tax
Under the stone
Taxation in the United Kingdom, despite its vital importance to UK persons both natural and legal, usually hides from the spotlight. Its complications do not make for exciting or even intelligible publicity. Perhaps twice a year, with the Budget and (increasingly) the Pre-Budget Report, the stone is lifted and the UK tax system is exposed to more or less fascinated scrutiny. Its numerous limbs wriggle and writhe as it blinks uncertainly at the unusual attention from commentators other than the strangely obsessed.
However, this year has been different. This year, the tax beast has been at the forefront of attention for much longer than usual. Significant parts of its body have had surgery, only for the surgeon to return for another go when the cure does not look as good as it did. Through all this, some of the more arcane elements of the tax system have passed into common currency, acquiring rather pathetic badges of familiarity. It was hard to imagine that “non-doms” would come to interest those apart from themselves and their advisers, or that the front pages would (on occasion) compare and contrast taper relief with entrepreneurs’ relief from capital gains tax. If it was more predictable that the removal of the 10% tax rate would create general interest, its time might have been thought to have passed, given that it was announced in Gordon Brown’s last Budget – and appeared to cause little fuss then.
It is also the case this year that along with a very large number of fairly technical changes perhaps mainly of interest to tax specialists, there were major changes in “mainstream” solicitors’ taxes, inheritance tax and capital gains tax. These changes had a long gestation period, having been announced before the turn of the year. And the capital gains tax changes caused their own political controversy, requiring amendment from the original proposals.
At least the original proposals, and even the amended version, make genuine and serious strides towards simplification. This trend is not particularly evident elsewhere, with another 420 pages of tax legislation set to join the existing thousands. There may be some respite as the tax re-write project approaches a landmark, with the publication of clauses on corporation tax. In the not too distant future, these will replace the remaining parts of the Income and Corporation Taxes Act 1988, much of which remains in place only as it affects companies. The tax law re-write will give us a much, much longer overall tax code – but the general consensus is that it is genuinely easier to understand. That would be a major achievement, but so much remains to be done if we are to have a tax system which is genuinely transparent and approachable. The horror that remains in aspects of the very recent introduction of stamp duty land tax is a reminder that the tax monster will always be capable of scaring those who must encounter it.
The basics (and a bit beyond)
Rates and allowances for income tax, capital gains tax, inheritance tax, corporation tax and national insurance are set out in the table on the right.
Comment on rates and allowances Income tax and national insurance
It is all the more ironic when the Chancellor to suffer from the fuss of abolishing the 10% rate, and who had to come up with some kind of solution, had not in fact devised the policy of removing that rate. The main function of the abolition – and the additional tax which it raised – was to pay for the reduction in basic rate from 22% to 20%, which is also to take effect from 2008-09. The combined package was to be, broadly, neutral in revenue raising terms. But it really did cause some anomalies, and increased tax for some of the poorest while reducing it for many of the more wealthy.
Hence there was an announcement on 13 May 2008, the effect of which was to increase the personal allowance by £600 for everyone. In order that this did not benefit higher rate taxpayers, the threshold at which the 40% rate comes into play was reduced from the figure originally announced, by £1,200. This late change will reduce the tax paid by those who would otherwise have paid at 10%, but also for most of those who pay at the new basic rate of 20%. It was a rough and ready solution to a very political problem. (These new figures are reflected in the table above.)
Of course, the original new rates and allowances had been known well in advance of the commencement of the 2008-09 tax year. They had been intimated to employers, and systems had been put in place for the original changes. Hence the further revisions will only come into practical effect in September 2008.
The end result of all this is a mess. Part of the mess was already there, because the 10% rate did survive, as the table above indicates, for savings income up to £2,320. But because savings income is always treated as the highest part of income, this rate will actually only be available in a very limited number of cases. And for the people affected, in many cases their savings income will have suffered deduction of tax at source at the new basic rate of 20%. This will necessitate a tax repayment claim, for what may be a very small (but in such cases disproportionately important) sum of money.
It can also be noted that the late change in the personal allowance did not carry over into the comparable figures for national insurance – thus the class 4 lower profits limit remains at the originally announced level, instead of being aligned with the new income tax personal allowance. This is a step away from the generally welcome attempts to bring what is in effect an extension of income tax into line with that tax properly so-called.
On a more positive note, the rise in age allowances beyond inflationary raises continues, as promised in past years.
Also on a positive note, special transitional arrangements are made for charities in relation to Gift Aid repayment claims for each of the years 2008-09 to 2010-11. The reduction in the basic rate to 20% restricts the amounts that charities can reclaim, but for those three years, charities can continue to reclaim the amount which could be reclaimed when the basic rate was 22% – that is, the fraction of 22/78 of the donation actually made.
Capital gains tax
The annual exempt amount increases with inflation – but of course that change is completely overshadowed by the radical structural changes mentioned below.
There was no further extension of the rises in the inheritance tax threshold which have been announced for a number of years ahead. The band will increase to £312,000 for 2008-09, £325,000 for 2009-10 and £350,000 for 2010-11. But again, the major change by the (limited) transferability of nil-rate bands (see below) overshadows this basic change.
As previously announced, the small companies rate increased from 20% to 21% from 1 April 2008, and this is to be followed by a further rise to 22% in 2009. In contrast, the main rate has now been reduced to 28%, making the differential of decreasing importance. The fraction to be used in calculating marginal relief becomes 7/400. Pressure grows for the main rate to be reduced, with international comparisons making it look higher than in many “competitor” countries; and the lower and upper profits limits for the small companies rate remain at £300,000 and £1,500,000 respectively, where they have been for many years.
Inheritance tax changes
The transferable nil-rate band was announced in the Pre-Budget Report. It may or may not have been in response to Conservative announcements about a possible £1 million nil rate band, but full details and draft legislation to implement this reform certainly appeared very quickly. The legislation will be in Finance Act 2008 and will insert new ss 8A-8C into Inheritance Tax Act 1984 (IHTA).
The effect of these changes is that where one spouse or civil partner dies, leaving a surviving spouse or civil partner, then on the death of that survivor, an increased nil rate band may be available. That increase, which is by a percentage of the nil-rate band amount at the date of the second death, depends on the proportion of the nil-rate band which was unused on the first death. So if the first to die used none of the nil-rate band on the first death (perhaps because the whole estate was left to the surviving spouse or civil partner), then the nil-rate band will be doubled when the second spouse or civil partner dies. The change is partially retrospective, in that the first death may have incurred at any time in the past (including in the era of capital transfer tax or estate duty) and these rules will apply as long as the second death occurs on or after 9 October 2007.
This change alters many of the imperatives of estate planning, in that it is no longer necessary, and perhaps not desirable, for the nil-rate band to be used on the death of a first spouse or civil partner. It may make it desirable to use a deed of variation or a distribution from a discretionary trust falling within IHTA s 144 to take the full estate to the survivor after the first death. And it also means that it is unnecessary for spouses to have their estate divided so that each of them owns assets worth up to the current nil-rate band.
It is possible for survivors to utilise the unused nil-rate bands from more than one former spouse, but the maximum increase is restricted to 100% of the nil-rate band at the date of death of the survivor.
While this new law will not be in force until Royal Assent to the Finance Act 2008, HMRC have been preparing for it since the Pre-Budget Report. They have been seeking and keeping the necessary information to process relevant claims as soon as this important change becomes law.
There is an important consequential change in relation to capital gains tax acquisition costs. It will now be unnecessary in many cases to ascertain values for inheritance tax purposes until the death of the survivor of two spouses – but on that second death, it may be necessary to ascertain values of assets which passed on the first death. Normally, valuations ascertained for IHT purposes are compulsorily adopted for capital gains tax, but this rule will not apply where IHT values in question are only established on the second death, and carried back to the first.
As well as dealing with changes from October 2007, Finance Act 2008 will also clarify changes made to inheritance tax on trusts in Finance Act 2006. These rules changed the treatment of trusts with interests in possession, but allowed the creation in existing trusts of what are termed “transitional serial interests” – new interests in possession created before 6 April 2008. The situation was not clear where a new interest was created for the same beneficiary as held it before the change – and this has been clarified to the effect that this will not be treated as a new interest.
The transitional period to create effective transitional serial interests has also been extended, to 5 October 2008.
The final IHT change to mention is in relation to pensions. Charges to IHT (and unauthorised payment pension charges) will not arise where unused funds pass as increased pensions at the same rate to members of schemes where there are at least 20 members. There are also changes being made to ensure that where IHT charges arise on unauthorised lump sum benefits from a pension scheme or alternatively secured pensions after the death of a member, any unused nil-rate band from that member’s death can only be used in relation to one IHT charge on such funds. IHT charges can arise in relation to pension funds on more than one occasion.
Capital gains tax: radical reform
The changes made to capital gains tax were announced in the Pre-Budget Report, but substantial pressure led to some amendments to the original proposals, notably by the introduction of so-called entrepreneurs’ relief. Even with this gloss, the reform of this most complex of taxes was radical. For once, the long schedule in the Finance Bill dealing with this change is to be welcomed, as despite its own length it removes much greater quantities of legislation from the Taxation of Chargeable Gains Act 1992. It should however be noted that the changes do not, for the most part, affect gains made by companies (although some of the things changed, such as taper relief, never affected companies in the first place).
The main changes are as follows:
The introduction of a single rate of 18% for individuals, trustees and executors. Whether this represents an increase or a decrease in actual liability depends not only on the taxpayer but also on the asset under consideration. But given that most chargeable gains are made by higher rate taxpayers, it will actually bring a decrease in many cases, although other changes complicate this picture. The big exception is of course business assets, where a 10% rate had become almost the norm and was easy to achieve for many taxpayers. The perceived rise in tax for such disposals led to the introduction of entrepreneurs’ relief. It is interesting to note that the overall changes were thought to be a significant tax-raising measure, indicating that the government hoped to gain from this increase in the rate for business assets. But (for example) most trusts and executors will be net beneficiaries. It will also be interesting to see whether the revived sharp difference between the 18% rate for capital gains and a 40% higher rate of income tax will lead to renewed attempts to characterise profits as capital rather than income, an exercise that had become increasingly irrelevant in recent years.
The abolition of taper relief. This applies to disposals on or after 6 April 2008 – and will also affect all deferred gains brought into charge after that date.
The abolition of indexation allowance.
Automatic re-basing to March 1982 value of assets owned on that date. This removes any option in relation to assets acquired before that date; it leads to the abolition of the so called “kink test”, which was always a great deal less exciting than it sounds. Also removed is so-called “halving relief”, which provided a measure of benefit where certain hold-over or roll-over reliefs had been claimed prior to March 1982.
The removal of many of the rules on UK settlor-interested trusts for capital gains tax, because both trusts and individuals will now be liable at the same flat rate.
These changes have a number of consequential effects. One very positive one is a very much simplified regime for identification of shares and securities of the same type. While the special identification rules for shares disposed of and acquired on the same day and those acquired within 30 days after a disposal will remain, shares of the same class in the same company will otherwise be regarded as coming from a single share pool, with an average acquisition cost for each share in the pool.
This reform is undoubtedly a great simplification and produces winners as well as losers. It would have been a greater simplification, although perhaps with serious political consequences, had the reform proceeded without the sop of entrepreneurs’ relief. Instead, there are 12 closely written pages of complex legislation with disturbing similarities to the former retirement relief for capital gains tax – a relief which continued to stimulate litigation long after its abolition.
Entrepreneurs’ relief applies to disposals made by individuals of: all or part of a trading business the individual carries on alone or in partnership;
assets of the individual’s or partnership’s trading business following the cessation of the business; shares in (and securities of) the individual’s “personal” trading company (or holding company of a trading group);
assets owned by the individual and used by his/her “personal” trading company (or group) or trading partnership.
Trustees can only claim jointly with a qualifying beneficiary where that beneficiary has an interest in possession in (effectively) the business (whether corporate or otherwise); and the business is or has been that beneficiary’s own business.
The relief works by charging 5/9 of gains up to £1 million – an effective rate of 10% on such gains. The £1 million is a lifetime limit, although it is not affected by disposals before 6 April 2008.
The period of ownership required is only one year. If the business has ceased, the disposals in question must be within three years of that cessation. (The definite extension to disposals after cessation is very welcome.)
The restriction to an individual’s personal trading company is significant and much more limiting than was the case for business asset taper relief. The individual must not only work for the company, but also hold at least 5% of its voting shares.
Clearly, the details of entrepreneurs’ relief will have to be addressed in relation to virtually every business disposal by an individual.
More generally, and in the medium term at the very least, the changes to the basic scheme of capital gains will make the tax much more significant. While the rate for higher rate taxpayers on non-business assets may have come down somewhat, it will not take long for that to be outstripped by the loss of indexation and taper relief – particularly if inflation continues to rise.
Alan Barr, Brodies LLP and University of Edinburgh