Capital gains tax - a pre-Budget explainer

This explainer has been produced by CIOT ahead of the Budget on 30 October 2024.

What might we see in the Budget?

Changes are widely expected in the tax treatment of ‘carried interest’ (which was in Labour’s manifesto) and in the rates of capital gains tax (CGT) on some, but not all assets (shares but not second homes, according to The Times). There are also reports that Business Asset Disposal Relief will be scrapped.

Less likely, but still within the bounds of possibility, are expansions in the scope of CGT to remove CGT uplift on death and/or, via the introduction of an ‘exit tax’, to capture gains made by people who emigrate from the UK.

Also talked about sometimes, but considered very unlikely, are an attempt to collect CGT on unrealised gains and placing CGT on people’s main homes.

All of these would, to varying extents, be aimed at raising additional revenue for the Exchequer.

We explore each of these in more detail below, starting with carried interest.

CARRIED INTEREST

What is ‘carried interest’? And why is it subject to CGT?

Private equity fund managers, operating in partnership with investors, buy investments – usually shares in private companies. ‘Carried interest’ is the name given to a manager’s partnership profit share, usually on excess returns above the expected (“hurdle”) return. Any separate fixed management fees received will be taxed as income, but the performance-linked/profit-related ‘rewards’ in the form of partnership shares are only subject to CGT. Usually this is at a rate of 28%.

In May 1987, the then-Inland Revenue agreed with the Taxation Committee of the British Venture Capital Association, that these managers’ profit shares were to be taxed as capital, rather than a revenue profit share. The understanding was that the ‘Limited Partnership’ which holds company shares as an investment and so general partners’ share of profits is not deemed as trading income.

What is likely to happen to carried interest in the Budget?

This is less clear than it seemed at the election.

Back in July Labour’s manifesto made clear that, if elected, the party would tax carried interest as income at the appropriate marginal rate (which would typically be 45% - plus national insurance - given the sums involved). It stated: “Private equity is the only industry where performance related pay is treated as capital gains. Labour will close this loophole.” Labour estimated that closing what it called the ‘carried interest tax loophole’ would raise £565 million a year by 2028-29.

Rachel Reeves clarified during the election campaign (in an interview with the Financial Times) that Labour would exempt fund managers who put their own capital at risk from the change. But she emphasised that most carried interest would still be taxed as income.

However more recently there have been reports that the chancellor is looking for a more far-reaching “compromise” on this policy amid warnings that the full advertised change would put the UK’s competitiveness at risk. Quoting ‘government insiders’ the paper suggests private equity managers will not be taxed at the full 45% tax rate on carried interest.

Shortly after the election, a broad ‘call for evidence’ was launched by HM Treasury on the tax treatment whereby the case for reform (though not expressly calling for the taxing of carried interest as income) was put forward, with opinions sought as to the significance of the current treatment with respect to the economy and other countries’ rules. The CIOT’s response urged the government to consider the international position before making any changes.

What is the case for taxing carried interest as income?

It is argued that it is an anomaly that profit shares from a partnership derived from actively managing investments are taxed as capital rather than income. CGT is a tax on the capital appreciation of an asset, thus a profit share is usually taxed as income, so by bringing carried interest within the scope of CGT, a perceived unfairness would be addressed.   Whether the 1987 agreement with the BVCA represents the law or a concession on the Inland Revenue’s part has never been tested in the courts.

And the case against?

First there is the pragmatic argument. While carried interest is a fairly narrow tax-base affecting relevantly-few taxpayers (c.3,000) there are concerns about what effect higher taxes on carried interest will have on investment within businesses and the private equity market, and about the possible loss of business to the US and mainland Europe as managers leave the country.

There is also an argument that carried interest genuinely is a capital return for risk-taking. Conservative ministers argued this before the election. For example Treasury Minister David Gauke said in 2015: “carried interest is a reward for a manager that is linked to the long-term performance and growth of the funds they manage. They are therefore capital in nature, and should continue to be charged capital gains tax”.

An entrepreneur with a good idea may set up a company with very little capital and become a shareholder in that company.  If, through the hard work of the individual, the idea is developed and the company does well, the individual’s shares increase in value.  When those shares are sold, this is clearly a capital gain.  The argument for carried interest being taxed as capital is that private equity executives effectively take the same risk as such an entrepreneur – committing time and effort in return for a super-profit over and above their normal “salary”.

CGT RATES

What are the options for changing CGT rates?

There are lots of possibilities here, as CGT rates are a bit complex.  One also needs to consider how much gain the rate applies to (the “tax base”). Rates currently range from 10% to 28%. If you are a higher or additional rate income taxpayer you pay CGT at 20% on your gains (24% on residential property, 28% on carried interest). If you’re a basic rate taxpayer only you pay at 10% (18% on residential property or carried interest) unless your gains tip you over the threshold for paying the higher rates.

There are separate rules for trustees and executors of estates and various reliefs of which the most notable are Business Asset Disposal Relief (formerly Entrepreneurs’ Relief) and the exemption for your main residence.

One possibility is that CGT rates could be aligned with those for income tax (as was the case between 1988 and 1998. This could mean capital gains are taxed at one’s marginal rate of income tax (as it was prior to 1998) or that gains have their own bands akin to income tax (as proposed by the Lib Dems prior to the election).

Alternatively the chancellor could keep the existing different rates for different types of gains (or even add to them), putting one or all of them up by a smaller amount.

What do we expect?

At time of writing, the latest rumours, as reported in The Times, suggest that the Chancellor will raise the main rate of CGT (the 10%/20% one covering shares and other assets) by “several percentage points” but will not change the rate for residential property, keeping it at 18%/24%.

If the government is looking for a compromise (as indicated above) in the treatment of carried interest it seems likely they will simply decide to raise the carried interest rate of CGT by a few percentage points from its current 18%/28%.

What are the main differences between how we tax income and capital gains?

Income tax is a direct and annual tax upon revenue, i.e. someone’s regular ongoing income from employment, self-employment, investments. CGT is a capital tax which only relates to disposals of capital assets, so is a one-off charge based on any transactions in a year, rather than recurring.

One thing this means is that while most of us don’t have much (if any) flexibility to shift our income between tax years, if we are selling something at a gain (such as shares, a second home or a valuable antique) we may be able to choose when to sell it to minimise our tax exposure.  Ways to do this include making maximum use of our annual exempt amount (though this is less important since it’s been reduced); choosing a year when CGT rates are lower – that is by selling ahead of any proposed increase or delaying ahead of any expected cut; or by timing gains so that they coincide with losses on other assets.

Why is there a difference between rates taxing income and capital?

At times in the past – for instance between 1988 and 1998 – the headline rate of CGT has been the same as the rate of income tax.  However, for most of the time since CGT was introduced in 1965 the rates have been lower.  There are three broad reasons for this:

• First, it is widely recognised that gains caused solely by general inflation shouldn’t be taxed.
• Second, assets can make losses as well as gains – and it is again generally recognised that tax should only be applied to the overall position (gains net of losses).  If gains are charged at the same rates as income, it becomes harder to justify why losses shouldn’t be set against income too.  But allowing this would give scope for careful timing of losses to reduce a person’s income tax liability!
• Third, it is often argued that lower CGT rates act as an incentive for investors and offer a reward for their risk-taking, as well as to encourage economic growth generally.
• Fourth, those making capital gains, and who pay the most CGT, are typically wealthier individuals. And it is sometimes said that those with the broadest shoulders also have the longest legs - that is that they can more easily move abroad before realising their gains. Remaining internationally competitive is therefore more important with CGT than with most other taxes.

What is the case for taxing capital gains at similar rates to income?

In broad terms it is that capital gains and income are indistinguishable:  they are both simply profit: if an asset increases in value by £100,000 between you buying and selling it you have earned £100,000 of profit. Why should you not be taxed on this like any other profit such as earnings?

Calls for aligning CGT with income tax are not new. Before his 1988 budget, Conservative chancellor Nigel Lawson said: “in principle, there is little economic difference between [earned] income and capital gains ... And in so far as there is a difference, it is by no means clear why one should be taxed more heavily than the other”. In Lawson’s 1988 budget, the income and CGT rates were aligned and stayed like that until 2008, albeit from 1998 onwards with taper relief available which was especially generous for business assets. So, this would not be without precedent.  Aligning the CGT and income tax rates would also ensure there is no advantage in making efforts to disguise revenue income as capital.

The argument that gains resulting from general inflation should not be taxed can be dealt with by some form of indexation or taper relief.

What is the case against?

This has two elements: the principled argument that capital gains are not (generally) income, and the pragmatic argument that it will damage the economy (by restricting entrepreneurship and encouraging emigration) and public finances in the long (and perhaps also the short) term.

Some differences between gains and income are set out above, but a key one is that gains are usually uncertain and involve an element of risk whereas income is guaranteed in return for the work or other service provided.

Another argument is that significantly increasing the rate of CGT will reduce the incentive for investment within businesses and the economy. As well as a decent rate of return any investor is also looking for an efficient exit strategy. By increasing the rates, investors, both within the UK and from abroad, will have less of an incentive to invest in UK businesses.

Additionally, high rates of CGT encourage individuals with large capital gains to leave the UK before realising them, or simply to hold on to their assets and not dispose of them. Both of these behaviours may reduce the yield.

HMRC’s Direct effects of illustrative tax changes indicates that the tax authority think that while small increases in CGT rates would raise some money, big increases would lead to a fall in revenue. (Though some observers, such as the Institute for Fiscal Studies, question this assessment.)

BUSINESS ASSET DISPOSAL RELIEF

What is Business Asset Disposal Relief?

This is the tax formerly known as Entrepreneurs’ Relief. It allows someone selling a business to pay CGT at only 10% on the first £1 million of qualifying gains in one’s lifetime.

In 2020, at the same time as the relief was rebadged, the lifetime allowance was reduced from £10million to the current £1million, severely blunting the effectiveness of the relief, effectively abolishing it for those who had already made more than £1million of qualifying gains.

What do we expect to happen to it?

Latest reports are that the chancellor is going to scrap it.

What is the case for scrapping it?

The relief has plenty of critics. A few years back the Resolution Foundation said it was “expensive, ineffective, and regressive” and labelled it “the UK’s worst tax break”. Sir Edward Troup, former chair of HMRC, is another who has called for it to be scrapped.

In a paper published on 6 October 2024 the Institute for Fiscal Studies argued that the relief “is not well targeted at entrepreneurship … and leads to a range of undesirable distortions”. However they warned that scrapping the relief in isolation would come with trade-offs: “distortions caused by rate differentials would be lessened … but distortions related to the base would be worse (a higher rate would weaken investment incentives and exacerbate the bias against risk-taking and the lock-in effect).” So they advocate replacing the relief with up-front tax relief for investment in shares. “The new up-front relief could be thought of as a replacement for BAD relief – a reorienting away from tax relief on large gains to tax relief on investment,” say IFS. 

And the case for keeping it?

Entrepreneurs have claimed that higher capital gains tax – including the scrapping or curtailing of business asset disposal relief – would harm investment, stifle growth and potentially end up costing the Exchequer money.

In an open letter to the Chancellor, 500 entrepreneurs (including the founders of Signal AI, Yonder and Zopa), said that: “Higher CGT or any restrictions on BADR would make this relief less competitive at a time when the rest of the world is making their reliefs more competitive. It would mean the UK has the second-highest CGT rate in Europe, and jeopardise the success of our country’s startup ecosystem by enormously weakening the incentive individuals have to build businesses.”

“Policymakers should also understand that entrepreneurship is an engine for further economic growth,” the letter continues. “By discouraging entrepreneurs from starting and growing their businesses, HM Treasury could well end up lowering the tax take overall. Indeed, this is what its own previous modelling suggests.”

As well as the economic arguments the optics of scrapping this relief without replacing it with alternative incentives for entrepreneurship and business investment could undermine the government’s claim that ‘kickstarting economic growth’ is one of its key missions.

OTHER POSSIBLE CHANGES

Could there be changes to CGT in relation to death?

When someone dies, there is no CGT chargeable on their estate, and when a beneficiary of the estate is bequeathed an asset, they receive it at ‘probate value’ i.e. the value at the date of death which acts as their base cost going forward for CGT purposes. If they subsequently sell their asset CGT is only charged on any post-death increase, meaning the deceased has escaped paying CGT on the value of their asset in their lifetime.

There are a number of ways the chancellor could act to address this:

1. CGT replaces inheritance tax on death. This would be a massive change and need a wholesale rewrite of tax law.  Proponents argue that by only taxing unrealised gains, the unfairness of IHT (in re-taxing already taxed income) is removed.  However, in only taxing gains, it would inevitably raise less than IHT – even if one were to strip out the current £325,000 tax-free amount – so is very unlikely to happen.
2. CGT in addition to inheritance tax on death - chargeable at the point of death as if the asset had been sold by the deceased at that point and payable by the beneficiary alongside inheritance tax.
3. No CGT uplift on death. No immediate CGT charge on death, but the gain would roll forward so would be charged on a disposal after death by the heirs or executors.
4. No CGT uplift on death for assets that qualify for inheritance tax relief (spouse exemption, business and agricultural property reliefs). This was proposed by the Office of Tax Simplification in a report in 2020.

Of these the third and fourth seem more likely.

The arguments for this change are that the current rules are anomalous, open to abuse and encourage people to hold on to assets they don’t need or use to avoid a big tax bill. The most common argument against is that if you add CGT to inheritance tax some estates would face very high overall taxation rates.

The IFS explore this possible change in greater detail in their recent paper.

Could there be an exit charge for people who leave the UK?

Currently there is no CGT ‘exit charge’ on individuals who leave the UK, so someone with a large amount of capital gains accumulated while resident in the UK can leave the country and almost immediately dispose of the asset somewhere with low or no CGT. Equally if you move to the UK and dispose of an asset you are taxed by the UK on your full gain since you acquired the asset (even if most of that accrued while you were living abroad).

The proposal here (for example from CenTax) is that a charge should arise through a ‘deemed disposal’ of your assets when you leave the UK (with a revaluation having taken place when you arrived). This would mean latent gains, which have arisen whilst an asset’s owner is in the UK, are always taxed. Whilst this may be effective for those investors already in the UK, it might heighten concerns that such a change will dissuade subsequent inward investment into the UK and discourage wealthy individuals from coming to the UK in the first place.

Might there be any other surprise announcements?

There is always the possibility of surprises and changes not subject to speculation. Rumours always abound!

A reform favoured by some campaigners is annual taxation of unrealised capital gains i.e. taxing the increase in the value of an asset when there has been no disposal of it. In the US President Biden has put forward a plan to do this in respect of those with a net wealth of $100million plus, and his potential successor Kamala Harris has endorsed it. There are a number of potential problems with this, including the challenges of annual valuation and the difficulties of levying a ‘dry’ tax charge, and there has been no suggestion so far that such a change will happen in the UK, but if it is introduced in the US, no doubt its outcome will be closely monitored here.

Principal Private Residence relief (PPR), giving a CGT exemption on the sale of your only/main home, is by far the most expensive relief to HM Treasury, especially given house price rises over the last 20 years. Therefore, objectively-speaking, this would be a prime target for reform – but to quote Sir Humphrey, making any changes to PPR would be ‘very courageous’ for any politician!

Finally, the CGT annual exempt amount has been cut from £12,300 in 2022-23 to just £3,000 in 2024-25. One effect of the change is to increase significantly the number of people who need to file a tax return (or a property disposal return), adding to the burden on both taxpayers and HMRC. While money is tight it is possible that alongside an increase in the rates and/or scope of CGT we could see partial compensation in the form of an increase in the exempt amount, perhaps back up to its 2023-24 level of £6,000.

This explainer was written by:
Chris Thorpe, Technical Officer, Chartered Institute of Taxation
John Barnett, Chair of Technical Policy and Oversight Committee, Chartered Institute of Taxation
George Crozier, Head of External Relations, Chartered Institute of Taxation