Capital gains tax – an explainer

This explainer is part of a series produced by CIOT for the 2024 general election

What is capital gains tax?

Capital gains tax (CGT) is a tax on the profit you make when you sell something - the ‘disposal of a chargeable asset’ to use the technical language.

While disposal usually means selling something it can also include giving it away or swapping it.  Other situations that count as a disposal include an asset being lost, stolen, damaged or destroyed or receiving capital sums in respect of an asset. Most things are chargeable (that is, within the scope of the tax), but notable exemptions include: your main/only private residence, cash, cars suitable for private use, plant and machinery owned for private purposes, and share ISAs.

Certain disposals (for instance to your spouse or to charity) are exempt from CGT.

The tax is calculated by deducting the purchase price (plus improvement and other incidental costs) from the actual disposal proceeds (or the market value in the case of gifts or where an asset is sold deliberately undervalued).

What are the current CGT rates?

First of all everyone has a CGT ‘annual exempt amount’ of £3,000 – total annual gains under this level attract no tax and usually require no reporting. This has been drastically reduced in recent years, from £12,300 in 2022-23 to £6,000 in 2023-24 and now to £3,000 in 2024-25. As a consequence hundreds of thousands more people have been brought into the scope of CGT (nearly 350,000 people a year predicted this report from the Office of Tax Simplification).

CGT rates are a bit complex. They currently range from 10% to 28%. If you are a higher or additional rate income tax payer 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 total taxable income (income minus personal allowance and taking into account any reliefs you’re entitled to) plus taxable gains (chargeable gains minus annual exempt amount) takes 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 is Business Asset Disposal Relief (formerly Entrepreneurs’ Relief) which lets you sell your business with a CGT rate of only 10% for the first £1 million of gains (this is a lifetime allowance).

Also worth knowing is that capital losses (selling something at a loss on what you paid for it) can be offset against gains in the same tax year or carried forward and offset against future gains.

How much does CGT raise?

The Office for Budget Responsibility estimates that CGT will raise £15.2billion in 2024/25. Whilst capital taxes such as CGT and inheritance tax raise comparatively small amounts compared to the main taxes (income tax, national insurance and VAT), they can still make a difference to a government’s spending options.

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 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.

Different governments have solved these issues in different ways.  Between 1988 and 1998 rates were aligned but there were special rules for inflationary gains and for losses.  Between 1998 and 2008 a “taper” relief was allowed reducing the rate of CGT depending how long an asset had been held.  But for most of CGT’s history, the compromise solution has been a simple, fixed, lower rate.

What changes are the Liberal Democrats proposing?

The Lib Dems have a number of proposed reforms of CGT:

• Higher rates – roughly aligned with those for income tax. There would be three rates: 20% (for gains up to £50,000), 40% (between £50,000 and £100,000) and 45% (over £100,000). Unlike now, where your CGT rate is determined by adding together your income and capital gains, the rate would be based solely on your gains
• A higher tax-free allowance of £5,000
• A new “inflation allowance”, so that any gains that are purely the result of inflation are not taxed at all
• A targeted relief for small businesses

They anticipate that these reforms would raise £5.2 billion a year in 2028-29, which they would spend on health services.

What is the case for these changes?

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 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.

Increasing the tax-free allowance to £5,000 would benefit, in particular, those individuals with small amounts of investments, saving them the need to report CGT as well as pay it. A concern of CIOT and our Low Incomes Tax Reform Group has been that such a drastic reduction in the allowance from 2023 will catch many such investors unaware, as well as adding to the administrative burdens on both taxpayers and HMRC.

An inflation allowance for individuals was in place as ‘indexation relief’ until 1998 (it was then frozen before finally being abolished in 2008). As many capital assets will be held for a long time, inflation will gradually erode the effect of someone’s purchase price. Providing for relief against indexation offers more of a level playing field and can be seen as a move towards greater fairness.

What is the case against?

By significantly increasing the rate of CGT, there is an argument that the incentive for investment within businesses and the economy will be reduced; as well as a decent rate of return, any investor is looking for an efficient exit strategy. By increasing the rates, both of these factors will be affected, and this needs to be factored into the tax yield.  Higher rates of CGT in the past also encouraged individuals with large capital gains to leave the UK before realising them.

Increasing the tax-free allowance, having just reduced it, would create a degree of uncertainty amongst investors. With thresholds and rates changing year after year, uncertainty can unnerve investors as much as tax increases.

An allowance for inflation will slightly undermine the expected increased tax yield.

What have the other parties said about CGT?

The Green Party say they favour “aligning the rates paid by taxpayers on income and taxable gains”. Plaid Cymru say they would “equalise capital gains tax with income tax”. Both, on the face of it, similar policies to the Lib Dems, though both think they could raise significantly more - £12-15 billion a year in the case of Plaid and £20 billion a year by 2029 in the case of the Greens. This suggests they would retain the current system (with no inflation indexation), just with higher rates.

The Conservatives have pledged not to increase CGT rates if re-elected and promised to maintain Private Residence Relief and Business Asset Disposal Relief. They have also said they would introduce a two-year temporary CGT relief for landlords who sell to their existing tenants.

Labour have made no commitment on CGT rates, saying only that they have “no plans” for further tax increases beyond those set out in their manifesto and that nothing in the party’s plans requires additional tax to be raised. They have said they would keep Private Residence Relief.

One of the proposals in Labour’s manifesto does relate to CGT – they would make ‘carried interest’ subject to income tax rather than CGT.

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

Private equity fund managers, operating within a partnership, will buy companies using borrowed funds. ‘Carried interest’ is the name given to a manager’s partnership profit share, though it is usually deferred until certain performance conditions are met – usually once those loans are paid off. 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.

This is because, 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 the case for this change to treatment of carried interest?

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 confined to capital appreciation of an asset – so, a profit share is usually taxed as income, so by bringing these payments 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?

Conservative ministers have argued both that carried interest is a capital gain (not income) and that taxing it more highly (whether as income or by raising CGT rates) would lead to the loss of the private equity industry to other countries.

Then Treasury Minister David Gauke argued 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 … Bringing carried interest into income tax could raise more initially, but over time the yield would disappear as the industry moved to more competitive jurisdictions.”

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