Capital Gains Tax: Following Uncle Sam and What It Means for UK Entrepreneurs

Rarely does a day go past without tax reform rearing its head in a daily financial news bulletin. In particular, continued talk of a capital gains tax (CGT) reform in the UK has been widespread and resounding for some time. In the wake of the unprecedented, but necessary, public spending throughout the pandemic, the Treasury will certainly need to find ways to reduce the deficit and rebalance the UK’s finances.

Some predicted that Chancellor Rishi Sunak might put in place CGT reforms in the Spring budget in March. He didn’t, and neither was there any mention of it on so-called “Tax Day” (23 March).

Since then, President Biden has set out plans to nearly double capital gains tax for wealthy Americans, with tax rates set to soar from 20% to 39.6% for those earning more than USD 1 million (mn) a year from investment income. With the UK generally following the U.S. over time on tax policy, the question now is “when?” and not “if?” the UK will follow in the footsteps of our American cousins. It could be only a few months away, in Autumn this year.

It is unlikely to be a controversial reform to the majority of the UK population, given that an increase in CGT is only estimated to impact a small percentage of the population. Of course, there may be a flight risk in imposing significant tax increases on the wealthy, which could itself lead to reduced investment and lower tax revenues. But there is increasing worldwide public awareness and discourse over the unequal distribution of wealth and the ever-widening gap between the rich and less well-off. This increasingly puts pressure on government policy, and in turn, on wealthy individuals.

Careful navigation through these difficult decisions in the months and years ahead is the order of the day for the chancellor, and the UK’s owner-manager community will be watching closely.

Potential Changes to CGT

The Office for Tax Simplification’s (OTS) review of the CGT system carried out in July 2020 is a good place to start when considering the potential impact of the reform. It found that the CGT system could be made simpler and fairer by:

1. Aligning CGT rates more closely to income tax rates
2. Reducing the CGT tax-free allowance
3. Removing the “CGT uplift” on inherited assets
4. Reassessing existing CGT reliefs

The realignment of CGT rates to income tax is an obvious place to start. The removal of the distinction between assets and property and an overall increase in rates is likely. There may be a gradual increase in rates to soften the initial blow or a threshold above which higher rates of CGT kick in.

There may also be a reduction of the existing CGT annual exemption of GBP 12,300, down to a lower sum, potentially between GBP 2,000 to GBP 4,000. This could be accompanied by further exemptions on personal items for individuals, but that will be of no benefit to business owners. Again, there may be a gradual downward tapering of the exemption to make the pill easier to swallow.

The so-called CGT uplift on inherited assets may also potentially be a victim of the chancellor. Currently, an individual that inherits an asset, for example, a shareholding in a family business, who then goes on to sell it for a profit is subject to CGT. This is based on the difference between the value of the asset when they inherited it and subsequently sold it, as opposed to the original price the deceased bought it for. This “CGT uplift” can significantly reduce the amount of CGT to be paid. However, the removal of the uplift could make holding on to such an asset less attractive and give rise to alternative tax planning during the shareholder’s lifetime.

Business Asset Disposal Relief (the renamed Entrepreneurs’ Relief) has already seen the lifetime limit reduced from GBP 10 mn to GBP 1 mn in the 2020 Spring Budget. There could be further tweaks to qualifying criteria, the 10% rate could be increased, or more controversially, the relief could be abolished altogether.

Although the measures remain uncertain, the direction of travel ahead for CGT reforms will undoubtedly erode some of the upsides of entrepreneurship.

And, in some scenarios, it may be that business owners looking to maximize value accelerate their exit plans now in anticipation of CGT reform.

So, Is Now the Time to Call It a Day and Wind Things Up?

The current CGT rules allow a tax-efficient exit for a business, although that window of opportunity is narrowing.

The exit of the business owner tends to happen through a trade sale, private equity investment, management buyout, or the (increasingly popular) employee ownership trust (EOT).

However, another less complex mechanism for exiting a business and generating a capital receipt involving a distribution of capital is via the members’ voluntary (solvent) liquidation process. Being a distribution of capital, the proceeds will be taxed at current CGT rates and subject to eligibility, qualify for Business Asset Disposal Relief.

Whilst we will always recommend seeking HMRC clearance to confirm the business owner’s tax position, the basic tax position is that distributions made during a winding up are capital, not income, thus the shareholder is treated as having made a disposal of his or her shares in return for the amount distributed.

When applying for HMRC clearance, a business owner would also be seeking confirmation that the targeted anti-avoidance rules (TAAR), which aim to combat cases of “Phoenixism” do not apply to distributions made in the process of winding up of a company.

For completeness, “Phoenixism” is a practice where a company is liquidated, and subsequently, its business is carried on under the same or broadly the same ownership via a new entity within a prescribed time frame. These rules were introduced in 2016 and, if applicable, will tax any proceeds received via a liquidation distribution as an income and not a capital receipt. Obviously, this is not an issue if the purpose of entering into a members’ voluntary (solvent) liquidation process is due to the owner calling it a day!

In summary, the members’ voluntary (solvent) liquidation process should not be overlooked as an effective means to triggering a capital receipt. We fully expect an increase in enquiries from business owners and their advisors as the race to exit and extract value from their businesses intensifies in the months ahead, with the shadow of CGT reform looming large once more.

Our Corporate Simplification team’s experience working with shareholders to maximise their returns tax, cost effectively and expediently puts us in pole position to help you and your clients implement their business exit. As ever, early consultation is recommended to ensure desired timelines are achieved.