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Could Lib Dem plan to reform CGT actually work?

  • Lib Dems propose new CGT rates depending on the gains made 
  • Could CGT reform work and raise tax revenues?

Investors’ profits are in the cross hairs in the run-up to the election as a number of parties call for higher capital gains tax rates.

But despite rumours that Labour will stage a CGT raid, the Liberal Democrats are the only main party with a manifesto commitment to hike capital gains tax rates, from 10 per cent and 20 per cent now, to 20 per cent, 40 per cent and 45 per cent.

Yet, rather than simply raising capital gains tax rates to match income tax rates, the Lib Dems have a plan to radically overhaul the tax – and it could even save some long-term investors money.

So, is this a better way to deal with profits on shares, funds, property and other assets? We look at the Lib Dem capital gains tax plan in detail.

The Liberal Democrats pledged to shake up the capital gains tax system to help fund the NHS

The Liberal Democrats pledged to shake up the capital gains tax system to help fund the NHS

Why capital gains tax?

Increases to income tax, national insurance and VAT have been ruled out by both Labour and the Conservatives, with the Tories even promising to cut NI again.

Ruling out any increases in these headline taxes, makes it harder to balance Britain’s books. The Institute of Fiscal Studies says the next government will inherit the toughest outlook for the public finances in 80 years.

But while raising income taxes would be unpopular – particularly with the tax burden the highest since 1948 – further big cuts to public spending are also unpalatable to many.

This conundrum means parties often look to other taxes to pull in more, like inheritance tax or capital gains tax (CGT).

Capital gains tax rates are lower than income tax rates and profits from investment and property tend to be made by wealthier people, which makes them a prime target for a hike.

The Liberal Democrat manifesto has pledged higher spending and set their sights on reforming capital gains tax to fund some of that.

There is also increasing speculation that Labour could raise capital gains rates if it comes to power next month, having failed to rule out a CGT raid but pledged not to raise income taxes.

Crucially, however, the Lib Dems have laid out a detailed plan that involves: hiking capital gains rates; raising the tax-free threshold slightly – albeit still to a far lower level than it was two years ago; staggering rates based on the size of gain; introducing indexation; and splitting CGT from income tax completely.

For some long-term investors that could mean less capital gains tax to pay on profits. 

What are capital gains tax rates now?

The rate of capital gains tax depends on the income of an individual and the type of asset being sold, with different levels for residential property. People’s main home – their ‘primary residence’ – is exempt from CGT.

Capital gains tax is charged on annual profits on CGT liable assets made above a tax-free allowance of £3,000. This CGT tax-free threshold has been slashed from £12,300 over the last 18 months by Conservative Chancellor Jeremy Hunt.

Basic rate taxpayers pay 10 per cent capital gains tax on most assets and 18 per cent on residential property, ie buy-to-lets or second homes.

Higher rate and additional taxpayers pay 20 per cent capital gains tax on most assets and 28 per cent on residential property.

Sole traders and partners selling their business may be able to qualify for the lower Business Asset Disposal Relief rate of 10 per cent, up to a lifetime limit of £1million.

Something called ‘carried interest’ also shares higher CGT rates of 18 per cent and 28 per cent. This is generally a share of profits for fund managers when investments perform above a certain level.

When the annual capital gains tax allowance was higher at £12,300, not that many investors paid CGT. Buy-to-let landlords and second home owners selling up were more likely to be caught due to large profits all in one go.

But with the limit now dramatically hacked back, HMRC estimates that 260,000 more individuals and trusts will pay CGT for the first time by 2024/5.

The Institute for Fiscal Studies estimates that by 2028/9, revenue from capital taxes will have almost doubled since 2010/11, reflecting an increase in asset prices, as well as the introduction of the higher rate of CGT and lower allowances.

> How does capital gains tax work? When and what you have to pay 

What do the Lib Dems suggest for CGT?

The Lib Dems say that the capital gains tax system is ‘broken for everyone’ and want to introduce different rates of CGT depending on the size of the gain, which they believe could raise £5.2billion per year by 2028-9.

While the new rates would match income tax rates, they would detach capital gains and income from each other.

The Lib Dems said: ‘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.’ 

This is in contract to the current system which mixes two taxes by adding capital gains to other income to decide the rate paid.

The Lib Dems instead propose different CGT rates based on the size of annual profits above a tax-free threshold of £5,000 

They propose a 20 per cent rate for gains up to £50,000, 40 per cent for gains between £50,000 and £100,000, and 45 per cent for more than £100,000.

Crucially, the Lib Dem plan would also re-introduce indexation, which means only real gains above inflation would be taxed. 

The Lib Dems said: ‘Most people are paying far too much when they sell a property or a few shares, because the system doesn’t account for inflation over the time they’ve owned them.

‘At the same time, a tiny number of super wealthy people – roughly the top 0.1 per cent – exploit it as effectively one giant loophole, to avoid paying the rates of income tax everyone else does.’

Could the Lib Dem CGT plan save investors money?

Small investors selling shares or funds they have held for a long time could benefit from the Lib Dem plan. 

Those selling a buy-to-let or second homes could also pay less tax if they make a profit of less than £50,000 – or they have owned the property for a long time. 

Stocks and shares and other assets

Under the current system, basic rate taxpayers whose gains on stocks and shares don’t take them over the higher rate income tax threshold pay CGT at 10 per cent. 

Under the Lib Dem plan, the rate of capital gains tax that they pay would double from 10 per cent to 20 per cent – but they would be able to make up to £50,000 of taxable gains at that rate.

Higher rate taxpayers pay capital gains tax at 20 per cent on stocks and shares and under the Lib Dem plan they would still only pay that on taxable gains of up to £50,000.

Crucially, however, indexation means they could take into account inflation over the holding period. This means that an investor selling assets they had held for the last ten years could chalk up 33 per cent of gains to inflation. 

Buy-to-let, second homes, property investments 

Investors in stocks and shares have the ability to spread sales to stay within the tax brackets, but this is not possible for those selling residential property who almost always make all their profit in one go.

Those selling residential property but making less than £50,000 would pay the same 20 per cent CGT rate under the Lib Dems as a basic rate taxpayer does now. 

Property sellers would pay a lower rate under the Lib Dem plan if they are a higher rate taxpayer – as their current rate is 28 per cent.

Basic rate taxpayers with other income could theoretically pay less on a £50,000 gain, as their income and capital gain would not be added together to bump them up a tax bracket.

Those making more than £50,000 on a property would pay higher rates on the portion above that at either 40 or 45 per cent under the Lib Dem plan. 

CGT: How it works out 

The Lib Dem plan would mean that some investors paid more tax on profits and some paid less, it depends on the size of the gain, other income and how long the assets were held for.

For example: 

A basic rate taxpayer making a £15,000 stocks and shares taxable gain on assets held for ten years.

Current CGT rules: Gain of £15,000 taxed at 10% = £1,500

Lib Dem CGT: Taxable gain reduced to £10,000 by indexation, then to £8,000 by higher tax-free allowance, taxed at 20% = £1,600

A higher rate taxpayer making a £15,000 stocks and shares taxable gain on assets held for ten years.

Current CGT rules: Gain of £15,000 taxed at 20% = £3,000 

Lib Dem CGT: Taxable gain reduced to £10,000 by indexation, then to £8,000 by higher tax-free allowance, taxed at 20% = £1,600 

A higher rate taxpayer share trader making £100,000 profit in a year

Current CGT rules: Gain of £100,000 taxed at 20% = £20,000  

Lib Dem CGT: Taxable gain reduced to £98,000 by higher allowance, £50,000 taxed at 20% = £10,000; £48,000 taxed at 40% = £19,200; total tax = £58,000

A higher rate taxpayer buy-to-let landlord making a £200,000 profit on a property owned for ten years.

Current CGT rules: Gain of £200,000 taxed at 28% = £56,000

Lib Dem CGT: Taxable gain reduced to £134,000 by indexation, then to £132,000 by higher tax-free allowance, £50,000 taxed at 20% = £10,000; £50,000 taxed at 40% = £20,000; £32,000 taxed at 45% = £14,400; total tax = £44,400

 

Does CGT need reform? 

Given the state of the public finances, it is unsurprising that some parties are looking to CGT to plug the gap. 

The top tax rate on income and capital gains are different, which supporters say encourages more investment and growth.

Critics say it pushes high earners with the flexibility to do so to disguise income as capital gains and pay less tax, which is also often magnified by transferring assets to a lower earning spouse.

Jason Hollands, managing director of Evelyn Partners argues that there is a justification for capital gains tax being lower than income tax.

Capital gains are irregular, unpredictable and involve risk… this is why historically they’ve been taxed at lower rates than income. 
Jason Hollands, Evelyn Partners 

He says: ‘There is a fundamental difference between income and capital gains.

‘Income from work is usually fairly constant, largely contractual and often entails little risk, especially if it is from full-time employed work.

‘Capital gains are irregular, unpredictable and involve the commitment of capital and the taking of risks. This is why historically capital gains have been taxed at lower rates than income.’

The Lib Dems have not confirmed what they would do about entrepreneur’s relief, which is a major benefit to those who start up businesses and rewards the risk that they take. However, it is also used by the self-employed working as limited companies and rolling up profits before cashing out in the future. 

Rachael Griffin, tax and financial planning expert at Quilter says: ‘The potential alignment of CGT rates with income tax rates, if that is what ends up being enacted, could see rates rise dramatically, impacting not just the wealthy but also a substantial number of small business owners and investors who play a crucial role in driving the economy in the UK.’

The Lib Dem policy is mitigated by a modest increase in the annual exemption to £5,000. That’s more generous than the current £3,000 limit, but far lower than the relatively recent £12,300. 

Indexation would be a benefit to long-term investors but introduces complexity to the system that has not been there since taper relief was removed by former Chancellor Alastair Darling in 2008, with lower flat rates of capital gains tax brought in.

Taper relief  was introduced by his predecessor Gordon Brown to replace indexation. 

Charlene Young, AJ Bell’s pensions and savings expert said: ‘Whilst a proposed increase in the tax-free allowance and an inflation adjusted index would be welcome, the combined allowances would need to be closer to the previous high of £12,300 to gain support from private investors.

‘A survey with AJ Bell’s investors ahead of the Budget this year showed 68 per cent would support an increase in the CGT rate if it meant a return of the £12,300 allowance. 

‘Only 13 per cent favoured the Chancellor’s approach of cutting the CGT allowance to £3,000 (which was implemented as planned in April this year.

‘Talk of inflation indexing brings us back to the days of Nigel Lawson as Chancellor. And whilst some inflation protection is great in theory, it’s difficult for taxpayers to understand and plan for, and risks imposing further complication in a tax system full of traps already.’

The election manifestos: what they mean for you

The economy, tax and people’s finances are a cornerstone of the all the manifestos, but what are the main parties proposing and what could it mean for you? 

The This is Money podcast takes a dive into the manifestos to see what’s there. 

Press play to listen to the episode on the player above, or listen (and please subscribe and review us if you like the podcast) at Apple Podcasts,  Audioboom and Spotify or visit our This is Money Podcast page.  

Does raising CGT increase the tax take? 

Capital gains tax has had lots of attention but it doesn’t raise that much money and changes are unlikely to solve Britain’s budget problems.

OBR estimates for the current tax year, suggest CGT will raise £15.2billion, representing just 1.3 per cent of all tax receipts and equivalent to 0.5 per cent of national income.

An unlike income tax, increasing CGT rates doesn’t automatically increase tax revenues.

Capital gains are only made when someone chooses to dispose of an asset, so if CGT rates increase owners might be put off selling and hold onto their assets for longer.

Doubling CGT rates would not mean doubling tax receipts.

The IFS says that the Lib Dems’ proposed CGT reform is ‘sensible’, but it’s unlikely that its overall package of tax rises would be able to support its public spending.

Many argue that it could affect levels of investment and see a rush to sell ahead of any rates, having little affect on tax revenues.

Hollands says: ‘Higher CGT can act as a disincentive to invest, since the taxman will take more of the returns while the investor takes all the risk – and business investment is an area where the UK economy needs a boost.

‘It is also a headache for the process of investing outside of tax-wrappers such as Isas and pensions, since routine switches from one investment to another and periodic portfolio rebalancing, will potentially clock up tax liabilities as profits are crystallised.’

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