Well done! You’re a successful investor, with serious capital gains to prove the point. What a shame a big chunk of it will have to be handed over to the taxman. But before you resign yourself mentally to knocking off a big slice of your profits, there are things you can do to reduce the amount you have to pay.
Below, we we look at how to deal with the specific issue of big unrealised gains that have built up over a number of years, and list the easiest ways to regularly trim a CGT liability.
Tackling big gains
‘I’ve built up a significant CGT liability and now avoid doing anything with the holding.’ ‘I use my own and my wife’s allowance every year, and I sell loss makers to offset gains. Now I am left with the most successful investments and reorganising the portfolio without incurring a large tax bill is difficult.’
These are typical and common laments among investors, who despite their best efforts to keep capital gains tax on a tight rein, often find that a tax liability has run away with itself and is difficult to control. What can you do?
Biting the bullet
The first rule investors in this situation should follow is to ignore the tax liability and judge the holding and its place in the portfolio as they would any other share. Admittedly, that may not be easy to do when you’ve run out of tax-relieving options and the tax rate is 28 per cent but it may be in your best interests to take some of the holding off the table and pay the tax if it represents an especially large chunk of your portfolio.
Focus on the risk you are taking by staying invested, and conjure up the worst-case scenario. Danny Cox at Hargreaves Lansdown recalls advising ex-Lloyds bank managers in the late 1990s who had built up substantial shareholdings in Lloyds (then priced at £7 a share) and were reluctant to sell due to capital gains tax. “The financial crisis was unexpected but the principles of not holding all your eggs in one basket holds true. The Lloyds share price is about 74p today but few took my advice to sell to diversify and spread their risk,” he says.
You should be holding the share for investment reasons not just tax. But if you decide to sell, what you do with the money is just as important. “Go back to investment principles, and if you decide selling is the right answer, think about where the proceeds will be going. If you use them to pay off debt, that might be a sensible use of the money. If you’re simply going to take it out of one UK blue chip and reinvest it in another, there’s clearly little point in realising the tax,” says Mr Cox.
You can snip away at the tax bill by using all the tactics outlined below, such as splitting the assets with your spouse/civil partner; using your annual exemption and any available losses; timing the sale to when your taxable income is low or using the proceeds to reinvest in high-risk tax-efficient schemes.
A second option is to simply wait. If you don’t have a good reason for selling the CGT-laden holding right now, then don’t. Tax is only payable on realised gains, not values. By waiting, you could benefit in future if tax laws change, and there’s no reason to assume capital gains tax laws will stay as they are for ever. A new lower, or higher, flat rate could be introduced, with, in the case of a higher rate, the reintroduction of indexation which should benefit anyone who has held shares for a long period.
There can also be tax advantages to waiting. You might qualify for a lower rate of CGT. And on death capital gains tax liabilities are wiped out. The holding(s) will be included in the deceased’s estate for inheritance tax (IHT) purposes and there may be IHT of 40 per cent to pay on the whole value or part of it. Clearly, a 40 per cent tax hit is more than the top rate of CGT, but even so, there are circumstances where the family of someone who chooses not to crystallise a CGT liability prior to death would be better off.
Let’s look at such a situation, that of ‘Mr Smith’, who owns shares worth £100,000 originally purchased for £50,000. His wife has died some years before and the value of their joint estate is well in excess of the combined IHT thresholds.
In one, Mr Smith sells the holding and at the end of the tax year, he pays CGT of £10,920 – ie, £50,000 less the annual exemption of £11,000 at 28 per cent. The funds remain as cash in his estate. A year later he dies, and the net cash in his estate is subject to inheritance tax. Mr Smith’s estate would incur IHT on that portion of £35,632 – ie, £100,000 less the CGT of £10,920, taxed at 40 per cent. The total tax paid on the £100,000 holding is £46,552.
In another Mr Smith does not sell the holding prior to his death and the estate pays inheritance tax of £40,000 on the holding of £100,000. His children inherit the shares with a CGT base cost of £100,000. If Mr Smith’s children sell the shares a month later for £100,000, the capital gain is nil. The total tax paid on the £100,000 holding is £40,000.
Therefore, scenario 2 produces a better overall result in this example.
Where one spouse has a reduced life expectancy, it can make sense to transfer assets to that spouse. That’s because any CGT liability will be wiped out on their death and the surviving spouse can either sell the shares free of tax or use their valuation at the time of the spouse’s death as the new base for calculating CGT in future.
But tax law is a minefield and professional advice should always be taken. If Mr Smith had survived for at least seven years after the share sale, he could have avoided IHT entirely. Nimesh Shah at Blick Rothenberg points out that in scenario 1, Mr Smith could have either gifted the shares to his children or sold the shares and gifted the cash, and if he then survived for seven years after making the gift, there would be no inheritance tax to pay. In this situation, payment of the capital gains tax would have been the most tax-efficient option.
Keeping CGT at bay: a checklist for investors
As a general rule, you should pay attention to capital gains tax as you go along, for example, as the end of each tax year approaches. The tax issue should never drive your decisions, but long before April dawns you should be fully aware of all the gains and losses you have crystallised in the previous 12 months, along with other risers and fallers in your portfolio. Armed with this information, you might be able to move your holdings around to your advantage.
Isas can help – but can hinder too
On the face of it, using the individual savings account (Isa) tax shelter seems like an obvious solution for dealing with capital gains tax. After all there is no CGT to pay on gains made within an Isa, which now has a generous £15,000 annual individual allowance, meaning a married couple can shelter £150,000 of holdings every five years.
For every £50,000 of gains you make in an Isa, you save £14,000 in higher-rate CGT. There will be tax savings on dividends received, too. But now that it’s possible to put high-growth Aim shares into Isas, deciding which shares to shelter and which to leave outside at risk of a tax raid, is slightly trickier. Income tax rates are higher than capital gains tax rates, so if you have lots of good dividend payers it might make sense to reserve the shelter for your income producing shares.
“Generally speaking, the rate of capital gains tax paid is lower than the rate of income tax you pay since gains within the annual capital gains tax allowance are tax-free and you have the option to defer gains, which you rarely can do with income. For these reasons it is usually better to shelter income-bearing investments in Isas rather than those geared specifically for growth,” says Danny Cox.
A second point is that if you fill your Isa with high-risk growth shares, you run the risk of suffering losses, but losses within an Isa cannot be used to reduce taxable gains made outside the Isa. So in an Isa, losses are wasted.
On the other hand, if you reduce this risk (of losses) by selecting your safest growth shares, there may only be small gains to shelter, in which case you might not be getting the most out of the shelter.
But it’s also worth remembering that Isas have saved many investors, now sitting on million pound-plus portfolios, from big capital gains tax bills.
How you use your Isa is a call only you can make.
Use your annual exemption
Each individual can currently make tax-free gains of up to £11,000 each tax year (the annual exempt amount, or AEA), but if you don’t use it, you lose it.
If you haven’t used your annual exemption naturally through exiting a position or pruning back a holding, then make effort to do so before 5 April each year.
While you cannot sell shares then buy them back immediately and deliberately to realise a gain or a loss – the 30-day rule (http://www.hmrc.gov.uk/cgt/shares/find-cost.htm) would simply mean that you would be deemed to have sold the shares that you then repurchased with no recognition of a ‘real’ gain or loss it is still possible to sell shares and continue to have exposure by buying them back in one of the four ways outlined below.
1. Buy the shares back after 30 days: This allows you to create a gain or a loss, but you run the risk the share price will move against you.
2. Bed and Isa: sell shares up to the AEA then buy them back into your Isa where they will be protected from capital gains tax in future
3. Bed and spouse: sell shares up to the AEA while your spouse buys the same amount of shares on the same day.
4. Bed and pension: Use your pension to buy the shares back.
Offset gains against tax losses
Losses are painful but they are also a useful way of cutting your capital gains tax bill.
Losses, and shareholdings that have become worthless, can be set against gains to reduce or wipe out your taxable amount. Arrange your gains and losses carefully, though, because if you have gains and losses in the same tax year, losses have to be applied in full in that tax year up to the amount of your total gains. That might mean you waste that year’s annual exempt amount. So, if possible, your gains should be equal to your losses plus the AEA. If your gains are greater than that year’s loss and the AEA combined, or if you only have gains, you can use previous years’ losses – and in this case, you only have to use just enough of the losses to reduce your gain to the annual allowance. See http://www.hmrc.gov.uk/cgt/intro/losses.htm.
If you don’t use the loss, it can be carried forward indefinitely. But you have to declare the losses in your tax return. “If you forget to mention it you have four years in which to claim a loss. If you don’t do it by then, it’s lost for good,” says Mr Shah, who also recommends adding a note to each tax return until you finally use the loss.
Reduce your taxable income
If you can reduce your taxable income, then your CGT rate could fall to 18 per cent. If you are nearing retirement, for example, your income might be expected to drop considerably.
Making a pension contribution will also reduce your taxable income.
“Effectively, your basic-rate tax band is increased by the amount of the pension contribution, meaning larger gains might be realised before the higher rate of capital gains tax is payable. For example, a pension contribution of £3,600 will extend your basic-rate tax band from £41,865 to £45,465. Providing your taxable income and gains are less than £45,465 in this tax year, you will pay capital gains tax at 18 per cent and none at 28 per cent,” says Mr Cox.
Even small changes to your income could mean that all your liability or even just part of it could be taxed at the lower rate. If your capital gains when added to your taxable income fall within the basic-rate band, you will pay the 18 per cent tax rate. If when added to your taxable income, they fall into the higher rate or additional rate tax band, you will pay 28 per cent. The diagrams on pages 23 or 22 shows how your gains will be treated depending on the level of your income.
Move abroad for at least five years
If you are non resident in the UK for at least five full tax years and you sell shares during the time that you live abroad, your gains will not be liable for CGT in the UK. However, they might be liable for a similar tax in your new country of residence.
Use reinvestment reliefs
Investors who back small and start-up companies, are rewarded with tax breaks, and these can be particularly useful for investors with CGT liabilities. There are two schemes: EIS and Seed Enterprise (SEIS). Both offer income tax breaks as well as CGT ones. With EIS, you can defer paying a capital gains tax bill by investing that money into an EIS. You have to stay invested in the scheme for three years but any new gains are entirely exempt from capital gains tax. When you dispose of your EIS shares, the original capital gains tax bill has to be paid. The risk is that you could lose your initial investment. “Safe bets aren’t allowed,” says Mr Shah.
SEIS is newer and offers more generous reliefs but the risk is higher. You can exempt 50 per cent of your capital gains so they never come back into charge. In both cases if the investment fails, you should be able to claim income tax relief as long as certain conditions are met. Read more at http://www.hmrc.gov.uk/seedeis/index.htm, http://www.hmrc.gov.uk/eis/part1/1-2.htm and http://www.investorschronicle.co.uk/2014/02/14/funds-and-etfs/vcts-and-eiss/i-love-vcts-uEa4FGCIS4jmgHYZsf4cPJ/article.html.
Transfer assets to your spouse
Transferring assets to your spouse doubles your AEA to £22,000 a year, and might mean a lower tax rate on £11,000 of capital gains. Your spouse can use all the same shelters and tactics described above to reduce her or his capital gains tax liabilities. Note that lifetime passing of assets to your spouse will not result in a CGT bill for you (unless you and your spouse have separated and are living apart), but the cost of those assets will be what you originally paid for them. In other words, your spouse’s CGT will be calculated on the gain made during the whole period of ownership.
How CGT works
CGT is payable at either 18 or 28 per cent depending on how much taxable income you have. If you pay higher-rate income tax, you’ll pay higher-rate CGT. Each individual has an annual exempt amount (for tax year 2014-15) of £11,000.
You should include in your calculations all allowable deductions such as the cost of buying and selling and stamp duty. Where you have bought the same type of share in a company in stages, the cost of each purchase is pooled to create an average cost and this is used along with the proportion of the total holding being sold to work out your cost base, while all shares purchased before 31 March 1982 are valued at their value on that day. Your broker, or even HMRC, will be able to give you that value.
More information can be found at: http://www.hmrc.gov.uk/cgt/shares/index.htm.