The first part of this blog (posted 16 November) focussed on those elements of the proposals pertaining to the private client sphere. I now turn to those which could impact on the business and entrepreneurial spheres.
Taxing Share Sales as Income
In the absence of aligning the rates of income tax and CGT, the OTS has suggested that some complexities or distortions could be reduced by taxing certain share sales as income. The two particular areas they have in their sights are share incentives for employees and retained earnings in small owner-managed businesses.
Whilst recognising that there are policy reasons for certain approved share incentives, the OTS draws attention to arrangements such as growth shares (shares which have a low value when issued but grow quickly in value if the company is successful). These are often conceptually similar to share options but any profit on the sale of the shares gives rise to CGT rather than income tax (which is charged on the profits arising on the exercise of a share option). Their recommendation is that consideration should be given to taxing more share-based rewards from employment as income rather than capital gains.
Given the already complicated rules dealing with employment-related securities and approved share incentive schemes of one sort or another, it must be questionable whether this is an area which the Government will want to look at in detail. It is however possible that growth shares and other similar arrangements which result in rewards relating to employment being subject to CGT rather than income tax will come under greater scrutiny.
The question posed by the OTS is whether an individual who accumulates trading profits within a company and then sells the company, paying capital gains on the profits from the sale, should be in a better position than somebody who carries on a business in their own name or receives the profits by way of salary or dividends.
The argument is that these profits all relate to the individual’s labour and so, in principle, should be subject to income tax rather than CGT.
The suggestion is that, on a sale or a liquidation of a close company which is classified as “small”, any part of the profit which represents accumulated earnings should be subject to income tax rather than CGT.
However, the OTS’ examples focus on personal service companies rather than companies carrying on trades which involve significant expenditure in order to generate any income.
Singling out owners of small companies in this way seems hard to justify, particularly as the OTS acknowledges itself that there may be many reasons why it is appropriate to accumulate profits within a company. It also recognises that knowing where to draw the line is very difficult and that there is a significant risk of creating further distortions or an arbitrary cliff edge. It would also create more complexity.
In my view, such a change is likely to be very unattractive politically and is unlikely to be adopted.
Entrepreneurs’ Relief/Business Asset Disposal Relief
It seems surprising that business asset disposal relief (BADR) is still under scrutiny given the changes made last year, in particular reducing the maximum relief from £10m to £1m.
However, the OTS recommends that BADR should be abolished entirely and replaced with some form of retirement relief, recognising that owner/managers may well build up value in their businesses as a form of pension arrangement.
This would bring CGT relief on the disposal of shares in closely-held trading companies back to pretty much where it was when CGT was first introduced.
Retirement relief was abolished in 2003 on the basis that it had become too complex and was replaced with reliefs which were designed to encourage entrepreneurial activity more widely. It is of course debatable whether BADR has achieved its objective. The OTS conclusion is that it has not. I agree.
There is certainly a case for having a relief for the disposal of shares in a closely-held trading company which is targeted more at retirement. It does however seem odd that the OTS is recommending this change at the same time as suggesting that retained earnings in a small, closely-held trading company should be taxed as income rather than as a capital gain.
Given the recent changes to BADR, it may be unlikely that the Government would now be interested in abolishing it entirely and replacing it with a different relief, the design of which would, inevitably, be controversial.
With barely a page of analysis, the OTS recommends that investors’ relief should be abolished. The main reason is that, since it was introduced in 2016, there is little evidence of people making use of the relief.
In a sense, this is not surprising since, realistically, the first year in which disposals might have taken place which would qualify for relief is the 2019/20 tax year in respect of which tax returns are not due until 31 January 2021.
Again, it is difficult to see why the Government would want to tinker with this relief without carrying out a wider review of the reliefs available to encourage investment into unquoted trading companies and deciding how best those reliefs should be targeted. This is more likely to be a medium to long-term project rather than something which the Government would want to initiate at the same time as trying to deal with the fallout from Covid-19 and Brexit.
How will the Government React?
The Government is of course currently looking for ways to raise tax revenue in a way in which is politically acceptable. This will inevitably include raising more from the wealthy and CGT is one of the ways in which that can be done without breaking any manifesto commitments.
Some modest increase to the rate of CGT therefore seems likely although alignment of rates of CGT with rates of income tax and some of the more radical recommendations from the OTS are much less likely to be pursued. It is interesting that the Financial Times is already reporting that allies of the Chancellor are distancing him from the recommendations in the OTS report.
The reality is that the real purpose of the Chancellor in asking the OTS to review CGT was to see what the public and political appetite was for raising more money from CGT. The answer seems to be that modest increases might well be accepted but that more radical reform may not be tolerated and would certainly make an over-complex tax moreso through ill thought through unintended consequences.