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Capital Gains Tax – time for a new “kink test”?

19 May 2010 No Comment

Our last blog entry about the possible changes in tax rates and targets for the “Emergency” budget on 22 June caused more calls to the office than any other we have written. ┬áWas the cause of those calls the possible rise in VAT to say 20%? Perhaps the dropped promise on IHT? The confusion on NIC changes? No, the possible increase in Capital Gains Tax (CGT) has been the over-riding issue. ┬áAnd rightly so if the commentators are to be believed.

The rumours are that the new government is planning to increase the CGT rate from 18% to 40% or 50% – in other words, the marginal rate of income tax. Sure, for some this would mean a rise to “only” 20% if the basic rate of tax remains the same – and there’s no suggestion that it won’t. ┬áBut for others, more than doubling or potentially nearly trebling the rate of CGT is seen as highway robbery. It’s a change which would attack second-home owners, those with a portfolio of shares for investment and buy-to-let investors who prefer property to pensions. Business assets are seen as potentially getting a “fairer” crack of the whip with what is being touted as “generous exceptions for entrepreneurial activities”.

The issue that many people mention about the current system is the lack of what is called “indexation”. CGT was introduced by Harold Wilson’s government in 1965 to stop the increasing trend of passing off income as capital and hence avoiding tax. You see, there’s nothing new in tax policy! Gains pre-1965 were exempt (and still are). An Indexation allowance (using RPI as a measure) was introduced in 1982 in an attempt to remove the gains relating purely to inflation while leaving the growth in capital taxable. You can see why they did it from this graph.

The period after 1985 was obviously the perfect time to be a tax advisor as CGT calculations became ever more complex and phrases such as the “kink test” were bandied about in accountant’s offices. Although it sounded interesting, somewhat disappointingly, the “kink test” was a calculation designed to check whether it was better to elect for a March 1982 value to be used for the cost of an asset rather than a calculated value using the purchase price and allowing for the rule changes up to 1982.

Alastair Darling finally removed indexation and the “kink test” in the Pre-budget report in 2007 – probably because Gordon told him that he had laid inflation to rest with “no return to boom & bust”. This is a phrase we all remember but which Gordon now claims never to have uttered! At the same time Darling “simplified” CGT rates from 10%, 20% and 40% to a uniform 18%. It was argued that the effective reduction in rates more than compensated for the removal of the inflation adjustment which Gordon had told him was no longer required.

So why is indexation in the news again? Well, if the commentators are correct and CGT rates return to the marginal rates of tax including the shiny, new 50% rate, shouldn’t we take account of the fact that inflation again stalks the land? After all, on 18 May the Office for National Statistics announced that the RPI was now at 5.3%, the highest inflation figure for 19 years. And it’s pretty obvious that the longer you hold an asset, the bigger effect inflation can have on the value of it. Removing inflation so that CGT is only paid on the “real” gain, not the inflated figure, is just a fair tax policy. And fairness, as we all know is something that all parties claim they support.

Jon Stacey

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