capital gains tax

This is an update of the capital gains tax (CGT) article first published in the May 2005 issue of student accountant. It provides guidance on the CGT content of CAT Paper 9 (UK) and the depth to which this area will be examined. EXCLUSIONS The following areas are specifically excluded from the syllabus: assets held on 31 March 1982 wasting assets (other than chattels) leases transfers between husband and wife, or between connected people incorporation relief the calculation of indexation allowance for individuals capital losses in the year of death. It should be noted that where an asset was purchased by an individual before 6 April 1998, the indexed cost as at 6 April 1998 will always be given by the examiner. The indexation allowance calculation for companies is, however, still required knowledge. THE SYLLABUS The CAT Paper 9 syllabus covers the following specific areas: basic calculations for individuals and companies part disposals chattels compensation and insurance proceeds shares and securities reliefs administration and payment of tax. Each of these areas is discussed in detail below. The rules for individuals and companies are different, and candidates are expected to understand both sets of rules. Question 2 of the CAT Paper 9 exam will always be on corporation tax, and may require a calculation of a gain as a result of an asset disposal by a company. Question 3 will always be on CGT for individuals. BASIC CALCULATION The basic calculation of a gain is simple, but the procedure depends on whether the sale is by an individual or by a company, and when the asset was purchased. The syllabus specifically excludes assets purchased 46 student accountant September 2007 before April 1982; only assets purchased after that date are therefore examinable. However for individuals, there is still a problem with assets purchased before 6 April 1998 and disposed of after that date. Disposals by a company The basic calculation is: Proceeds Less: Cost Unindexed gain Less: Indexation allowance Indexed gain x (x) x (x) x Proceeds is the actual amount received on sale, but this must be reduced by any expenses of selling to give the net proceeds. If the disposal is at under value, or by way of a gift, then the current market value must be used as the proceeds figure. The cost is the gross amount paid for the asset (including any expenses of purchase), or the market value at the time received, for example, by way of a gift. Either of these amounts can be increased by any additional capital enhancement expenditure. Indexation allowance is an allowance for the effects of inflation and is measured by reference to the movement in retail price indices. The indexation factor representing the movement between the months of purchase and disposal will always be provided in the exam. The indexation factor must be multiplied by each individual cost element (including enhancements) used in the calculation. The resultant indexation allowance then reduces the unindexed gain to give the indexed gain. Indexation allowance cannot increase a loss or convert a gain into a loss. In the latter case, if the indexation allowance is greater than the gain then the result is nil (neither a gain nor a loss). EXAMPLE 1 ABC Ltd purchased a factory on 2 October 1987 for 100,000, incurring expenses of 5,000. The company spent 20,000 on an extension to the factory in November 2000. The factory was sold for 290,000 on 31 March 2007, with expenses of sale amounting to 8,000. Indexation factors: October 1987 to March 2007: 0.908 November 2000 to March 2007: 0.141

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relevant to CAT Paper 9 (UK)

The gain is: Proceeds Less expenses Cost Expenses Extension Unindexed gain Indexation allowance: 105,000 x 0.908 20,000 x 0.141 Indexed gain 290,000 (8,000) 100,000 5,000 20,000 282,000

(125,000) 157,000

(95,340) (2,820) 58,840

Disposals by an individual The basic calculation is effectively the same as for a company, but with two major differences. First, indexation allowance ceased to be available from 6 April 1998, and second, taper relief was introduced with effect from the same date to give relief from gains based on periods of ownership. In addition to these major differences, an individual is entitled to an annual exemption of 8,800 (for 20062007) against the total gains of the tax year. Where an asset is purchased prior to 6 April 1998, and is disposed of on or after that date, then the cost is indexed to April 1998 and no further. The indexed cost of the asset as at 6 April 1998 will be provided in the exam. Candidates will not therefore be required to calculate indexation allowance for individuals. To compensate for the loss of indexation allowance, taper relief can reduce chargeable gains occurring September 2007 student accountant 47

after 5 April 1998. This is given by reference to the number of complete years of ownership from 6 April 1998 onwards, or the date of purchase, if later. The amount of relief differs depending on whether the asset concerned is a business or non-business asset. Note that a non-business asset will qualify for an additional year of ownership (a bonus year) if it was purchased prior to 17 March 1998. For taper relief purposes, the date of any enhancement expenditure after 5 April 1998 is irrelevant, and the total gain is tapered in accordance with the total period of ownership from the original purchase date (or 6 April 1998 if later). The definition of a business asset is required knowledge. However, the examiner will usually, but not always, state whether the asset sold is a business or non-business asset. No questions will be set where an asset changes use and is partly business and partly non-business for CGT purposes. A table showing the percentage of gain chargeable can be found in all the recommended textbooks and will always be given in the exam. EXAMPLE 2 Greg purchased a house in 1987 for 80,000 and extended it in June 1999 at a cost of 18,000. He sold the property in February 2007 for 246,000. It had never been his main residence and the indexed cost as at 6 April 1998 was 129,000. The gain is: Proceeds Indexed cost Extension (after 6 April 1998) Untapered gain 129,000 18,000 246,000 (147,000) 99,000

Taper relief: 9 years (8 years + one bonus year) = 65% Chargeable gain 64,350

CAPITAL LOSSES Capital losses can only be used in the same or future years. For companies, the situation is simple losses must be set off, in full, against gains in the same accounting period. If net losses remain, these must be carried forward to future periods and used against the first available capital gains. They can never be used against other income in any year, or carried back against capital gains in previous years. For individuals, the situation is a little more complicated. Losses must be used as far as possible against capital gains in the same tax year (6 April to 5 April). If any losses remain, they can be carried forward against capital gains in future tax years, but need only be used to reduce the gains down to the annual exemption (8,800 for 20062007). It must be emphasised that in the tax year of the loss, the full loss is to be used against untapered gains before reference to the annual exemption. Both current year capital losses and brought forward capital losses (where necessary) must be used in priority to taper relief. However, losses 48 student accountant September 2007

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are first allocated to those gains with the highest chargeable percentage of gain in general to non-business assets before business assets. It should be noted that the special rules for capital losses in the year of death are not in the CAT Paper 9 syllabus. EXAMPLE 3 John sells three assets in 20062007. A gain of 14,000 is made on a business asset (taper percentage 25%), a gain of 19,000 is made on a non-business asset (taper percentage 80%) and a loss of 6,000 on the third asset. A capital loss of 4,000 is brought forward as at 6 April 2006. The best use of the losses is: Business asset 14,000 x 14,000 Nonbusiness asset 19,000 (6,000) 13,000 (4,000) 14,000 25% 3,500 9,000 80% 7,200 Total Gain Current year loss Loss brought forward Untapered gains Taper percentage Chargeable gains Annual exemption Total taxable gains 33,000 (6,000) 27,000 (4,000) 23,000 10,700 (8,800) 1,900 The use of capital losses will be a regular feature of CAT Paper 9 exams and the end of year summary illustrated in Example 3 should be well understood by all candidates. PART DISPOSALS Where a taxpayer makes a disposal of part of a set of items, or a share of (for example) a painting, then the cost of the part sold is to be calculated by reference to the part disposal formula. This formula is not given in the exam and must therefore be memorised: Gross proceeds x Cost Gross proceeds + MV of the remainder An important feature of this formula is that any expenses of sale must not be deducted from the proceeds figure and gross proceeds must be used. Any expenses can, however, be used in the normal gain calculation. The remaining proportion of the cost is deemed the cost of the part retained, and will be used in any future disposal. EXAMPLE 4 Jeremy purchased a valuable piece of art for 240,000 in August 2000. In February 2007, he was short of cash and decided to sell a 25% stake

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in the painting for 90,000. He incurred solicitors fees of 10% on the sale. The remaining 75% stake has a market value of 380,000 in February 2007. The gain is: Net proceeds (90,000 - 9,000) Cost: 90,000 (90,000 + 380,000) x 240,000 Untapered gain Non-business asset Taper relief: 6 years = 80% Chargeable gain 81,000 (45,957) 35,043

Or

(7,800 - 6,000) x 5/3 = 3,000

The lower gain is taken 3,000 (No taper relief asset held for <3 years) Painting: 6,000 (7,600) (1,600)

Deemed proceeds Cost Restricted loss 28,034

The cost of the part retained is 194,043 (240,000 - 45,957). CHATTELS Chattels with a useful life of less than 50 years (wasting assets) are exempt from capital gains unless they are plant and machinery used in a trade. The calculation of the gain/loss for other chattels depends on the actual cost and disposal value. If the cost: and the disposal proceeds are both less than 6,000, then the asset is exempt from capital gains is more than 6,000 but the disposal proceeds are less than 6,000, then the gross proceeds are deemed to be 6,000 in the loss calculation is less than 6,000 but the disposal proceeds are marginally above 6,000, then the 5/3rds rule applies. Wasting chattels (plant and machinery) follow the same rules as above. However there can never be a capital loss on the sale of plant and machinery. This is because capital allowances will cover any wear and tear, ie the actual loss. Plant sold at a loss therefore will always have a nil result for CGT purposes. EXAMPLE 5 Bill sells the following assets in October 2007: an antique desk for 5,800 he originally purchased it for 4,000 in August 1999 a Ming vase for 7,800 it was originally purchased for 4,500 in May 2005 a painting for 5,000 which had cost 7,600 in June 2001. The gains/losses are: Desk: Exempt both cost and proceeds are below 6,000. Vase: Proceeds Cost 7,800 (4,500) 3,300

COMPENSATION AND INSURANCE PROCEEDS When an asset is destroyed, any compensation received is usually used as the proceeds figure in a normal capital gain calculation. If, however, the proceeds of a non-wasting asset are reinvested in another asset within 12 months of the date the compensation was received, then any gain resulting from the previous destruction can be deferred and deducted from the cost of the replacement. If all the proceeds are not reinvested then a gain equal to the proceeds retained will be taxed immediately, and only the remaining gain can be deferred. No other situation involving compensation receipts will be examined in CAT Paper 9. EXAMPLE 6 Peter purchased an asset for 30,000 in May 2000. It was subsequently destroyed in January 2007. The insurance company paid 35,000 and a replacement asset was purchased in March 2007 for 33,500. The asset has never been used in a business. 35,000 (30,000) 5,000 (1,500) 3,500

Proceeds Less cost Gain Amount not reinvested Deferred Taper relief: 6 years = 80% Chargeable gain Base cost of new asset: 33,500 - 3,500

(chargeable now)

1,200

= 30,000

SHARES AND SECURITIES The rules for companies and individuals are completely different. The following areas need to be understood: matching rules the construction of the s104 pool (companies only) bonus and rights issues awareness of disposal of rights calculation of gains. September 2007 student accountant 49

The Section 104 pool Note: This ceased on 6 April 1998 for individuals. Where this pool forms part of the question for an individual, the value of the pool as at 6 April 1998 will always be given. Matching rules These outline the order in which shareholdings are deemed to be sold for capital gains purposes. For an individual the order is: same day next 30 days (on a FIFO basis) shares purchased after 5 April 1998 (on a LIFO basis) the s104 pool. For a company the order is: same day previous nine days (on a FIFO basis) the s104 pool. On a disposal of shares, gains for each holding must be computed separately. Bonus and rights issues These are both treated in a similar fashion with the main difference being that rights issue shares involve the taxpayer buying the shares and are, in effect, therefore treated as a simple purchase. Bonus issues merely add extra shares to a holding with no financial implication. The most important rule with both of these issues is that the share issue must be allocated to the existing holding that gives the entitlement to these new shares. For taper relief purposes, the holding period on disposal is measured from the date of purchase of the original holding not from the date of the rights or bonus issue. Awareness of disposal of rights This requires candidates to understand what a right to purchase is, and to know the options open to the taxpayer. These are: to ignore it therefore no capital gains action, to purchase the offered shares therefore the action is as in the paragraph on bonus and rights issues (ie a purchase allocated to the relevant existing holdings), or finally to sell the right, which results in a part disposal or a disposal of a small capital distribution. Calculation of the gain This calculation, as a result of a disposal of rights, will not be required knowledge. EXAMPLE 7 Sylvia had the following transactions in the shares of ABC plc: 14 October 1987 2,000 shares for 4,400 19 June 1999 1,000 shares for 3,500 21 May 2000 1,500 shares for 4,500 16 September 2001 A one-for-two bonus issue 12 March 2007 800 shares for 2,000 50 student accountant September 2007

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She sold 4,800 shares on 9 March 2007 for 2.80 per share. The indexed value of the s104 pool as at 6 April 1998 was 5,600. Calculate the total chargeable gains. Sylvia has no capital losses or other capital gains in 20062007. The shares are non-business assets. Step 1: Allocate the bonus issue to existing share holdings Section 104 pool Shares Cost 4,400 4,400 Indexed cost 5,600 5,600 Balance as at 6 April 1998 Bonus issue (one-for-two) Balance June 1999: Shares Purchase Bonus issue (one-for-two) 1,000 500 1,500 Cost 3,500 3,500 2,000 1,000 3,000 May 2000: Purchase Bonus issue (one-for-two) 1,500 750 2,250 4,500 4,500 Step 2: Match the disposal to the holdings Disposal Next 30 days May 2000 June 1999 s104 pool 4,800 (800) (2,250) (1,500) (250) Nil Step 3: Calculate gains (each must be done separately) Next 30 days: Proceeds (800 x 2.80) 2,240 Cost Gain No taper relief May 2000: Proceeds (2,250 x 2.80) Cost Untapered gain (2,000) 240 6,300 (4,500) 1,800

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Taper relief: 6 years = 80% Chargeable gain June 1999: Proceeds (1,500 x 2.80) Cost Untapered gain Taper relief: 7 years = 75% Chargeable gain s104 pool: Proceeds (250 x 2.80) Indexed cost 250/3,000 x 5,600 Untapered gain Taper relief 9 years (8 years plus 1 bonus year) = 65% Chargeable gain Step 4: Total gains 240 + 1,440 + 525 + 151 =

1,440

4,200 (3,500) 700

525

700 (467) 233

following the appropriate tax year-end, and the CT600 must reach HMRC within 12 months of the end of the relevant accounting period. Individuals pay capital gains tax on their net chargeable gains after the annual exemption for the tax year, whereas companies include their net chargeable gains in their corporation tax calculations and pay tax at their appropriate marginal rate. For individuals, tax is usually due on the 31 January following the tax year (no payments on account). For companies, it is due nine months and one day after the accounting period end. If the company is large, then the tax on the gains will be included within the quarterly payment system. The calculation of tax for individuals depends on the taxpayers income assessed under income tax rules, and the income tax thresholds for any particular tax year. Income tax must be calculated first and then net chargeable gains are taxed using up any remaining bands of tax, using 10%, 20%, or 40% only. Capital gains are never taxed at 22% or 32.5%. EXAMPLE 8 Geraldine has net chargeable gains (after taper relief) for the tax year 20062007 amounting to 14,000. Her total taxable income (after her personal allowance) for income tax purposes amounted to 28,500 for the same year. Calculate the capital gains tax payable and state the due date of payment. Step 1: Check amounts assessed to income tax First 2,150 @ 10% Next 26,350 (28,500 - 2,150) @ 22% or 20% Step 2: Calculate amount of gains chargeable Net gains 14,000 Less annual exemption (8,800) Taxable gains 5,200 Step 3: Tax the amount of the gain falling in the remaining basic band at 20% Step 4: Tax any remaining gain at 40% First 4,800 (33,300 - 28,500) x 20% 960 Next 400 (5,200 - 4,800) x 40% 160 Total CGT payable 1,120 Step 5: Payment date 31 January 2008

151

2,356

Note the taper relief in the above example would be done at the end of the year once any current or brought forward losses had been utilised. RELIEFS There are three main reliefs in the CAT Paper 9 syllabus: for individuals only, gift relief and principal private residence (PPR) relief; and rollover relief for both individuals and companies. For all three reliefs, the full conditions of entitlement must be understood. In the case of rollover relief, the special treatment of depreciating assets (holdover relief) is also required knowledge. Calculations of gains for gift relief and rollover relief will be set, but no calculations will be set for PPR. PPR questions will only require knowledge of the rules and the deemed periods of occupation, including letting relief. Gifts with part payment and restricted rollover relief claims (due to not all proceeds being reinvested) are both examinable. The interaction of taper relief with these reliefs is also required knowledge (ie only the chargeable gain is tapered not the gains deferred by rollover or holdover relief). Questions involving assets which are partly business and partly non-business, or assets which change their use during ownership, will not be set. ADMINISTRATION AND PAYMENT Candidates must know how and when gains are to be reported to Her Majestys Revenue & Customs (HMRC). An individual must give written notice of their chargeable gains within six months of the end of the tax year. However, if the individual has already been issued with a tax return, gains are simply reported on that return. Companies use the corporation tax self-assessment form (CT600) for a particular accounting period. The self-assessment form for individuals has to reach HMRC by 31 January

CONCLUSION It is hoped that candidates will be better prepared for the CAT Paper 9 exam as a result of reading this article. It should be read in conjunction with the published Syllabus and Study Guide, which can be accessed on the ACCA website. Keith Molson is examiner for CAT Paper 9 (UK) September 2007 student accountant 51