How to manage higher capital gains tax

Last year’s increases to capital gains tax (CGT) were perhaps not as bad as feared, but calls for reform have restarted as another budget looms. It’s a good time to consider the financial planning threats and opportunities arise.

Higher rates of capital gains tax were an unwelcome addition to the burden shouldered by investors, who already faced lower tax-free allowances for dividends and capital gains, as well as frozen income tax thresholds, pushing them up towards higher tax bands. The rise in the minimum wage and employers’ National Insurance will have also reduced the profit margins of many of the businesses they invest in.

Higher rates come on the back of a severe cut in the annual CGT allowance in recent years, from £12,300 to £3,000, so investors suffered a double blow to their profits. The tax itself is one thing, but investors facing capital gains tax also face high levels of complexity in calculating their liability if they invest regularly, or if they invest in funds which provide return via a combination of income and gains. Plenty of people will find themselves in this situation. Staying out of the capital gain tax net may well be as rewarding in terms of reducing paperwork as it is in keeping more of your gains in your own pocket.

Pensions and ISAs

The tax relief afforded to pensions and ISAs continues, although proposals are in play to curtail the generous tax treatment of pensions on death. In particular, investments held within pensions and ISAs aren’t subject to capital gains tax, nor are the dividends they produce subject to income tax. A rise in capital gains tax, especially combined with an annual CGT allowance of just £3,000, means investors should prioritise pensions and ISAs if they’re hoping for growth on their investments.

‘Bed and ISA’ or ‘Bed and SIPP’

Those who hold unwrapped investments can perform a manoeuvre called a ‘Bed and ISA’ or ‘Bed and SIPP’ to move them inside a tax shelter. This does involve selling assets so there is potentially a capital gains tax liability at this point, though investors can mitigate this by judicious use of their annual £3,000 CGT allowance. Once inside the SIPP or ISA, any further gains are then free from tax. Investors who feel they might breach the £3,000 annual CGT allowance using this approach might consider pairing the sale of a profitable investment with a loss-making one. Losses can be used to offset gains, thereby reducing the capital gains tax liability, then either or both investments can be rebought within the ISA to avoid tax on future gains.

‘Bed and spouse’

Assets can be transferred to a spouse or civil partner free of capital gains tax, and by doing so investors can utilise two sets of the annual £3,000 CGT allowance on profitable share sales. By doing a ‘Bed and Spouse and ISA’ it’s also possible to then use two sets of the annual ISA allowance of £20,000 to shelter those assets from future capital gains. For higher rate taxpayers, there may also be some merit in transferring assets to a spouse even where the gain exceeds the annual CGT allowance of £3,000, if they are a basic rate taxpayer.

The previous increase on the rate of capital gains tax for basic rate taxpayers more than higher rate taxpayers narrowed the value of this ploy. But it might still mean paying capital gains tax at 18% rather than 24%. In this scenario, capital gains are added to your income and can push basic rate taxpayers into the higher band, so it pays to exercise due care and attention when working out how much to transfer.

VCTs, EIS and SEIS

Venture Capitalist Trust (VCT) and Enterprise Investment Scheme (EIS) schemes are extended until 2035. Wealthy, adventurous investors who have filled their pension and ISA allowances and still have money to invest might consider going down this route. The tax perks are very attractive for VCTs and EIS, but investors should ensure they don’t let the tax tail wag the investment dog. In particular, they shouldn’t be tempted into taking more risk than they’re comfortable with simply to save tax. VCTs and EIS invest in small, early-stage companies which might fail and have low levels of liquidity.

Capital gains on investments held within both VCTs and EIS are free from tax, and in addition an EIS investment provides the opportunity to defer capital gains made elsewhere, whereas an SEIS investment comes with a 50% exemption on gains made elsewhere.

Multi-asset funds

Investors with unprotected share portfolios not only face capital gains tax when they sell up to fund spending, but even when they periodically rejig their portfolios to rebalance them, switch investments, or change their risk profile. Higher rates of capital gains tax therefore favour the use of funds and investment trusts, where gains made on portfolio companies held within the funds are free from capital gains tax.

Multi-asset funds in particular are likely to remain popular in the face of higher rates of capital gains tax. These are set and forget funds which come in a variety of risk categories. The idea is investors can simply hold one of these funds for the long term, with rebalancing and portfolio switches taking place within the fund, and therefore not subject to capital gains tax. Investors still potentially face capital gains tax when they sell down the fund, but they will do this much less frequently than if they were running their own stock or fund portfolio.

What about gilts?

We know lots of people have been attracted to low coupon gilts because capital gains on government bonds are free from tax. It’s natural to assume the rise in capital gains tax prompted more people to look at these gilts, and at the margins that might be the case. However, what investors piling into gilts have been fleeing was actually income tax on cash, rather than capital gains tax on growth assets. A theoretical gilt yielding 4% entirely through capital gains is equivalent to a cash account yielding 6.7% in the hands of a higher rate taxpayer, and 7.2% in the hands of an additional rate taxpayer (assuming the higher rate taxpayer has used up their personal allowance; additional rate taxpayers don’t get one). Those are pretty attractive compared to actual cash rates.

By comparison, the same 4% yielding gilt is equivalent to a capital gain of 5.3% in the hands of a higher rate or additional rate taxpayer, assuming they can’t defray any of this by using tax shelters or their annual £3,000 CGT allowance. More to the point, investors tend to rightly compartmentalise their assets into short- and long-term holdings. Growth assets fit firmly in the latter, and most investors running share portfolios would probably hope to harvest more than 5.3% over the long term.

By contrast, the gilts we've seen investors buying in bulk over the last few years are short dated, which suggests investors view these as short-term, cash proxies. Gilts will continue to prove popular for those seeking to avoid income tax on cash, especially as gilt yields have continued to rise.

Will consumers continue to hoard cash?

UK consumers are arguably already too risk averse when it comes to managing their money, and both the complexity and rate of capital gains tax serves to discourage investment in the stock market. This is mitigated to a large extent by the protection afforded by pensions and ISAs. Previous hikes in CGT were not big enough to move the dial substantially, but at the very least it’s an unhelpful signal that the government wants to tax your gains from investing. A rise in CGT alone hasn't pushed that many more people towards cash, but by the same token it hasn't improved incentives for them to get investing either, which has benefits for their own long-term financial planning, as well as for the UK economy and stock market.

The Financial Conduct Authority (FCA) recognises this is an issue. In 2021, the regulator identified 8.4 million adults who had more than £10,000 in cash and set about trying to reduce that number to under 7 million. It appears the regulator may be swimming upstream on this one though. Since 2021, that number has risen from 8.4 million to 11.8 million, as a result of higher interest rates. Higher capital gains tax won’t exert a huge amount of force in one direction or the other. But the task of convincing consumers to leave the familiar surroundings of a bank account continues to be quite the challenge.