Your Money: A case of capital punishment

The Chancellor giveth and he taketh away: Iain Morse examines the impact of the Budget's capital gains tax changes on savers
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The Independent Culture
What is it with Gordon Brown? One moment the Chancellor of the Exchequer appears to be encouraging investors' willingness to set money aside for the long-term, the next minute he takes away their benefits.

Both sides of this split financial personality came to the fore in last week's Budget, in which Mr Brown made changes to capital gains tax (CGT) intended to reward long-term investment by cutting CGT on disposals held for two years or more.

But he also ended the practice of "bed and breakfasting", the sale and next day re-purchase of shares to make full use of annual CGT exemptions.

The Chancellor's announcement means the basic annual exemption of pounds 6,500 stays in place, increased to pounds 6,800 for tax year 1998-1999. Gains on shares up to this amount can be realised before any liability to CGT arises. Any excess gains will be added to income and taxed accordingly, but are also subject to a 10-year tapering relief (see table).

Under the old system, gains on shares and unit and investment trusts were reduced by "indexation", an allowance used to adjust the difference between purchase and sale prices by inflation. This meant tax was only paid on "real" capital gains.

For example, an investment of pounds 20,000 made in September 1992, and sold exactly five years later for pounds 30,000, would have shown an adjusted gain of pounds 7,140. After claiming the CGT exemption of pounds 6,500, this would have left just pounds 640 liable to tax.

This allowance is to be frozen from 6 April, and replaced by indexation of the annual exemption for capital gains.

The main reason given for this change was the decline in long-term rates of inflation. Even so, investors will have to wait at least seven years before the tapering relief on CGT compensates for loss of the indexation allowance.

This assumes investments grow at 8.5 per cent annually. while inflation stays at an average rate of just 2.5 per cent. If inflation starts to increase, then investors could end up paying tax not just on a "hybrid" basis, calculated under both the old and new systems.

Under the old system, losses on share disposals could also be offset against gains, effectively reducing an individual's tax liability. The basis for such offset has also been changed, allowing losses to be deducted only from gains before these are subject to tapering relief. The net effect is to reduce the value of this allowance.

New rules on bed-and-breakfast impose a min- imum 30-day limit on re- investment into shares previously held and disposed of in the same year. Bed and breakfasting was used in two ways to reduce CGT bills.

Firstly, it allowed investors to "use up" the annual exemption, while keeping the same portfolio of shares. Secondly, it allowed them to "re- base" the price of these shares at a higher value, without paying tax on gains.

Of all the changes to CGT made in the Budget, this has provoked most controversy among stockbrokers and tax advisors.

Bryan Johnston, of the stockbrokers Bell, Lawrie, White & Co, says: "It will result in tram-line investing; selling one lot of shares and buying another, both in the same industry sector, both heading in the same direction."

Brokers are already working on ways round the abolition of bed and breakfast.

Last week, there were reports that stockbroker Charles Schwab & Co is developing a product based on share derivatives designed to allow investors to re-invest into the same shares after 30 days without loss.

IG Index, the city's bookmaker, has already launched a betting system which allows someone selling shares to bet on their going up or down in value over the 30-day period. IG Index's managing director, Stuart Wheeler, argues that "anyone could use this".

Angela Knight, of the Association of Private Client Investment Managers and Stockbrokers, is less sure. "The development of these new products based on derivatives, or intended to hedge risk for investors over the 30-day period before they go back into favourite shares, can only be risky and expensive," she says.

Elsewhere, Brian Dunk, a director of chartered accountants Coopers & Lybrand, doubts whether the changes have done much to improve the lot of private investors.

He argues: "It's easy to build-up a CGT liability in a portfolio and be locked into particular investments as a result. But portfolio managers are more focused on the quality of investment than tax issues. Changes to the tax should have given more flexibility."

Another Budget change will hit savers who have built up holdings in single companies over a long period of time. Under the old rules, purchase prices for these could be "pooled" at an average cost price. After 6 April, disposals from a "pool" will be treated on a last in, first out basis, and taxed accordingly.

This means that if you have built up a shareholding over, say, a 10-year period, buying some within two years of disposal, you will incur the maximum tax rate payable under the tapering relief.

One major consequence of these changes is to make unit and investment trusts more attractive than share portfolios to individual savers. Shareholdings within these collective investments can be bought and sold by managers without a CGT liability arising for investors, until they finally dispose of the trust.

By contrast, individually held share portfolios may be subject to tax whenever disposals take place.

Bed-and-PEPing, the practice of realising gains within the exemption limit and re- investing them in to a tax-free PEP, will continue and the same should be possible after the introduction of ISAs.

With annual contribution limits to ISAs at pounds 7,000 for the tax year 1999/2000 and pounds 5,000 thereafter, many expect a rush into the new accounts.

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