Rules of the capital gain

CONVENTIONAL wisdom has it that capital gains tax is the tax that fails to bite, writes Anthony Bailey.

Critics of the tax argue that it is over-complicated, expensive to administer, and raises relatively little revenue. They say it distorts investment decisions and the efficient use of capital. People facing tax bills are reluctant to sell investments for fear of crystallising a tax liability.

Yet CGT is still a reality for those who have to pay it. It is a tax on the rise in value of most assets. Of concern to many people will be the rise in value of investments such as shares and unit trusts and also second homes (first homes are generally exempt). Investors in particular need to master the rules to minimise or eliminate the bill.

The two key elements of CGT planning are the annual exemption - the gains you can make before you become liable for tax - and the indexation rules, which make purely inflationary gains tax free.

The annual exemption is £5,800, rising to £6,000 on 6 April. Gains within the exemption are tax-free. An investment may rise in value over several years, but the exemption can be used only in the year the investment is sold (or given away).

If the exemption is not used within the tax year it is lost and cannot be carried forward. That is why anyone who is likely at some time to breach the threshold should consider realising enough gains before 5 April to get £5,800 of them tax-free.

That can mean one of two things. If, for example, some shares are due to be sold soon, it may be beneficial to bring the sale forward to the current tax year.

But for people who are happy with their existing investments, the end- of-tax-year alternative is to bed-and-breakfast shares or unit trusts, selling them one day and buying them back the next. Most stockbrokers and many unit trust companies offer special rates for this sort of deal.

Shares that cost £6,000 and are now worth £11,000 could be sold and rebought. A gain of £5,000 is realised, no tax is payable, and when those shares are next sold the starting value for CGT will be £11,000 instead of £6,000.

Any capital losses can be set against gains, so people who have already realised substantial gains in the current tax year can consider realising a loss - either through the bed and breakfast route or by selling for good the loss-making shares.

The principle is simple enough, but care needs to be taken to choose the right investments. In particular, the monetary gain showing on a specific share or unit trust will be more than the gain for CGT purposes once inflation has been taken into account.

In calculating a taxable gain the initial cost of the shares can be increased by an indexation allowance. The allowance measures the rise in the retail prices index between the month of purchase and the month of sale. If the RPI has risen by 30 per cent, the tax-free allowance on shares costing £1,000 would be £300 - that is, on top of the annual exemption.

It used to be possible to use the allowance to turn a gain into a loss, or to increase a loss. Now it can be used at most to eliminate a monetary gain. However, purely "indexed losses" of up to £10,000 can be claimed on disposals of shares and other assets made between 30 November 1993 and 5 April 1995.