The Tax Man Cometh

Margaret Mitchell in ‘Gone with the Wind’ wrote “Death, taxes and childbirth! There’s never any convenient time for any of them”. Convenient or not, June 22nd 2010 is probably an important date that you will want to schedule into your diary. This is the date when the new coalition government will tell us of its plans to haul a nation, which is currently riddled with debt, into prosperity through taxes and spending cuts. It has already signalled clear intentions to raise capital gains tax for non-business assets to be more in line with income tax. So far, details have been scant on the type of ‘non-business assets’ that will fall in the net, and of the ‘generous exemptions’ promised to entrepreneurs.

The result of all this? Stockbrokers up and down the land are now more popular as confused investors make a beeline for them. The fear is that these new changes adversely affect small investors and savers who have saved prudently for their retirement and now find that the goal posts have moved.

There has already been some movement towards capital gains tax products over the last couple of months as many high earners sought to lock a CGT rate of 18%. It is precisely this behaviour that the government is hoping to discourage with the new (expected) tax rate of 40% or even 50%. However, according to the HM Revenue & Customs, 53% of all people who paid CGT in 2008 did on gains of less than £25,000. Hardly stratospheric if the whole point is to reprimand those who are out to make a quick buck by making speculative investments!

The primary message from 7IM’s own investment advisors is to make one of two choices - pay tax now at a rate of 18% or pay tax later at a rate of 40% (or possibly higher) - on a £100,000 gain, paying CGT now would mean parting with £18,000. Paying tax later would on the other hand, mean paying HM Revenue £40,000. If the decision to take the CGT hit were to be delayed only to be stung with a 40% tax rate later, the portfolio of investments would need to rise significantly in value in order to get you back to the same net proceeds from sales. In that vein, many of 7IM’s clients are choosing to pay now rather later. However, this does not mean just cashing in assets. It allows the proceeds to be reinvested immediately into a more diversified, risk-managed strategy aligned with financial planning aims and objectives. Of course there is one ‘damned if you do and damned if you don’t’ scenario which would materialise if the new CGT rate were to be applied retrospectively from April 2010!

The second message is one of tax planning as in doing more of it through use of tax efficient wrappers such as offshore bonds, ISAs and SIPPs. Unitised portfolios such as the multi-manager OEICs run by 7IM can also be used to avoid paying elevated rates of CGT on individual stocks and shares. Money can be switched between underlying funds and managers without being subject to a tax charge. This of course not only allows for effective tactical asset allocation (the ability to respond quickly to market movements and take advantage of investment opportunities) but also makes it easier to manage CGT allowances for clients on an ongoing basis. Non-unitised investments have the added burden of being overwhelmed by CGT rules. A reluctance to pay tax at the new rate may mean holding on to rising shares (and gains); the cost would be throwing asset allocation between equity and bonds off kilter and putting oneself in a higher unsuitable
risk profile. In summary, good financial planning is essential as we transition through the tax changes, and efficient personal strategic investment decisions will help you go a long way in mitigating that tax tail which threatens to wag the investment dog.

Small investors aside, the new Chancellor’s budget will also have implications for another key group - the entrepreneur. A Stateside study released this week by the Kauffman Index of Entrepreneurial Activity reported that in the US, 2009 had the highest level of entrepreneurial activity in 14 years, even exceeding the number of start-ups during the technology boom of 1999-2000. Challenging economic times can motivate those who find themselves made redundant to start up new enterprises, and increasing entrepreneurship can be the key to an economic recovery. Although similar data is not available for the UK, a Deloitte report last year found UK entrepreneurs having a very tough time. Many companies in the study reported that sales growth will take a backseat to survival, a third said banks had reduced their lending facilities and nearly a third informed of their plans to sell within the next three to five years.

The ‘generous exemptions’ promised to entrepreneurs say Deloitte needs to “stretch to include employees. At present, many employees do not qualify for the current entrepreneurs’ relief - yet their involvement with growing companies is vital. Employee tax breaks help to make a big contribution towards getting good people to take reasonable risks with growing businesses”. Quite right too!

Venture capital firms are also vital in assisting companies which are young or helping a great idea come to fruition. Many executives and employees of these firms invariably end up backing these projects with some of their own money. Entrepreneurship involves taking risk and the new coalition must take care to remember that while it is taking important steps to tackle the deficit, it must not stem growth in this sector - a sector that will play a robust part in any recovery to be had. It aims to boost a part of this sector by providing a 20% tax relief on investments (max £500,000) in Enterprise Investment Schemes (EISs) while also allowing rolling over CGT for three years. It’s important to remember here that this only delays the paying of CGT and does not help avoid it.

If the CGT were to increase to 40%, UK enterprises would find themselves with one of the highest rates in the world. Only Denmark would rank higher at 62.9%. But will this move work to bring in higher tax receipts that the government so desperately need? According to one study by the Adam Smith Institute, analysis of US CGT data shows the CGT increase has had the opposite to the desired effect - i.e. rises in capital gains tax has led to falling capital gains tax revenues. While it reports that fewer significant shifts in UK CGT rates make it difficult to draw clear conclusions here, it does note that the reduction of CGT on business assets to a rate of 10% held for two years did have a positive revenue effect.

The Institute also disputes the theory that lower CGT rates will result in people shifting income to capital gains, pointing to countries who have a CGT rate of zero but still manage to raise significant revenue from income taxes.

Whatever happens come June 22nd, the markets will still have plenty to worry about in the weeks ahead. Sovereign debt crisis, employment data, Central Bank meetings and political uncertainty will be the bigger picture and making a capital gain in this environment may itself be a big thing, let alone paying tax on it!

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And finally... my colleague Amy Halford has pointed me towards this bizarre story as further evidence of the worldwide recession taking its toll. A man dubbed ‘the grim eater’ has been warned off by undertakers in New Zealand for gate crashing up to four funerals a week, even taking home leftovers in Tupperware containers. Perhaps the food was to die for!

Have a good week.

Aparna Ram
Senior Research Analyst
Seven Investment Management Limited

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This article represents a personal and light-hearted view from Director, Justin Urquhart Stewart of Seven Investment Management Limited, and is based on current financial news and events around the world. Its content should not be used for investment purposes and you should contact an independent financial adviser before making any investment or financial decision. Seven Investment Management Limited is authorised and regulated by the Financial Services Authority. Member of the London Stock Exchange. Head office: 23 Austin Friars, London EC2N 2QP. Telephone 020 7760 8777. Registered in England and Wales number 4092911. Registered office: 3 More London Riverside, London SE1 2AQ.