CGT issues in Family Wills

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    Capital Gains Tax

    The main tax planning tool we need to understand as a will writer is inheritance tax, as this allows us to take the correct approach when planning a client’s estate. It does not, however, mean it is the only area of taxation we need to be aware of when looking at how we plan our client’s estates.

    The other main type of taxation to consider comes in the form of ‘Capital Gains Tax’ (CGT) which is important in planning out a client’s estate, especially when it comes to dealing with either lifetime transfers by gift or through the use of lifetime trusts.

    In this paper we are going to establish the basics of ‘Capital Gains Tax’ (CGT) so we can understand what is defined by a disposal in regards of capital gains tax and the types of reliefs that are available under current legislation.

    The first points we need to establish are what does capital gains tax actually mean and when does it come into effect. The best explanation of capital gains tax is ‘a tax on any gain which an individual makes when they sell or dispose of an asset’.

    The term ‘dispose’ or ‘disposal’ can be defined to be when an individual ceases to own an asset. A disposal can be made in a number of different ways, i.e. by selling it, giving it away, a transfer to someone else, exchange for something else and finally receiving compensation for the disposal (an example would be if the owner receives an insurance payout when an asset has been destroyed).

    This raises the question are all transfers liable for Capital Gains Tax (CGT) when there is a disposal of an asset? The answer is no, not all transfers are liable for CGT, below is a list of examples which are exempt:

    1) Sale of your car,
    2) Personal possessions worth up to six thousand pounds each (for example jewellery, paintings),
    3) Stocks and shares you hold in tax-free investments savings accounts, such as ISA’s and PEP’s,
    4) UK government ‘gilt-edged’ securities and ISA’s and PEPs,
    5) Betting, lottery or pool winnings,
    6) Personal injury compensation,
    7) Foreign currency brought back from out of the country.

    However apart from the above list, most assets will suffer a charge of CGT, however it is important to remember if you pay income tax on the gain or profit you make from disposing of an asset, you won’t have to pay CGT on the gain as well. An example would be if you’re trading as a property dealer, jewellery maker or antiques dealer.

    We now understand the basic concept of ‘Capital Gains Tax’ and how it can be attracted to a transaction. The next logical step would be for us to establish how we calculate a gain to establish if any CGT liability exist. The formula below outlines the steps for calculating the gain is as follows:

    a) The sale price at disposal
    b) Less acquisition cost (less the cost of buying)
    c) Less costs of improvements/ enhancing expenditure
    d) This would provide then gain on the asset

    An example of how the capital gain will be calculated is illustrated below:

    Richard buys a rental property in 2008 for two hundred thousand pounds and undertakes fifty thousand pounds worth of improvements to the property. In 2013 he sells the property for three hundred thousand pounds.

    The capital gain is as follows-

    Price received for property    300,000.
    Less acquisition cost    (200,000.)
    Less Improvements       (50,000.)
    Therefore a gain of       50,000.

    The other important factor which we need to consider is every individual receives an annual allowance of £10,900 per year and a trust receives £5,450 in a tax year. Again let’s apply this to the example above to see how this will reduce the gain made on a disposal.

    Richard buys a rental property in 2008 for two hundred thousand pounds and undertakes fifty thousand pounds worth of improvements to the property. In 2013 he sells the property for three hundred thousand pounds.
     
    The capital gains is as follows-

    Price received for property    300,000.
    Less acquisition cost    (200,000.)
    Less Improvements       (50,000.)
    Less Capital Gains Annual Allowance    (10,900.)
    Therefore a taxable gain of      39,100.

    If in the above example this was not an investment property, but if it was Richard’s main residence, then this disposal would not incur any Capital Gains Tax. The reason for this is it would be classified as the seller’s main residence and the property would therefore qualify for principle residence relief.

    If in the example above an individual owns more than one residence, they may elect which property will be treated for CGT as their main residence however a married couple will only be able to elect one property between them and not one property each.

    It is also important to remember transfers which arise between spouses are deemed not to attract CGT. Therefore transfers between spouses will neither attract a gain or a loss for CGT. Effectively, tax on any gain since the acquisition by the donor’s spouse is deferred until there is a disposal by the donee spouse . Again, let’s consider this in an example:

    In 1999 Richard bought a house for fifty thousand pounds which is not his primary residence. In 2013 he gives this property to Jennifer his wife the value of the property has increased to the value of seventy thousand pounds.

    Richards deemed disposal consideration   50,000.
    Less: Acquisition cost    (50,000.)
                                Nil

    Therefore when Jennifer comes to sell the property her acquisition cost will be Richard’s original acquisition cost of fifty thousand pounds.

    Shifting assets between spouses is not an effective way of trying to receive an uplift on CGT in life and, on top of attracting conveyancing costs in regards to changing the ownership of the property, this will not be effective for CGT planning.

    It is also important to remember that capital losses are normally set against the gains of the same year and any losses which exceed the gains for the year can be carried forward to the following year. 

    The next point we will consider is the effect of death in relation to CGT and what effect this has on the deceased’s estate. It’s also worth remembering assets owned by the deceased are uplifted for CGT purposes on death meaning the Personal Representatives (PR)(the executors) acquire the assets at their probate valuation at the date of death.

    Therefore death is not deemed to be a disposal by the deceased and hence no CGT to pay . When the PR’s dispose of an asset, the acquisition cost is the probate value of these assets at the date of death and not the testators original acquisition cost.

    No liability arises when assets are vested in the legatees by the PRs; the PR’s acquisition (on death) is taken to be the legatee’s acquisition cost for future CGT purposes. A ‘legatee’ includes any person inheriting under a will or intestacy whether beneficially or as a trustee, if a trust arises following the death.

    Again an example of this can be seen below:

    Shares worth fifty thousand pounds were acquired by the testator ten years before his death for the price of five thousand pounds.

    The gain of forty five thousand pounds over this period will not attract any CGT. Any gain in the future will be calculated with an acquisition cost of fifty thousand pounds, thanks to the uplift to the current market value on the date of the testator’s death.

    A similar CGT-free situation for revaluation of trust exists when a life tenant of a qualifying interest in possession trust dies . Again, let’s put this into an example.

    Since the trust was created in 2000, trustees have been holding two hundred thousand pounds of quoted shares for Richard on trust for life and on his death these shares will pass to the remainderman who is Liam.

    Richard has just died and the shares are now worth three hundred thousand pounds.

    a) The gain of one hundred thousand pounds during the trust period does not attract a CGT liability.
    b) The trustees are deemed to dispose of the investment at market value at Richard’s death.
    c) The investment transferred to Liam is ‘deemed’ to be acquired by him for his future CGT purpose at their market value at Richard’s death.
     
    An important point to note: Not all of the investment will be transferred to Liam as some will have been sold by the trustees to pay the IHT liability that has been triggered by Richard’s death.

    There are other important reliefs with regards to CGT that we need to be aware of to ensure a donor, settlor or testator makes the most of these allowances.

    The first of these reliefs is known as ‘Hold-over and Rollover relief’ and is provided in relatively limited circumstances by the Taxation of Capital Gains Act 1992 , as detailed in section 165  and 260 . These two provisions operate in the same way, by permitting gains which accrue to the donor to be held over. Tax is effectively deferred by permitting the donee to acquire the gifted property at the donor’s acquisition cost.

    This will mean tax that would otherwise have been due on the disposal by the donor is deferred until the donee later disposes of the property. The donor can then elect to pay the CGT or to make a further roll-over election and delay payment till the donee disposals of the asset. There is also entrepreneur’s relief (if available), remember this is not applicable if hold-over relief is claimed.

    To obtain hold-over relief, an election is required by both the transferor and the transferee, although where the transferee is a trustee only the election of the transferor is required.

    Once the election has been made the following will occur:

    a) The amount of any chargeable gain which the transferor would otherwise have made on the disposal; and
    b) The value at which the transferee would otherwise be regarded as having acquired the asset,

    Shall be reduced by an amount equal to the amount which is held-over gain on the disposal.

    Again let’s consider this in an example:

    Richard gives his personal company, which he acquired in 2007, to his daughter Mia. The market value is one hundred thousand pounds.

    An election for hold-over relief under section 165 is made.

    a)Disposal consideration (market value)   100,000.
    Less cost price        50,000.

    Held-over gain      50,000.

    1) At this point Richard’s gain on disposal is reduced to nil.
    2) Mia’s acquisition cost will be 50,000. (100,000. – 50,000.)

    b) Mia sells her shares for 200,000. Her gains are calculated as follows:

    Deemed consideration (sale proceeds)   200,000.
    Less cost price       (50,000.)
    Therefore a gain of     150,000.
    Mia can use her annual allowance    (10,900.)
    A chargeable gain of      139,000.

    Mia chargeable gain is made up of the gain during her period of ownership and the gain which was rolled over from Richard (under section 165 or 260 of the TCGA 1992).

    It is also important to remember that since 10th of December 2003, hold-over relief has not been available under sections 260  or 165  for any disposal to a trust which is ‘settlor interested’ immediately after the disposal If the settlement later becomes a settlor interested trust the relief is clawed back.

    The above is an anti-avoidance measure which was introduced as a ‘settlor interested’ trust is a trust where any property may be payable to the settlor or the settlors spouse in any circumstances. However from the 6th of April 2006 it also includes a trust which may benefit the settlor’s unmarried minor children. This now severally restricts the limits and the occasions on which hold-over relief can be claimed.

    Also it’s important to remember that section 165  or 260  only applies where the transferee is either resident or an ordinarily resident in the UK. Thus, disposals of chargeable assets to non-resident individuals in the UK, CGT liability on held-over gains is immediately triggered.

    The CGT is primarily payable by the donee who if is overseas which could lead to a failure of the tax being recovered. If they fail to pay the tax within 12 months this fall back on the donor who probably does not have the funds to settle the bill, however the donor does have the right of recovery from the donee.

    Because of the risk of a clawback charge, the donor should be advised to consider insurance cover, retention of part of the gifted property for six years and indemnities from the donee.

    A further relief was introduced in the Finance Act 2008, which creates new sections 169H-169R  in the TCGA 1992 . The relief applies only in relation to disposals (by sale or gift) made on or after 6th of April 2008.

    The relief applies where a there is a ‘qualifying business disposal’ and falls under the Entrepreneurs relief. This occurs where there is a disposal of certain business assets that meet a certain criteria which is outlined in the following 3 steps.

    The first step is with this type of disposal that it must be a) the business (or part of it) which is a going concern; or b) an asset which is used in the business following the cessation of that business.

    However, in either case only those assets used for the purposes of the business carried on by the sole trader or partner are eligible for relief. Shares and other assets held for investments purposes are not eligible for relief.

    Where there is a disposal of assets following the cessation of a business then the transferor needs to have owned the business for a minimum period of one year, ending on the date of the disposal, providing the disposal occurs within three years after the cessation of the business.

    Also remember when distributing company shares and establishing if they qualify for relief the following steps must be satisfied:

    1) The company must be a trading company;
    2) The transferor must have a shareholding that gives at least 5% of the voting rights to (the transferors personal company), and
    3)  The transferor must be an officer or employee of the company.

    Note as well as the above the following conditions must be satisfied:

    a) Either during a one-year period ending with the date of disposal; or
    b) During a one year period ending with the date when the company ceases to be a trading company, providing that the disposal occurs within three years after the trading company ceases to be a trading company.

    Therefore the third step is in regards to individuals, partnerships or companies in if this relief is to be used they need to qualify for this relief they need to establish the following:

    a) The assets disposed of must have been used for the purposes of a business run by:

    1) A partnership in which the transferor is a partner; or
    2) A trading company which was the transferor’s personal company and of which the transferor was an officer or employee; and

    b) The disposal of the asset must be associated with a qualifying disposal of the transferor’s interest in the partnership or company arising from the withdrawal of the transferor from the business; and

    c) The assets were in use for the purposes of the business during the period of one year ending with the earlier of:

    1) The date of disposal of the partnership interest or company shares with which the asset disposal is associated; and
    2) The cessation of the business of the partnership or company using the asset.

    This relief is not an automatic right where there has been a qualifying business disposal as under the above the above steps; the transferor must choose to claim the relief. If he does so, the effect is that any losses arising from the qualifying disposal are first offset against the gains from that disposal.

    The net gain produced is then reduced by four-ninths. This means where there has been a qualifying business disposal, the transferor’s may choose to claim the relief. If he does so, the effect is that any losses arising from the qualifying disposal and are taxed at the CGT level after deductions of the annual exemptions.

    However, the use of this relief is subject to a lifetime cap of 1 million of the qualifying net gains. Each time a person claims the relief, the value of the net gains for which he claims is added to his lifetime total, and once the person exceeds the limit he will not be able to claim the relief in relation to any further qualifying gains.

    Richard holds a directorship in 2 company’s A and B in which he has a 10% holding in each. In 2012 he sells his interest in company A making a gain of six hundred and thirty thousand pounds.

    If Richard elects to take the relief his net gain is reduced by four-ninths to three hundred and fifty thousand pounds and this figure is added to any other gains he has made in the tax year, after deducting his annual allowance, and are taxed at 28%. Richard now has only has three hundred and seventy thousand pounds of his one million lifetime limit.

    If Richard sells his shares in B in the next tax year and realises a gain of five hundred thousand pounds, he can only claim the relief in relation to the first three hundred and seventy thousand pounds. The further one hundred and thirty thousand pounds is fully taxable.

    There is an important planning point here which is a director or a shareholder may wish to cease active involvement with the company but retain the shares. If the individual is likely to sell the shares they own, it may be worth continuing as a director until the date of the sale to retain the benefit of this relief.

    Conclusion

    It is important to remember that when we consider estate planning, in regards to transfers, we must consider the balance between both IHT and CGT.

    When recommending a trust we need to be making sure the client is aware of any CGT that will become payable and how this will affect the use of their annual allowances, and what other reliefs are available.

    Therefore using either Lifetime Chargeable Transfers or Potentially Exempt Transfers can have serious consequences in that there will be a disposal for CGT. If we are to use such mechanisms there needs to be a consideration of the tax which could be owed.

    Also for those with business interests we should always consider if any further reliefs can be applied for the benefit of these clients.

    Although we did not apply the 28% current CGT charge to any of the examples the article was more focused on making sure that you are aware of the calculation and the other reliefs available.

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    Matt Walkden Will Writer

    About Matt Walkden

    I am a Professional Will Writer and I offer a small number of other products that complement my Will Writing such as Lasting Power of Attorneys (LPA’s), Fixed Price Estate Administration, often called Probate and some Property Products such as changing a family home from Joint owners to Tenants in Common.

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