Britain’s complex taxation laws need a radical shake-up and – without compromising deficit reduction – the best place for the chancellor to start is by scrapping inheritance tax, argues Stephen Herring
The IoD challenged the political parties in the run-up to this year’s general election to adopt an agenda for bold reforms of the UK’s unnecessarily complex tax legislation. We made three important points which, at first sight, represent hurdles before sweeping changes can be introduced.
First, we accept the need to eliminate the annual fiscal deficit over the course of this parliament and face the greater challenge of starting to reduce Britain’s accumulated public sector net debt, which will have grown to £1.6trn by 2018. Second, we recognise that it is becoming increasingly difficult to identify further public sector spending reductions that could finance significant tax cuts. Finally, it is understood at the Treasury that those who lose out from tax reforms (including tax simplification) understandably criticise the reform, while those who gain generally remain silent. Hurdles such as these are hardly media-friendly to officials or politicians.
Which taxes can be reformed?
The summer budget updated the government’s forecasts for tax revenues. Table A (below) lists the amounts the more significant taxes – those yielding at least £5bn – are forecast to collect in 2016/17. The government has started a formal consultation on the tax relief for pension contributions and, more generally, the tax treatment of pensions from the initial contribution through accumulation to final receipt.
Any changes introduced would almost certainly result in individuals either gaining financially or losing out from the reform. Income tax and national insurance (NI) contributions are such substantial taxes that merely reforming one aspect, such as the treatment of pension contributions, will have a major impact across both income and generational groups.
The government has wisely but unsurprisingly stated in the consultative document that it is not committed to reforming the existing system unless a sufficient consensus for reform emerges. A similar issue arises on the even more tentative proposal to merge income tax and the employee/self-employed NI contribution.
Almost everyone across the political spectrum agrees in principle that merging these two taxes upon earnings is the right thing to do but drilling down to the key issues, such as the taxation of pensions and earnings after retirement age (both of which are exempt from NI contributions), challenges this apparent consensus.
The chancellor announced a cut in corporation tax in the budget from 20 per cent to 19 per cent in 2017/18 and 18 per cent in 2020/21 on entirely valid global tax competition grounds to ensure that the UK has the most competitive corporation tax rate in the G20.
Nevertheless, this tax will continue to collect over £40bn beyond 2020/21 and, in our view, further substantial reform to the tax is unlikely in this parliament, excluding possible additional reliefs targeted at small and medium-sized companies.
So far as VAT is concerned, the system is heavily influenced by UK membership of the European Union so radical reforms would have to overcome complex hurdles. The other indirect taxes and duties are successful ‘stealth taxes’ for the Exchequer and are relatively simple and inexpensive to collect, which suggests that they would be well down the government’s list for significant reform.
We think it is likely that both business rates and council tax will be reformed in this parliament. The former has been the focus of three consultative documents in the last two years and there is widespread support for reforms that would introduce a system more responsive to the modern economy and more advantageous to smaller and medium-sized businesses.
The controversial proposals for some form of mansion tax have now rightly been abandoned but the debate highlighted some issues with regard to the existing council tax that may be addressed – notably the infrequent and irregular revaluations undertaken.
We would be surprised, however, if reforms of either of these taxes were to be dramatic from the perspectives of most businesses or individuals. We would be even more surprised if reforms significantly altered the combined tax take of around £60-65bn in this parliament. This leaves us with capital taxation as the remaining candidate for bold and radical reform before 2020.
So why capital taxation?
Table A ought to provide a prompt to the chancellor. CGT and IHT together currently yield around £12bn for the Exchequer, with less than half the yield of either business rates or council tax, less than one third the yield of corporation tax, around nine per cent of yield of NICs or VAT, and less than seven per cent of the yield of income tax.
In an ideal fiscal world, the IoD would like to see both of these taxes repealed – with a single caveat. The caveat is that income tax and corporation tax legislation might have to be further strengthened to prevent the temptation for products to be developed which attempted artificially to convert taxable income and profits into non-taxable gains.
We are conscious, though, that the abolition of both of these poor-yielding taxes is extremely unlikely while the fiscal deficit persists. The case for dual abolition is, however, authentic and focuses upon the flaws inherent in both taxes.
CGT often prevents or delays economically desirable transactions occurring such as the sale of a business to another company to generate revenue increases, cost savings or synergies, or the sale of an asset to allow the equity to be invested in more economically productive areas.
IHT typically falls upon the affluent (rather than the wealthy) and the unlucky. It taxes the affluent because those with assets above the existing far too low, nil-rate band threshold of £325,000 pay IHT at a punitive rate of 40 per cent but generally do not have the financial flexibility opportunity available to the wealthy (say, those with financial assets of more than £10m) to transfer assets more than seven years before their death to their dependents.
It taxes the unlucky because (thankfully, for most other reasons) we cannot accurately predict whether we will survive for the seven-year accumulation period for gifts applicable to IHT. We are aware of numerous examples of an accident or sudden illness leading to a substantial and unbudgeted IHT liability which often damaged the progress or, indeed, the viability of the family business.
The chancellor has the opportunity to merge these taxes into a single capital tax without needing to raise other taxes or abandon his commitment to eliminating the annual fiscal deficit during the course of this parliament. However, before describing how this might be achieved, it is worthwhile briefly describing the main elements of both CGT and IHT.
Capital gains tax
CGT has an annual exemption of £11,100 (for 2015/16) and is charged broadly at a rate of 18 per cent for basic-rate taxpayers and 28 per cent for higher-rate taxpayers on gains above this threshold. There are various, relatively minor, exemptions for chattels and depreciating assets but there are also three much more important reliefs.
First, an individual’s death is not an occasion of charge for CGT, so the gain arising between the acquisition of an asset and its probate value is exempt from the tax. Purely from a taxation perspective, this is a favourable outcome but if an individual had sold an asset in March and unfortunately died in May (in the next tax year), his/her beneficiaries might well consider themselves to be not well treated by the tax system when CGT is paid by executors.
Second, a so-called business asset rollover relief is, rightly, available on the disposal of certain land, buildings and fixed plant and machinery used in a trading business where replacement assets are acquired within three years of the disposal.
Third, there is a key relief for the disposal of an interest in a trading business or the shares in a trading company or the holding company of a trading group. This relief is known as entrepreneurs’ relief and results in a lower CGT rate of 10 per cent being applied to an individual’s first £10m of qualifying capital gains.
It is often a complex relief to apply as there are strict rules about the length of ownership of the assets or shares, whether the business qualifies as trading for the purpose of entrepreneurs’ relief and the extent to which the assets have been used in a trade.
We often wonder whether the Exchequer would benefit if the relief were to be abolished but CGT was cut to a flat 10 per cent rate which encourages investors to realise capital gains rather than hold assets during their lifetime to eliminate a CGT liability at 28 per cent.
Inheritance tax (IHT) is paid upon an individual’s estate at death or gifts above the nil-rate band of £325,000 at a rate of 40 per cent. It is a much more complex tax than CGT with a large number of complex rules and targeted reliefs including gifts to charities, qualifying business assets and assets held in trusts. One of the most important features of the tax is the seven-year rule which exempts from IHT gifts made more than seven years before death.
A complex taper relief applies to gifts made between three and seven years before death. Most gifts are treated as potentially exempt transfers with an IHT liability only arising if the individual does not live for more than seven years after the gift. These complex provisions are designed to ensure that so-called deathbed gifts are not made by a dying person to avoid IHT.
Other important reliefs include the following: first, transfers between spouses and civil law partners do not usually create an IHT liability. This is because IHT is targeted upon gifts being made to the next generation although it is, arguably, a poorly designed relief to achieve this objective.
Second, various small gifts do not count against an individual’s lifetime nil-rate band of £325,000. These include small gifts up to £250 to an individual in a tax year, regular gifts from an individual’s after-tax income (for example, Christmas presents), gifts to charities and political parties which meet the stated criteria and, most bizarrely in the 21st century, gifts to individuals in anticipation of or upon that individual’s wedding or civil partnership ceremony fixed at £1,000, £2,500 or £5,000, depending on the relationship to the participant.
Third, there are two important IHT reliefs focused upon businesses. Agricultural property relief and woodland relief are given at 100 per cent of the agreed valuations and are intended to recognise that such land and forestry assets are often valued above their agricultural or forestry values because of the amenity value of the land and it would be extremely difficult to fund the payment of a significant IHT liability out of after-tax profits generated by these activities.
It is considered undesirable from economic and land use standpoints if such landholdings were to be broken up to fund an IHT liability. Business property relief is much broader and applies to most interests in trading businesses or shares held in unlisted trading companies (which includes most businesses traded on AIM).
The relief is given at either 50 per cent (for assets used by a qualifying trading business or 100 per cent for the businesses or shares themselves. There are complex calculations where a trading company owns excepted assets that are not used in its trade.
Finally, the commitment in the Conservative party’s 2015 manifesto to ease IHT for more modest estates has been satisfied by the introduction in the budget of an additional nil-rate band from April 2017 for a main residence transferring at death to that individual’s direct descendants of up to £175,000. In essence, this means that from 2020/21 a couple could transfer up to £1m IHT-free provided that the value of their main residence were to be at least £350,000.
It is understandable that this is a popular additional IHT relief but the IoD invariably favours broader-based, less focused personal tax reliefs which are less likely to influence behaviours. In other words, we recommended to the Treasury that the nil-rate band should simply be increased to £1m with no special rules for main residence ownership or ability to transfer an unused allowance to the individual’s surviving spouse or civil law partner.
We asked our Policy Voice survey panel about IHT in July and 68 per cent considered that the additional main residence relief was overly complex and most (74 per cent) considered the lifetime nil-rate band to be either slightly too low (29 per cent) or much too low (45 per cent). Invariably, members favour personal tax simplification, and capital taxes are clearly no exception to this rule.
How CGT and IHT interact
The term is not widely used in the UK but the term pyramid taxation – often used in the US – is a fair description, or criticism, of taxation where a sum of money that has already been subjected to direct taxation is taxed again by another direct tax. This is not an unusual occurrence with CGT and IHT.
For example, if an individual sells a portfolio of listed shares, and realises a capital gain upon which CGT is paid – and dies soon after the sale, thereby creating a liability to IHT – the combined CGT and IHT liability could exceed 55 per cent.
The same outcome can also arise where the asset sold does not meet the qualification criteria for IHT business property relief (for example, a hotel let to a hotel operator). Clearly, these are onerous liabilities and, in our opinion, unfair tax outcomes.
It is often wrongly assumed that countries competing with the UK for business investment have less generous tax reliefs, but this is by no means always the case for CGT and IHT. An astute chancellor will generally keep a close eye on competing tax regimes with the understanding that the tax regime invariably influences business location decisions for most medium/large companies and, indeed, an increasing number of entrepreneurial businesses.
Most of the UK’s major competitors have some form of CGT but the UK rate of 28 per cent (the level paid by higher rate and additional rate taxpayers) is towards the top end (an exception being France). For example, a fixed rate of 20 per cent often applies in Italy, China and Japan while other countries such as Germany often exempt gains from taxation if the asset has been owned for a minimum period. So far as the US is concerned, capital gains are generally taxed at a maximum of 20 per cent for those in the top rate income tax bracket but other taxpayers pay 15 per cent.
Turning to IHT, the international picture is significantly more varied and, indeed, often more generous than the UK’s legislation. In Germany, the tax system is broadly comparable to the UK as there is an exemption of €500,000 (£370,000) with the rates varying between 30 per cent and 50 per cent depending upon the relationship with the transferee.
In France, the taxation of assets is more onerous than the UK and includes a wealth tax with rates up to 1.5 per cent per annum on wealth in excess of €10m as well as an inheritance tax applying at rates between five per cent and 45 per cent on most gifts in excess of €100,000. In the US, an estate and gifts tax applies at rates between 18 per cent and 40 per cent but there is a much more generous exemption of $5.34m (£3.5m) or more than 10 times the UK nil-rate band of £325,000. It should also be stated that many countries now have no inheritance tax or estate tax whatsoever, including Australia, Austria, Canada, New Zealand, Norway and Sweden.
Merging CGT and IHT
The starting point for considering whether there is scope for reform of CGT and IHT in an era of fiscal deficits must be the impact on the Exchequer’s tax receipts; in short, are far-reaching tax reforms affordable? As Table A notes, CGT and IHT are only forecasted to collect £12bn out of the Exchequer’s total projected receipts of £629bn in 2015/16. Accordingly, the chancellor ought to be confident that he could enact radical reform of both taxes without threatening the imperative to eliminate the fiscal deficit during this parliament. Our recommendations are included in Table D (below).
The way forward
The chancellor has announced that he intends to leave a legacy at the end of this parliament of having eliminated the UK’s annual fiscal deficit. In our view, he should look to supplement this by abolishing IHT and thereby removing a complex, widely unpopular and arbitrary tax at relatively little cost to the Exchequer. This ought not to be the end game for UK tax reforms, simplifications and reductions in this parliament but it would represent an authentic, affordable and radical first step.
Those who lose out from tax reforms (including tax simplification) understandably criticise the reform, while those who gain generally remain silent.
• The government has started a formal consultation on the tax relief for pension contributions.
• We think it is quite likely that both business rates and council tax will be reformed in this parliament.
• Capital gains tax (CGT) and inheritance tax (IHT) together currently yield around £12bn for the Exchequer.
• CGT often prevents or delays economically desirable transactions occurring.
• IHT typically falls upon the affluent and the unlucky – rather than the wealthy.
• The chancellor has the opportunity to merge CGT and IHT into a single capital tax without needing to raise other taxes or abandon his commitment to eliminating the annual fiscal deficit during this parliamentary term.
• IHT is a much more complex tax than CGT with a large number of complex rules and targeted reliefs.
• Invariably IoD members favour personal tax simplification, and capital taxes are no exception.
• It is often wrongly assumed that countries competing with the UK for business investment have less generous tax reliefs, but this is by no means always the case for CGT and IHT.
• The chancellor ought to be confident that he could enact radical reform of CGT and IHT without threatening his overarching imperative to eliminate the fiscal deficit during this parliamentary term.