Capital Gains Tax - Essay Example

Capital Gains Tax The purpose of this essay is to critically examine what accounts for the disposal of an asset in relation to the Capital Gains tax. The essay initially describes the background of Capital Gains tax in terms of the proper definition for the chargeable person and the chargeable asset. Then it moves onto discuss the issues of the chargeable disposal, the exemptions and part disposals. Thesis Statement and Research Methodology The essay aims to discuss the factors that affect the disposal of an asset in relation to the Capital Gains Tax. For the purpose of research, I have analyzed and made use of many literature reviews. Introduction A company operating in a market has to undergo many processes e.g. the earning of revenue, the deduction of the costs, the payment of wages etc. The consideration of taxes for firms is one aspect that the firms need to be very cautious about. Taxes are generally enforced on the profits or income of the companies and individuals. There are many types of taxes, the common ones being the income tax (levied on income) and the sales tax (levied on sales). Another type of tax is the Capital Gains Tax which would be discussed throughout the paper. Back Ground to Capital Gains Tax According to Burman (1999), a Capital Gains tax is the one that is levied on the Capital Gains of a company or any individual.1 Capital Gains refer to the profit that is earned due to the sale of a non-inventory asset which was bought at a fairly low price. These Gains may be earned due to the sale of assets like the stocks, the bonds and property etc. For example, if a person Mr. Edward Cullen buys some shares worth £2,500 n sells them for £12,500 then he makes capital gains worth £10,000. (12,500-2,500) Campbell (1977) argues that Capital Gains have a lot of strategic importance2. This is because according to him, the business income alone does not prove to be sufficient for the motivation of investors. His study (1977) also shows that the investment in the US and other countries like France, Britain, and Germany has improved over the years due to the increase in the enthusiasm towards the Capital Gains3. However, the introduction of the Capital Gains tax is something that discourages companies and individuals. This is because the incidence of the tax means that the companies no longer enjoy the relatively newer and higher profits that they previously had. As a consequence, they may get discouraged by the tax and may try to sell the asset for a price that is lower than the price that is chargeable. Ultimately the Capital Gains earned by the companies and individuals may decrease and so will the eagerness towards investment through the sale of the non inventory assets. But all of this depends on the respective criterion of the government policies for the charging of the person and the assets. 2-Chargeability of Individuals and Assets 2a-Chargeable Individuals The Capital Gains tax does not apply to the people who sell personal belongings worth £ 6,000 according to Lee (2009)4. This is because the government does not want to exploit the people who are already getting lesser amounts of profits through the sale of the personal belongings. Also, according to the UK Capital Gains tax rules, the first £ 9,200 count towards the Annual Exempt Amount (AEA). AEA refers to the amount that is not subject to tax. Gains that exceed this amount are taxed annually as they become a part of the taxable income of the individuals and corporations both. (UK Capital Gains Tax Rules) The rate at which they are taxed may vary from 10 % to 40 % depending on the income of the individuals. According to Collman (2010), this tax is almost 18 % on average. Therefore, a chargeable person is the one whose profit from the sale of the personal belonging is greater than £ 6,000, after an initial £9,200 that contributes to the AEA. 2b-Chargeable Assets The UK Capital Gains tax policy is also defines the criterion of the chargeable assets. According to the rules introduced by the UK government the assets that can be charged include property, shares, jewellery and other business assets like goodwill. The tax rate may apply to the property that is not used for private purposes, as Lee (2009) relates5. As a general rule, Capital Gains tax is applicable to the property that may be rented but where one should not have resided. Also, it applies to business premises such as shops and farms or to any form of land (e.g. used for farming). (Capital Gains Tax) Capital Gains tax is also applicable to be levied on certain shares and bonds owned by companies. The companies and organizations may be charged if they are to sell or dispose of units in units trust, shares and debentures. Further, they may be charged for the disposing or the selling of business assets like the goodwill. 2c-The issue of disposal The chargeability of the certain assets and individuals may seem very easy, as described by the rules of the Capital Gains Tax; however this is not the case. According to Micheal Meacher, the UK based investment trusts that were held by the people in the UK in 2004-2005 were £ 284 million while the ones that were reported by were just £ 5.8 million or just 2% of the total income6. (21 Apr 2008 : Column 1131) Although there may be a lot of reasons associated with this behaviour, for example tax evasion (or the people not declaring the Gains) or tax avoidance, one reason, however, may also be the issue of disposal. People may be confused about the meaning of disposal and the criterion for ‘gifts’. Meaning of disposal Disposal literally means to get rid of something. In this case however the meaning of disposal is not just to get rid of something. In fact according to Burman (1999), disposal in relation to the Capital Gains means the sale of the assets so that they can no longer be a part of one’s equity and at the same time maybe a source of profit to the owners7. So basically the meaning of disposal in this context refers to the sale of non-inventory assets. The definition of disposal in terms of the Capital Gains tax can be of two types. Firstly ‘disposal’ here means the ceasing of the ownership of an asset that may have been sold, given away, exchanged, or exchanged for something else according to HM Revenue and Customs (2010)8. Examples may include the repayment of a debt or the grant of an option. Secondly, ‘disposal’ refers to the disposal of an asset when in actuality one is just ‘deemed’ to have exposed of it. The examples of such ‘disposals’ include the receiving of an insurance payout for a damaged asset, value shifting, company migration etc. (HRMC, 2010) Issues of disposal also arise in the case of gifts. Gifts Gifts are the investments that are provided by the UK government itself for the individuals and the companies in order to achieve long run objectives. According to HRMC (2010), the gifts include the Premium Bonds (that are usually in sterling) that pay a fixed amount of interest rate. The gains associated with the sale or the exchange of gifts are also associated with the Capital Gains and so certain rules of the Capital Gains tax apply to the gifts. According to HRMC (2010), if the gifts are sold to a spouse or a civil partner then one is not liable for the payment of the Capital Gains tax provided that the two partners have lived together for the least part of the year in which the gift was exchanged9. The second condition is that the gift should not be something that is provided for the exchange of something else. However if in a later period of time, if the partner decides on disposing of the asset then the tax applicable to him/her would be over a time period of the ownership by both the partners. For example if a person, Mr Edward gives some jewellery, that was initially bought at 800£, to his wife, then the wife, after spending 300 £ on the repairing and selling at £ 2000, incurs costs that equal £1100 (800+ 300) and makes a profit of £ 900 (2000-900). The taxes that apply to the gifts that are given to other connected behave differently. Arm’s Length and Other Considerations According to HRMC (2010), arm’s length refers to a transaction that is done in a normal commercial way10. Generally, in an arm’s length an individual or a company sells or disposes of the assets at higher prices so that a certain amount of profit can be achieved. However in reality, this may not always be true. For example, if Mr Edward wants to sell his furniture quickly in order to leave for another state, and if Mr Jacob knows that Mr. Edward is leaving, then he would offer him a lesser price and so Edward would be forced to have a ‘bad bargain’. People may also be forced to sell at prices that are lower or sell it even when they know that the buyers are willing to give more for the assets in another way. According to HRMC (2010), such situations are the ones where the arm’s length is not applicable. Arm’s length does not hold true usually when there are connected people involved in the transactions. Lee (2009) defines the connected people as the ones who may be closely related for example brothers, sister, parents, certain trustees etc11. For such people, one may not be able to charge at a higher price. The result of which is that lower profits are earned. The Capital Gains Tax rules, in such situations, imply that these should not be considered separately. Rather the profits and losses from such transactions should be added (or subtracted) to the gifts allocated to each of the connected people. The market value is also one consideration that has to be taken into account. For example, in some transactions where the person is not sure of what to charge for the asset, he/she can determine the market value, or the value that can be earned if the asset is old in an open market, and charge accordingly. For example, if Mr. Edward gives Miss Bella an antique and Ms. Bella gives him £5,000 as a token gesture. The market value, suppose, for the antique the day that it was given was £50,000. If Mr. Edward buys it back after a certain number of years for £40,000 then the capital gains of Mr. Edward would be £10,000 (50,000-40,000). This is because the amount of £ 4,000 that was given as a gesture is simply ignored. While some of the assets may be sold or disposed off completely, others are ‘part disposals.’ 2d- Part disposals Part disposals include the disposal of a portion of the total asset. For example, one may have disposed of a part of the inherited property or half of the furniture owned. For the Capital Gains Tax applicability, initially the value of the entire asset is taken into account and then the initial cost of the asset is divided over the part sold. Consequently, the gains and the loss from the part disposal are then compared and, if need be, the Capital Gains tax is levied. 2e-Wasting Assets/Chattels A wasting asset is defined as the one that, according to the HRMC (2010), has a life of around fifty years e.g. plant machinery12. If a wasting asset is sold, then there always arises some restriction in the consideration of the cost associated with the plant. The result of which is that the tax may not be levied even if truly it is applicable. Chattels are personal possessions that are ‘tangible’ assets. They may include furnishings, paintings etc for households. For the taxation of chattels, the rules of the Capital Gains tax are the same as for other assets i.e. the profits earned from the exchange of the chattels are not taxed if they are lesser than or equal to £ 6,000. Exemptions Some of the assets earned by the individuals and companies are exempted from the Capital Gains Tax. These assets are the ones that one is not charged for even after they have been sold for a higher price than what they were initially brought for. According to Lee (2009), the government does not consider the gains from the sale from the ‘exemptions’ as something that has to be taxed13. Some examples include personal possessions worth less than £ 6,000, as mentioned before. The stocks and the shares that are held in tax free investment savings accounts are also exempted from the taxation under the Capital Gains Tax rules. Certain government bonds and securities like the National Savings Certificates and also the gains earned through betting and lottery winning are further assets that are not to be taxed. Conclusion To conclude, the Capital Gains tax is the tax rate that is levied on an individual’s or a company’s profits or gains that are earned through the sale (or disposal) of non inventory assets. The HRMC (2010) defines clearly the tax rate that is applicable to a chargeable asset or a chargeable person. It also takes into account different sets of situations that may arise due to such transactions e.g. the transactions related to gifts, connected people and so on and also mentions explicitly the rules that are associated with each situation14. The set of rules introduced by the UK government makes it easier for the individuals to calculate their gains and costs so that they are prepared for the incidence of the Capital Gains Tax. References Burman, L. (1999). The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed. UK. Brookings Institution Press, pp.3-4, pp. 9-33. Campbell, C. (1977). Economic growth, capital gains, and income distribution, 1897-1956 (Dissertations in American economic history). US. Arno Press. pp. 1-5. Collman, E. (2010).Capital gains tax explained. UK. Times Online. 14th January. HRMC. (2010).Capital Gains Tax [Internet] Available from [Accessed 26 May 2010] Lee, N. (2009). Revenue Law Principles and Practice, 27th ed. UK. Bloomsbury Professional, p.559, pp. 580-590, pp. 593-597. Site Editor. (2008). 21 Apr 2008 : Column 1131 [Internet] Avalialable from < http://www.parliament.the-stationery-office.com/pa/cm200708/cmhansrd/cm080421/debtext/80421-0017.htm> [Accessed 26 May 2010] Site Editor. (2010). UK Capital Tax Gains Rules [Internet] Avalialable from < http://www.fairinvestment.co.uk/uk_capital_gains_tax_rules.aspx> [Accessed 26 May 2010] Read More