Capital gains

This is an updated version of my article on capital gains that has previously been published in student accountant. It is relevant to candidates sitting Paper 2.3 in June or December 2005. Optional Question 4 in Section A of Paper 2.3 will cover capital gains, either for an incorporated business or an unincorporated business. Capital gains may also form part of a question in Section A.

For ease of reference, the terms 'limited company' and 'individual' are generally used in this article rather than 'incorporated business' and 'unincorporated business'.

Overview
Although there are a lot of similarities in the way in which the capital gains of a limited company and the capital gains of an individual are taxed, there are also some very important differences.

A limited company's capital gains form part of the profits chargeable to corporation tax. An individual's capital gains are subject to capital gains tax. Although there are certain links between capital gains tax and income tax, these are two completely separate taxes.

The indexation allowance is given when calculating capital gains for a limited company. However, individuals only receive the indexation allowance up to April 1998. They now have the benefit of taper relief instead.

Individuals can benefit from rollover relief, holdover relief for the gift of business assets, and rollover relief when a business is incorporated. However, limited companies can only benefit from rollover relief.

Basic computation - limited companies
Using the correct layout makes the calculation of a capital gain much easier. There are several points to remember:

• It is necessary to keep the incidental costs of acquisition and the incidental costs of disposal separate. The incidental costs of acquisition qualify for indexation allowance, while the incidental costs of disposal do not.
• Enhancement expenditure is that expenditure which adds to the value of the asset concerned. Therefore, the cost of repairing an asset is not enhancement expenditure.
• Limited companies receive the indexation allowance up to the month of disposal.
• The indexation factor is normally rounded to three decimal places.
• The indexation allowance cannot be used to create or increase a capital loss.
• Although you may be required to calculate the indexation allowance, it is not examinable in detail. In many cases the indexation allowance figure will be given as part of a question. You may be given the actual indexation allowance figure, or the figure given as the cost of an asset may include the indexation allowance.

Example 1
A Ltd sold a factory on 15 February 2005 for £320,000. The factory was purchased on 24 October 1995 for £164,000, and was extended at a cost of £37,000 during March 1997. During May 1998 the roof of the factory was replaced at a cost of £24,000 following a fire.

A Ltd incurred legal fees of £3,600 in connection with the purchase of the factory, and legal fees of £6,200 in connection with the disposal. Retail price indices (RPIs) are as follows:

A Ltd's capital gain in respect of the factory is as follows:

• The factory extension is enhancement expenditure as it has added to the value of the factory.
• The replacement of the roof is not enhancement expenditure, being in the nature of a repair.
• The indexation factor for the cost of the factory from October 1995 to February 2005 is:
  190.0 - 149.8
  149.8 = 0.268
• The indexation factor for the enhancement expenditure from March 1997 to February 2004 is:
  190.0 - 155.4
  155.4 = 0.223

When a limited company has a capital loss, it is first set off against any capital gains arising in the same accounting period. Any remaining capital loss is then carried forward and set off against the first available capital gains of future accounting periods.

Although capital gains are included as part of a company's profits chargeable to corporation tax, capital losses are never set off against other income.

Example 2
B Ltd has the following results:

The corporation tax liability of B Ltd for the years ended 31 March 2004 and 2005 is as follows:

• The capital loss for the year ended 31 March 2004 is carried forward, and so the capital gain for the year ended 31 March 2005 is £77,000 (85,000 - 8,000).

Basic computation - individuals
The layout of a capital gains computation for an individual is similar to that for a limited company. Remember that individuals only receive the indexation allowance up to April 1998. You will not have to calculate the indexation allowance for an individual. Where necessary, either the indexation allowance figure will be given, or the figure given for the cost of an asset will already take account of indexation.

For disposals after 5 April 1998 taper relief may be available. The relief is more generous for business assets than for non-business assets. The percentage of the gain chargeable is as follows:

A non-business asset acquired before 17 March 1998 qualifies for an addition of one year to the period for which it is actually owned after 5 April 1998. Therefore for disposals of non-business assets during 2004-05, taper relief is based on seven complete years of ownership if the asset was owned prior to 17 March 1998.

It is obviously important that you know the distinction between a business asset and a non-business asset. The most relevant types of business asset are as follows.

• Assets used for trade purposes by a sole trader.
• Shares in unquoted trading companies.
• Shares in quoted trading companies where an individual either has a 5% shareholding or is an employee of the company.

An individual's capital gains are taxed as if they were savings income. Therefore the rate of capital gains tax is 10%, 20% or 40% depending on whether the individual pays income tax at the starting rate, the basic rate, or the higher rate. Capital gains tax is collected as part of the self-assessment system, and is due in one amount on 31 January following the tax year. Payments on account are not required in respect of capital gains tax.

There are a number of common mistakes that should be avoided when dealing with capital gains tax:

• An unincorporated business is not treated as a separate entity for capital gains tax purposes. Therefore when a business is disposed of you should deal with each asset separately.
• Motor cars are exempt assets, so do not include them in your capital gains tax computation.
• Do not forget to deduct the annual exemption.
• A figure for taxable income will normally be given if you are expected to calculate the capital gains tax liability. It is not necessary to deduct the personal allowance from this figure.
• Do not use the basic rate of 22% instead of the savings rate of 20%.

Example 3
Cindy has been in business as a sole trader since 1 May 1996. On 28 February 2005 she sold the following assets:

• Goodwill for £50,000. The goodwill had been built up since 1 May 1996, and had a nil cost.
• A freehold office building for £130,000. The office building was purchased on 1 July 2003 for £110,000, and was always used by Cindy for business purposes.
• A freehold warehouse for £140,000. The warehouse was purchased on 1 May 1996 for £94,000, and was never used by Cindy for business purposes. The indexation allowance from May 1996 to April 1998 is £6,000, and from May 1996 to February 2005 it is £18,500.
• A motor car for £25,000. The motor car was purchased on 1 November 2002 for £23,500, and was always used by Cindy for business purposes.

Cindy's taxable income for 2004-05 is £20,000. Her capital gains tax liability for 2004-05 is as follows:

• The capital gains tax liability will be due on 31 January 2006.
• Goodwill is a business asset, and taper relief is based on six complete years of ownership.
• The office building is a business asset, and taper relief is based on one complete year of ownership.
• The warehouse is a non-business asset. As it was owned prior to 17 March 1998, taper relief is based on seven complete years of ownership.
• Motor cars are exempt from capital gains tax.

Taper relief is computed after deducting any current year capital losses. For this purpose, capital losses are set against capital gains on the most beneficial basis. Therefore a capital loss should be set against the capital gains qualifying for the least amount of taper relief.

Example 4
During 2004-05 Ding had the following capital gains and losses.

• A capital gain of £12,000 on a business asset.
• A capital gain of £14,000 on a non-business asset.
• A capital loss of £8,000.

The assets were all owned for two complete years prior to their disposal.

The capital loss is set off against the non-business asset since this does not qualify for taper relief.

Shares - limited companies
The disposal of shares can create a particular problem. This is because the shares disposed of might have been purchased at different times, and it is then difficult to identify exactly which shares have been sold. As far as limited companies are concerned, disposals of shares are matched with purchases in the following order:

• Shares purchased on the same day as the disposal.
• Shares purchased during the nine days prior to the disposal.
• Shares in the 1985 pool.

The 1985 pool aggregates all purchases except for those purchased on the same day or during the previous nine days.

Remember that when calculating indexation allowances for the 1985 pool, the indexation fraction is not rounded to three decimal places. In some cases the calculation of the indexation allowance will not be necessary because you will be given a value for the 1985 pool. Where you are expected to calculate the value of the 1985 pool, you will not have to compute more than two indexation allowances.

Example 5
On 15 June 2004, E Ltd sold 70,000 £1 ordinary shares in F plc for £275,000. E Ltd had originally purchased 40,000 shares in F plc on 10 June 1995 for £110,000, and purchased a further 60,000 shares on 20 August 1999 for £180,000. RPIs are as follows:

June 1995 149.8
August 1999 165.5
June 2004 186.8

Capital gain:

1985 Pool

Shares - individuals
Because taper relief may be given in respect of disposals made after 5 April 1998, it is necessary to separately identify purchases made after that date. The system of share pooling therefore no longer applies for individuals. Disposals of shares are matched with purchases in the following order:

• Shares purchased on the same day as the disposal.
• Shares purchased within the following 30 days.
• Shares purchased after 5 April 1998 (taking the most recent purchase first on a LIFO basis).
• Shares in the 1985 pool.

Because indexation is not examinable as regards individuals, you will not be expected to calculate the value of the 1985 pool. You will simply be given a figure for the value of the 1985 pool as at 5 April 1998.

Example 6
Gia has had the following transactions in the shares of H plc:

1 June 1994 Purchased 3,000 shares for £6,000. The indexed value of the 1985 pool at 5 April 1998 is £6,900.
30 April 2003 Purchased 1,500 shares for £6,750
15 May 2003 Purchased 500 shares for £2,500
15 February 2005 Sold 4,000 shares for £24,000

The shares in H plc are not a business asset for the purposes of taper relief. Gia's capital gain for 2004-05 is as follows:

• Taper relief is not available in respect of the shares acquired on 30 April 2003 or 15 May 2003 since they were not held for three complete years.
• The shares included in the 1985 pool were owned prior to 17 March 1998, so taper relief is based on seven complete years of ownership.

The reason that disposals are matched with shares purchased within the following 30 days is to prevent a practice known as bed and breakfasting. A person might sell shares at the close of business one day and then buy them back at the opening of business the next day. Previously, a gain or loss could thus be established without a genuine disposal being made. The 30-day matching rule makes bed and breakfasting much more difficult, since the subsequent purchase cannot take place within 30 days.

Example 7
Ian purchased 1,000 shares in J plc on 5 May 2004 for £10,000. The shares have fallen in value, so he would like to establish a capital loss. Therefore the shares were sold on 2 December 2004 for £2,000, and purchased back on 10 December 2004 for £1,900.

Ian's transactions are caught by the 30-day matching rule. The disposal on 2 December 2004 will be matched with the purchase on 10 December 2004, and so for 2004-05 he will have a capital gain of £100 (2,000 - 1,900).

With individuals it might be necessary to establish a market value figure where the shares are disposed of by way of a gift rather than being sold.

Example 8
Kim made a gift of her entire shareholding of 10,000 £1 ordinary shares in L plc to her daughter. On the date of the gift the shares were quoted at £5.10-£5.18, with recorded bargains of £5.00, £5.15 and £5.22.

• The shares in L plc are valued at the lower of the quarter up price (£5.10 + 1/4(£5.18 - £5.10) = £5.12) and the average of the days highest and lowest bargains ((£5.00 + £5.22)/2 = £5.11).
• The deemed proceeds figure is therefore £51,100 (10,000 x £5.11).

Bonus Issues
With a bonus issue there is no additional cost involved. The only thing that changes is the number of shares held.

Example 9
On 22 January 2005 M Ltd sold 30,000 £1 ordinary shares in N plc for £140,000. M Ltd had purchased 30,000 shares in N plc on 9 February 2001 for £97,500. The indexed value of the 1985 pool on 3 January 2005 was £103,500. On 3 January 2005 N plc made a 1-for-2 bonus issue.

• M Ltd was issued with 15,000 (30,000 x 1/2) new shares as a result of the bonus issue.
• The cost of the shares sold is therefore £65,000 (97,500 x 30,000/(30,000 + 15,000)).
• The indexation allowance is £4,000 (103,500 - 97,500 = 6,000 x 30,000/(30,000 + 15,000).

Rights Issues
With a rights issue the new shares are paid for, and so the cost figure will have to be adjusted. Although for matching purposes the rights issue shares are deemed to have been purchased at the same time as the original holding, the indexation allowance only runs from the time of the rights issue.

Example 10
On 22 January 2005 O Ltd sold 30,000 £1 ordinary shares in P plc for £140,000.

O Ltd had purchased 30,000 shares in P plc on 9 February 2001 for £97,500. The indexed value of the 1985 pool on 3 January 2005 was £103,500. On 3 January 2005 P plc made a 1-for-2 rights issue. O Ltd took up its allocation under the rights issue in full, paying £1.50 for each new share issued.

• O Ltd was issued with 15,000 (30,000 x 1/2) new shares under the rights issue at a cost of £22,500 (15,000 x £1.50).
• The cost of the shares sold is therefore £80,000 (97,500 + 22,500 = 120,000 x 30,000/(30,000 + 15,000)).
• The indexation allowance is £4,000 (103,500 - 97,500 = 6,000 x 30,000/(30,000 + 15,000).

Where an individual is concerned, taper relief is calculated from the date that the original holding was purchased.

Example 11
Assume the same information as in Example 10, except that the shares were purchased and sold by Quinn rather than O Ltd, and the cost of the original 30,000 shares was £103,500. The shares in P plc are not a business asset for the purposes of taper relief.

• The cost of the shares sold is £84,000 (103,500 + 22,500 = 126,000 x 30,000/(30,000 + 15,000)).
• Taper relief is based on three complete years of ownership even though the new shares were owned for just 19 days.

Takeovers
A paper for paper takeover is not a chargeable disposal. The new shares simply take the place of the original shares, and are deemed to have been purchased at the same time and for the same cost. Where more than one class of new share is acquired as a result of the takeover, the original cost is apportioned according to the market values of the new shares immediately after the takeover.

Example 12
On 28 March 2005 R Ltd sold its entire holding of £1 ordinary shares in T plc for £55,000. R Ltd had originally purchased 10,000 shares in S plc on 5 May 1995 for £14,000. The indexed value of the 1985 pool on 7 March 2005 was £17,200. On 7 March 2005 S plc was taken over by T plc. R Ltd received two £1 ordinary shares and one £1 preference share in T plc for each £1 ordinary share held in S plc. Immediately after the takeover each £1 ordinary share in T plc was quoted at £2.50 and each £1 preference share was quoted at £1.25.

• On the takeover R Ltd received ordinary shares valued at £50,000 (10,000 x 2 x £2.50) and preference shares valued at £12,500 (10,000 x £1.25).
• The cost attributable to the ordinary shares is £11,200 (14,000 x 50,000/(50,000 + 12,500).
• The indexation allowance attributable to the ordinary shares is £2,560 (17,200 - 14,000 = 3,200 x 50,000/(50,000 + 12,500).

Where an individual is concerned, taper relief is calculated from the date that the original holding was purchased, rather than from the date of the takeover.

Example 13
Assume the same information as in Example 12, except that the shares were purchased and sold by Uri rather than R Ltd, and the 10,000 shares in S plc were originally purchased on 5 May 2000 for £14,000. The shares in S plc and T plc are not business assets for the purposes of taper relief.

Taper relief is based on four complete years of ownership.

Rollover relief
Rollover relief is available to both limited companies and individuals. It allows a capital gain to be deferred (rolled over) where the disposal proceeds of the old asset are reinvested in a new asset. The deferral is achieved by deducting the capital gain from the cost of the new asset.

To qualify for rollover relief both the old asset and the new asset must be qualifying assets. The most relevant types of qualifying asset are as follows:

• Land and buildings
• Fixed plant and machinery
• Goodwill (for individuals only).

It is not necessary for the old asset and the new asset to be in the same category.

Example 14
What are the conditions that must be met in order that rollover relief can be claimed?

• The reinvestment must take place between one year before and three years after the date of disposal.
• The old and new assets must both be qualifying assets and be used for business purposes.
• The new asset must be brought into business use at the time that it is acquired.

Where the disposal proceeds of the old asset are not fully reinvested in the new asset, the amount not reinvested reduces the amount of capital gain that can be rolled over. Therefore if the amount not reinvested is greater than the capital gain, no rollover relief is available.

Where the new asset is a depreciating asset, then the gain does not reduce the cost of the new asset but is instead held over. A depreciating asset is an asset with a predictable life of less than 60 years. The only types of depreciating asset that you need to be aware of are fixed plant and machinery and short leaseholds.

Example 15
V Ltd sold a factory on 15 February 2005 for £320,000, and this resulted in a capital gain of £85,000. The company is considering the following alternative ways of reinvesting the proceeds from the sale of its factory:

• A freehold warehouse can be purchased for £340,000.
• A freehold office building can be purchased for £275,000.
• A leasehold factory on a 40-year lease can be acquired for a premium of £350,000.

The reinvestment will take place during May 2005.

Warehouse

• The sale proceeds are fully reinvested, and so the whole of the gain can be rolled over.
• The base cost of the warehouse will be £255,000 (340,000 - 85,000).

Office building

• The sale proceeds are not fully reinvested, and so £45,000 (320,000 - 275,000) of the capital gain cannot be rolled over.
• The base cost of the office building will be £235,000 (275,000 - (85,000 - 45,000).

Factory

• The sale proceeds are fully reinvested, and so the whole of the gain can be held over.
• The factory is a depreciating asset, and so the base cost of the factory is not adjusted.
• The gain is held over until the earlier of May 2015 (10 years from the date of acquisition) or the date that the factory is sold.

Remember that rollover relief is applied after taking account of any indexation allowance that is available. However, where an individual is concerned, a claim for rollover relief will mean that any entitlement to taper relief is lost in respect of the old asset.

When the new asset is subsequently sold, only the period of ownership of that new asset counts in deciding how much taper relief is due.

Example 16
Victor sold a freehold factory on 30 November 2002 for £140,000. The factory was purchased on 1 August 2000 for £95,000. The gain arising on this disposal was rolled over against the cost of a freehold warehouse that was purchased for £160,000 on 15 September 2002. The warehouse was sold for £220,000 on 30 April 2004. Both the factory and the warehouse were used by Victor for business purposes as a sole trader.

• The sale proceeds are fully reinvested, and so the whole of the gain can be rolled over.
• Taper relief is based on one complete year of ownership.

When the asset disposed of was not used entirely for business purposes, then the gain relating to the non-business proportion does not qualify for rollover relief.

Example 17
Wan sold a freehold factory on 8 November 2004 for £146,000, resulting in a capital gain of £74,000. The factory was purchased on 15 January 1996. 75% of the factory had been used for business purposes by Wan as a sole trader, the other 25% was never used for business purposes. Wan purchased a new freehold factory on 10 November 2004 for £156,000 - used 100% for business purposes.

• The proportion of the gain relating to non-business use is £18,500 (74,000 x 25%), and this amount does not qualify for rollover relief.
• The sale proceeds are fully reinvested, and so the balance of the gain can be rolled over.
• The base cost of the new factory is £100,500 (156,000 - 55,500).
• The figure chargeable relates to a non- business asset. Taper relief is based on seven complete years of ownership since the factory was acquired prior to 17 March 1998.

Holdover relief
Holdover relief is only available to individuals. It allows a capital gain to be deferred (held over) when a gift is made of a qualifying business asset. The deferral is achieved by deducting the capital gain of the donor who has made the gift from the base cost of the donee who has received the gift.

Holdover relief is also available when a sale is made at less than market value. In this case there will be an immediate charge to capital gains tax where sale proceeds exceed the original cost of the asset.

The most relevant types of qualifying business asset are as follows:

• Assets used for trade purposes by a sole trader.
• Shares in unquoted trading companies.
• Shares in quoted trading companies where an individual has a 5% shareholding.

These assets are virtually the same as those that are business assets for taper relief purposes.

Remember that the market value of an asset is used rather than the actual proceeds when a gift is made between family members since they will be connected persons.

Example 18
On 15 April 2004 Xu sold 10,000 £1 ordinary shares (a 30% shareholding) in Y Ltd, an unquoted trading company, to her daughter for £75,000. The market value of the shares on that date was £110,000. The shareholding was purchased on 10 July 1999 for £38,000. Xu and her daughter have elected to hold over the gain as a gift of a business asset.

• Xu and her daughter are connected persons, and therefore the market value of the shares sold is used.
• The consideration paid for the shares exceeds the allowable cost by £37,000 (75,000 - 38,000). This amount is immediately chargeable to capital gains tax.
• The shares in Y Ltd are a business asset, and taper relief is based on four complete years of ownership.

A claim for holdover relief will mean that the donor loses any entitlement to taper relief. When the donee subsequently sells the asset, only his or her period of ownership counts in deciding how much taper relief is due.

Example 19
Following on from Example 18, Xu's daughter sold the 10,000 £1 ordinary shares in Y Ltd on 5 May 2005 for £140,000.

Taper relief is based on one complete year of ownership.

The transfer of a business to a limited company
Rollover relief is available when an unincorporated business is incorporated. As such, it is obviously only available to individuals. For relief to be available, all the assets of the unincorporated business must be transferred to the new limited company in exchange for a consideration that must be wholly or partly in the form of shares.

The deferral is achieved by deducting the capital gains arising on the disposal of the assets of the unincorporated business from the value of the shares received from the new limited company.

Where some of the consideration is in the form of cash or loan, then that proportion of the capital gains cannot be rolled over.

Example 20
On 8 April 2004 Zoe incorporated a wholesale business that she had run as a sole trader since 1 March 2002. The market value of the business on 8 April 2004 was £250,000. All of the business assets were transferred to a new limited company, with the consideration consisting of 200,000 £1 ordinary shares valued at £200,000 and £50,000 in cash. The only chargeable asset of the business was goodwill, and this was valued at £100,000 on 8 April 2004. The goodwill had a nil cost.

1. The proportion of the gain relating to the cash consideration cannot be rolled over, so £20,000 (100,000 x 50,000/250,000) of the capital gain is immediately chargeable to capital gains tax.
2. Taper relief is based on two complete years of ownership.

A claim for rollover relief on incorporation will mean that any entitlement to taper relief is lost in respect of the assets transferred. When the new shares are subsequently sold, only their period of ownership counts in deciding how much taper relief is due.

Example 21
Following on from Example 20, Zoe sold 50,000 of the £1 ordinary shares in the new limited company on 5 May 2005 for £130,000. The new limited company is an unquoted trading company.

• The base cost of the shares is £120,000 (200,000 - 80,000).
• The shares qualify as a business asset, and taper relief is based on one complete year of ownership.

Conclusion
There is quite a lot to learn with regards to capital gains, and the differences in treatment between limited companies and individuals do not make this any easier. It is particularly important that you know how to:

1. layout a basic computation for both a limited company and for an individual
2. calculate taper relief
   and
3. apply the three different reliefs that are available.

David Harrowven is examiner for Paper 2.3