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TaxationWeb by Jennifer Adams

Jennifer Adams, Editor of TaxationWeb’s Capital Taxes section, considers what investors can do to improve the tax position on their share portfolios.When taxpayers come to pull together the information necessary to complete their personal Income Tax Return forms for the year 2003/04 they could be in for a shock. For the last couple of years we have been so used to the pages headed "Capital Gains" either being left blank or noting a loss to carry forward that it may come as a surprise to have to complete those pages again using taxable amounts being that according to the Stock Exchange, the FTSE 100 index gained in excess of 34% over the last fiscal year. Whether this rise will continue will obviously depend upon such matters as Iraq and the rising price of crude oil. However, now may well the time to take what gains have been earned - at least up to the CGT annual exemption limit.

Bed and breakfasting

The traditional way of exempting capital gains has always been to ‘bed and breakfast’ shareholdings, which means that:-

* A capital gain is triggered in the current year on the sale but the taxable gain is covered by the annual exemption;

* The investment is repurchased at a current cost thereby uplifting the base cost which is then carried forward resulting in a smaller gain on a future disposal.

There will obviously be transaction costs and loss of taper relief as the ‘clock’ for the uplift of taper relief must start again and this must be weighed against the benefit of the uplift in base cost.

Arrangement blocked

Finance Act 1998 (now included as TCGA 1992, s 106A(5)) restricted the above traditional method of bed and breakfasting (for individuals only - companies retain the original rules) by introducing a rule which states that a share disposal must now firstly be matched in a set order against purchase. Those of us in practice pre-6 April 1998 will recall the concept of ‘pooling’ where individual acquisitions lost their identity in the pool which was treated as a single asset with an average cost per share. As the Revenue said at the time ‘Pooling, which does not require retention of the details (cost and date) of individual share acquisitions is inconsistent with a system which tapers the gain according to the period for which the shares have been held. Therefore it has to be abolished’ - and you have to admit that they had a point.

Thus disposals made on of after 6 April 1998 are now identified with acquisitions in the following set order:-

I. Same day disposals;

II. Acquisitions within the following 30 days (using a First In First Out Basis (FIFO));

III. Previous acquisitions on or after 6 April 1998 (using a Last In First Out Basis (LIFO));

IV. Any shares acquired after 5 April 1982 and comprised in a Pool referred to as a ‘s104 TCGA 1992 holding’;

V. Any shares acquired after 6 April 1965 and held as a ‘1982 holding’;

VI. Any shares held on 6 April 1965 (using a LIFO Basis); and finally:

VII. Any other shares acquired subsequent to the disposal.

However, the method of ‘Pooling’ is not fully abolished for non-company taxpayers because, as the above states, the legislation matches shares of the same class acquired on the same day and as such this has the effect of averaging the cost over all of the shares held.

Share options

These strict rules do pose their own problems. Take for example, a taxpayer who acquires shares in both his company's approved and unapproved shares options schemes on the same day, he will be faced with a tax bill on the exercise of unapproved option scheme shares and in order to pay that income tax bill he may have to sell the shares held in the approved scheme. As the two sets of shares are acquired on the same day under the rules above they should be ‘pooled’ and as such even if the taxpayer merely sold sufficient shares to fund his income tax charge he may be faced with a potential CGT liability as well.

After protestations from taxpayers the Revenue recognised the unfairness of this and FA 2002, s 50 contained a special provision allowing the taxpayer to set aside the ‘normal’ matching rules but only if the shares are acquired as a result of the exercise of an option under the Enterprise Management Incentive Scheme or under an approved share option scheme. In this instance, not only is there no charge to income tax on the exercise (ITEPA 2003, ss 528, 529(1)), but also, should the taxpayer be faced with a situation such as given above then he is allowed to make an election following a part disposal of any of his holding for an alternative matching rule to apply. For this purpose only the rules states that the shares acquired on the day of acquisition are divided into two groups:

I. ‘approved scheme’ shares; and

II. the ‘remainder’

The disposal is initially matched with shares in the ‘remainder’ group (which will always have a higher base cost for CGT purposes) before being matched with any of the approved scheme’ shares. Whether the election is actually made will obviously depend upon what other gains or losses the taxpayer has made during the tax year.

Planning possibilities?

Apart from the special FA 2002, s 50 rules given above it is still possible to achieve the same result as the traditional ‘bed and breakfast’ on the sale of other shares by either:-

I. selling one type of stock and buying a different one - this obviously just increases the base cost retained in the portfolio of shares rather than increasing the base cost of one share; or

II. selling the investments in one capacity and buying them back in another - this can be achieved by having a trustee of a trust in which the owner has an interest in possession buy back the shares or if not a trustee then a manager of a PEP owned by the investor; or

III. what is deemed ‘bed and spousing’ in which one spouse sells and the other buys (this must be arranged via a broker so that the deal is genuine and not just dealt with directly one to another.) The first transfer to the spouse will be covered by the TCGA 1992, s 58 (1) (‘no gain, no loss’ rule) and then when the transferee spouse sells, the taper relief is computed by reference to the couple's combined period of ownership which means that the gains on disposal are shared between the couple to avoid wasting the annual exemption - any unused annual exemption cannot be transferred from one spouse to the other.

Whether the above method of tax saving is worthwhile will only be relevant if the CGT exposure is likely to exceed the annual exemption in a future year but transaction costs and the practical complications of "bed and breakfasting" must also not be forgotten.

Jennifer Adams
September 2004