John Baldry is Tax Partner at Kirkland & Ellis International LLP
One of the interesting policy differences between the Conservatives and the Liberal Democrats is on tax. The Liberal Democrats’ manifesto pledged to equalize capital gains and income tax rates, and they were the only party which proposed that measure. This was intended to partly pay for the rise in the personal allowance threshold to £10,000. The increased personal allowance has been accepted as part of Coalition Government policy, although it is expected that it will be phased in over several years. The more open question is what happens to the other side of the Liberal Democrat policy, which obviously fell into the too difficult box at the time of the agreement. The coalition agreement says the parties will seek a detailed agreement on taxing non-business capital rates at rates similar or close to those applied to income with generous exemptions for entrepreneurial business activities.
The coalition agreement could be given effect in a number of ways. Prior to the current regime, business assets had an effective tax rate of 10% after 2 years. Non-business assets had a higher minimum rate. A flat rate of 18% was introduced in 2008, which increased tax for non-business assets, but actually cut it for non-business assets. A return to that type of regime, with business assets fairly widely defined, would be one option. The current entrepreneur relief (which gives a rate of 10% on the first £2 million of gains) is really too narrowly defined to assist the investment management community.
The introduction of the 50% income tax rate is largely responsible for the upward pressure on the capital gains tax rate. Large rate differentials between income and capital gains encourage tax planning of the sort HMRC dislike. However, equalization seems an unnecessarily drastic response, and, if the reaction to the increase in tax from 10% to 18% is anything to go by, is likely to give rise to a dramatic reaction from the investment community, and at the least will operate as a disincentive to investment managers, entrepreneurs, managers investing in their own businesses through buy-outs, and employee investment in general. Most of the economically developed world now taxes longer term capital gains at lower rates; it would certainly be strange for the UK to be going in the opposite direction.
UK Governments have never really grasped the importance of tax competitiveness as part of a cohesive policy to make the United Kingdom an attractive place to do business. This is not a mistake other countries, such as Ireland, make. They know that one of the best ways to attract investment into a country is to provide a tax regime which encourages it, one which does not give rise to excessive compliance costs, and which provides certainty.
The UK economy is extremely fragile, and only the private sector can save it. Only tax revenues can pay off the mounting public sector debt. To take any action which is likely to discourage the investment community from operating and investing in the UK (and paying tax here) would be lunacy in the current climate. The reaction to recent changes to the non-domiciliary rules, the new 50% rate of income tax, and the increase in the capital gains tax rate have already given rise to serious examination of alternative jurisdictions for investment managers and advisers. It is beyond doubt that if the capital gains rate is increased further in a way which affects the investment industry, the UK will lose business, and therefore tax revenue. It will not easily be regained or replaced.
