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October 2007 Pre-Budget Report

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This was Chancellor Darling's first go at a Budget speech and it was full of political gestures and a few surprises. The supporting documents were quite extensive and there may well be further details to emerge as legislation is published, such as the mysterious promise of measures to bring empty residential properties to market. However, this could have been a veiled reference to the change in the rate of capital gains tax from April 2008, which may well encourage owners of buy to let properties to sell up.

This summary concentrates on the most important tax effects for our business and personal clients.

Inheritance Tax

Inheritance tax (IHT) matters to a lot of people, especially those who live in marginal constituencies where house prices have doubled in the last seven years. The Tories found this out when they proposed an increase in the threshold where estates start paying IHT to £1 million. At present when you die all your wealth, including the value of your house, is taxed at 40% on all amounts above the so-called nil rate band, which is currently set at £300,000.

The Labour Party said this increase in the nil rate band to £1 million could not be funded, but the Chancellor has found another way to placate families worried by the potential IHT burden. Spouses and civil partners will now be able to make full use of the nil rate band belonging to each spouse. That gives a total inheritance tax exemption for a married couple of £600,000 (for 2007/08) rising to £700,000 for the tax year 2010/11.

This helps to solve the current common problem that when the first spouse dies and leaves everything to the survivor there is no IHT to pay as wealth inherited by a UK domiciled spouse is exempt from inheritance tax. However, when the surviving spouse dies there is usually a large IHT bill as all the wealth previously owned by the couple is now in the hands of one person, with only one nil rate band to use.

The Chancellor is to allow any nil rate band, which was not used on the death of the first spouse, to be transferred to the widow or widower who dies on or after 9 October 2007. Say Fred died on 1 October 2007 with an estate worth £500,000. His executors will be required pay IHT at 40% on £200,000 (£500,000 - £300,000) amounting to £80,000. If Fred dies on 1 November 2007, and his wife did not use her nil rate band when she died previously, he now has the benefit of two nil rate bands totalling £600,000. Now Fred's executors will pay no IHT at all on his estate of £500,000.

Family Businesses

Income Shifting

Family businesses have been waiting anxiously for the full Government response to the triumphant win by the taxpayer Mr Jones in the Arctic Systems case. The day after the House of Lords judgement the Treasury minister said they would act against couples who indulge in income splitting in an unfair way.

The Government has now changing the description of this unacceptable behaviour to income shifting, defined as where one person diverts their income to a second person who is subject to tax at a lower rate, to obtain a tax advantage. The Pre Budget Report indicates that new legislation to tackle income shifting will take effect from April 2008, but it will only apply to income paid in the form of company dividends or partnership profits. Thus paying your spouse a fair salary for work done will not be attacked.

The exact details of how the income shifting rules will apply are open to consultation, but the factors that may be taken into account include:

The work done in the business by each individual;
The amount of capital contributed to the business; and
The business risks each person takes.

Associated Companies

Where you run your own independent company, the corporation tax payable by your company can be affected by the number of other companies run by your business partners, spouse or civil-partner. This is the case even if the various other companies have no commercial connection with your company. This so-called associated companies rule can mean even a very small company will pay corporation tax at the large company rate.

The Government has said it will look at this rule as it affects companies run by business partners. However it may also look at companies run by spouses and civil-partners. If the associated companies rule is reformed some smaller companies could save corporation tax.

Capital Gains Tax

Presently, if you hold business assets, including unquoted shares, for at least two years, the amount of capital gains tax you pay on their sale is discounted to 75% of normal rates. That works out at just 10% tax for a higher rate taxpayer, or 5% for a basic rate taxpayer. This is due to the operation of taper relief, which was introduced by Gordon Brown in April 1998.

Now on its 10th birthday taper relief is to be abolished and replaced with a flat rate of capital gains tax of 18%. Indexation allowance for individuals and trustees (but not for companies) is also to be abolished from 6 April 2008. This will simplify the capital gains calculations, but it does not hide the fact that the potential 10% tax rate payable on the sale of businesses will jump to 18% from 6 April 2008.

If you are planning to sell your business, or an asset used by a business such as a commercial let property, which you have owned for at least two years, you may save at least 8% tax if you sell before 6 April 2008. The exact calculation of the tax due on the sale will depend on how the business has been owned, or how the property has been used for the last ten years, so ask us to check the potential tax bill for you.

The new flat rate of capital gains tax will be good news for anyone selling a non-business asset, such as a buy-to-let property, or quoted shares. At present the maximum the capital gains tax bill can be cut to for gains on non-business assets is 60% of normal rates, which works out at 24% for higher rate tax payers and 12% for basic rate taxpayers. If you expect to make a large gain on a non-business property, it may be better to agree the sale on or after 6 April 2008 to save at least 6% on your tax rate, possibly more.

The annual capital gains exemption (currently £9,200) will be retained, as will other capital gains reliefs such as hold-over, roll-over and the deferral of gains using the Enterprise Investment Scheme.

Non-Domicile Residents

There has been much carping in the press about foreign born individuals who live and work in the UK but pay no UK tax on their overseas income or gains. These individuals are referred to as non-domiciled, or 'non-doms'. The Tories suggested that every non-dom who wanted to protect their off-shore income from UK tax should pay a flat tax charge of £25,000 per year.

The Chancellor said this would not raise much money but has proposed a very similar charge of £30,000 per year on any non-dom who has lived in the UK for at least seven years, and wants to keep their off-shore income out of the UK tax net. From 6 April 2008 non-domicile individuals who have been tax resident in the UK for at least seven years will have a choice:

pay UK tax on all their worldwide income wherever it arises and have the use of the UK personal allowances against UK income; or
pay tax on their UK income without deduction of personal allowances, and pay an annual £30,000 tax charge.

The remittance basis will continue to apply to non-doms who choose b), so they will only be taxed in the UK on any overseas income or gains they bring into the UK. There is an exception for non-dom individuals who have overseas income amounting to less than £1,000 per year. They will be able to carry on claiming UK personal allowances and apply the remittance basis to their small amounts of foreign income.

The definition of the time required to be present in the UK to be tax resident is to be changed marginally to include the days of arrival and departure in the UK. Also the technical rules governing what is considered to be a remittance of income or gains will be tightened up.

This new £30,000 tax charge for longer-term residents should not dissuade talented people from coming to work in the UK for short periods of two or three years. It is also thought that it will not discourage millionaires from settling here, as £30,000 per year is a relatively small price to pay to keep the bulk of your wealth free from UK tax.

Company Car Fuel

If a car is provided for private use of an employee, that employee pays a benefit in kind tax charge based on a percentage of the car's list price when new. The percentage is set according to the CO2 emissions of the vehicle. If the company also provides fuel for private journeys, the car fuel tax charge is based on the same percentage of a set value, currently £14,400. From 6 April 2008 this set value will increase to £16,900. This will increase the tax charge paid by the employee for having free fuel in his company car by about 17%.

National Insurance

Rates and allowances

The Pre-Budget report is normally the time when all the national insurance rates, personal allowances and tax credit rates and thresholds are announced for the next tax year. However as the Pre-Budget Report was so early this year those figures are not quite ready yet. They are by law based on the inflation figures for the year to September, which will not be released until about 16th October, so the new allowances for 2007/08 will be announced sometime after that date.

Holiday Pay
There is currently an exemption from national insurance on holiday pay paid by third parties. This exemption was designed to be used in industries such as construction where there is high staff turnover, but it has been abused in many other trade sectors. The facility to pay NIC free holiday pay will be withdrawn in most circumstances from 30 October 2007, but it will be retained in the construction industry for five years.

VAT

Property

Property owners can pay a reduced rate of VAT of 5% when they renovate or alter residential properties that have been empty for at least three years. This vacant period will be reduced to two years from 1 January 2008.

Simplification

The Government is to consult on how to simplify certain VAT rules that apply to businesses in the UK. In particular:

the option to tax election that applies to most commercial properties;
the frequency that businesses need to submit VAT returns;
the capital goods scheme for businesses that are partially exempt; and
the VAT retail schemes.

Self-assessment

When personal tax self-assessment was introduced in 1995/96 individuals were not required to make on-account payments of tax within the tax year unless:

their tax bill for the year was £500 or more; or
less than 80% the tax due was deducted at source (such as under PAYE).

The tax level in 1) has not been changed since 1995. Remarkably this minimum level will be doubled to £1,000 for 2009/10 to take effect for tax payments due on 31 January 2010 and 31 July 2010.

This change will help many self-employed taxpayers who have relatively small tax bills, but at present have to pay small amounts to HMRC at least three times a year.