What is the effect of the various indexation provisions on capital gains tax valuations and computations?
This question has already been examined in this column on January 10 1987, p 87, but since that time, as the indexation provisions have been changed again, it is well worth reconsideration.
Capital gains tax is a tax on increases in the value of assets and is based broadly on the difference between the acquisition cost of the asset and the sale proceeds on disposal. A gains tax was introduced initially by the Finance Act 1962 in the form of short-term gains (a tax on the profit on the resale of assets acquired and resold within three years). Short-term gains were taxed as income. The Finance Act of 1965 extended short-term gains to cover all gains to be taxed at a special rate and the new tax became known as capital gains tax. Since 1965 there have been many minor changes to the tax, introduced in various subsequent Finance Acts, and these changes have been consolidated in the Capital Gains Tax Act 1979.
Generally speaking it is not a tax to suffer from undue interference (unlike the old tax on development gains and current taxes on gifts, for example), but in recent years it has been criticised as amounting to a tax on inflation rather than real gains and on the grounds that it was unreasonable to tax the holder of an asset purely because of changes in the value of money. As a consequence significant adjustments have been introduced in recent Finance Acts, creating further allowances in an attempt to strip out the inflation element so that the tax would be based only on real gains.
Computation
In general the tax is computed by deducting the consideration paid for the asset in question from the disposal proceeds. In cases such as gifts or disposals which are not at arm’s length (those between connected persons, for example) the gain will be computed by reference to the market value of the asset. In addition, in arriving at the actual gain, the taxpayer is entitled to take account of allowable deductions. These will include incidental costs of acquisition and disposal; fees and professional charges; stamp duty and advertising; plus any enhancement expenditure. Enhancement includes physical improvement as well as the cost of obtaining planning consent where appropriate, but repair and maintenance expenditure is specifically excluded.
The four computations which follow are intended to illustrate the changes which have taken place since the 1979 Act. Each refers to the same example, but with different disposal dates. The valuer, when computing a capital gains tax liability, must now have regard to the date of disposal because this date will determine the precise rule to be applied.
Computation 1
A property is purchased in March 1980 at a cost of £20,000. The same property is sold some years later for £50,000. Between the dates of acquisition and disposal the property was extended at a cost of £5,000. Incidental costs of acquisition were £1,000 and incidental costs on disposal £2,500.
The basic computation of gain on the transaction would be as follows:
Indexation
Indexation was first introduced in 1982 to apply to disposals made on or after April 6 1982. The detailed provisions were contained within sections 86-89 of and Schedule 13 to the Finance Act 1982. In effect, in addition to the allowance outlined above, an indexation allowance can now be included as part of the deductions in arriving at the chargeable gain.
This allowance is calculated by reference to the change in the Retail Price Index between the date of disposal and the date of acquisition or March 31 1982 if that is later. This phrase is somewhat ambiguous. What it means is that if the asset was acquired before March 1982 then March 1982 becomes substituted for the RPI at the date of acquisition. In other words, the benefit of the indexation allowance will apply only to that part of the gain which has occurred after March 1982.
The allowance will be added to the initial acquisition cost and any enhancement expenditure, but not to incidental costs of disposal.
The calculation is made by applying the following formula:
The Act provides that all indexation fractions be rounded to three decimal places.
Computation 2
Assume circumstances similar to the first example, but that the improvements were carried out in July 1984 and the disposal takes place in March 1985.
Given that the RPI for March 1982 was 79.44, for July 1984, 89.10, for March 1985, 92.80, Computation 1, above, can now be recalculated as follows to include the indexation allowance:
1982 valuations
For disposals between April 5 1985 and April 6 1988 taxpayers have the option of basing the indexation calculation on the value of the asset as at March 31 1982. This extension of the indexation provisions was introduced in the Finance Act 1985, section 68 and Schedule 19. This is a valuable addition because in a rising market it will usually provide the taxpayer with greater allowable deductions.
Computation 3
The situation is identical to the first example above, but now assume the disposal is made in May 1985. The value of the asset at March 31 1982 has been agreed at £25,000.
Rebasing
There is now a further means of increasing the allowances to be deducted from the disposal proceeds before arriving at the chargeable gain. This is available for assets which were held on March 31 1982 where the disposal takes place after April 5 1988. Rebasing was introduced by the Finance Act 1988 (section 96 and Schedule 8) and operates by substituting the 1982 market value for the acquisition cost. Clearly this will give an enhanced allowance where the value since acquisition has risen. This will not always be the case, and if rebasing produces a higher gain then the gain will be calculated by reference to the pre-1988 Finance Act rules.
Assets held on March 31 1982 and disposed of after April 5 1988 will be rebased automatically where the market value at March 31 1982 exceeds the allowable expenditure (acquisition cost plus incidentals). For disposals prior to that date it was necessary for the taxpayer to make an election. Note that the 1982 value is substituted for the acquisition cost plus the incidental costs of acquisition.
Rebasing cannot be used to increase a gain or loss compared with what it would have been under the old rules. Also, where there is a gain under the old system which becomes a loss through rebasing and vice versa, it will be assumed that there is neither a gain nor a loss.
Computation 4
The circumstances are as outlined above, but assume the disposal is made in May 1988.
Chargeable gain
Without the benefit of indexation or rebasing the chargeable gain in the first computation was £21,500, considerably more than the gain of £8,115 produced by the final computation. The circumstances are the same except that the assumed disposal dates vary, the last case taking full advantage of the changes introduced by successive Finance Acts. This emphasises the significance of the disposal date for it is this that will determine which indexation rules should apply. These are summarised below.
These changes clearly have had a significant effect on the size of capital gains by effectively stripping out a major part of the gain resulting from inflation. The overall effect of indexation might have been expected to reduce the revenue produced by the tax, but the product of the tax has more than doubled as a proportion of the total product of all revenue taxes between 1984 and 1989. While there are still regular pleas for the abolition of capital gains tax, it remains an important revenue earner, its product for 1989-90 estimated at £2.100m.(1)
For the practising surveyor the main significance of the indexation changes is the requirement for a working knowledge of 1982 values, progressively more difficult as this date becomes more remote. If clients are to be properly advised in all cases, valuers will need a sound data base of 1982 values. With 53% inflation since March 1982, every additional £1,000 negotiated on to the 1982 base value increases the allowable deductions by £1,530, thus saving the 40% taxpayer £612. There is thus every incentive to maximise this figure.
Finally, it must be stressed that capital gains tax is a complex area of taxation law and, while the above notes have attempted to provide an illustration of the effect of the indexation provisions, any specific advice to a client should be based on a detailed reading of the appropriate statute and reference to tax specialists where appropriate.
(1) Inland Revenue Annual Statistics 1989, HMSO
