With close to two months until the tax year-end, this is likely to be a key focus for financial planners across the UK. Many planners of course focus on maximising the use of ISA allowances, but fully utilising Capital Gains Tax (CGT) allowances should also be considered. Similar to an ISA allowance it’s a ‘use it or lose it’ opportunity with no element of carry forward.
As a quick reminder, the CGT allowance for individual clients in the tax year 2018-2019 is £11,700 which means that the first £11,700 of any gain generated is tax-free. Any gains made above this rate are taxed at the prevailing CGT rate for the investor (20% for higher-rate tax payers and 10% for basic rate tax-payers).
Due to the annual ‘one shot’ nature of the allowance, investors should ideally try to use as much of it as possible each year, ‘harvesting’ gains to reduce their future tax liability. This can be done by selling and then repurchasing holdings (with some restrictions described below). However, unless their portfolio offers the flexibility to release taxable gains in a personalised fashion, the investor will not be able to take advantage of any available CGT harvesting techniques.
This is particularly relevant when looking at unitised portfolios. One of the main arguments cited in promoting a unitised portfolio, as opposed to a segregated portfolio, is that no CGT is incurred by trading within the fund whereas selling positions in a segregated portfolio generates gains which may incur CGT. That is true, but it ignores the fact that any realised capital gain under the allowance is tax free, and also reduces future capital gains. Whereas the CGT liability of a buy-and-hold client in a unitised portfolio just builds up over time if the unitised portfolio performs, the tax liability of a client with an otherwise identical segregated portfolio will go up more slowly, or perhaps not at all.
For example, consider someone who invests £100,000 in a portfolio which utilises CGT harvesting and another £100,000 in a single buy-and-hold unitised portfolio and then assume that each year the portfolios make £10,000 in gains. After 10 years both portfolios are worth £200,000 and are then liquidated. In the case of the unitised portfolio, a £100,000 gain is realised after the ten years, and tax must be paid on the full gain (less the annual allowance). However, there would be no tax to pay for the portfolio using CGT harvesting. That client also generated £100,000 in gains, but those gains were spread out over 10 years, with the gains of £10,000 per annum being fully offset against the allowance each year (we assume the annual CGT allowance remains above £10,000 per year in the future).
As with most tax considerations there are a host of rules covering the exact mechanics of calculating CGT, with a few being particularly pertinent to a CGT allowance harvesting strategy.
30-Day ‘Bed and Breakfast’ rule
It used to be reasonably straightforward to release gains from a portfolio by simply selling the investment and then buying it back the next day – the so called ‘bed and breakfast’ strategy. However, in 1998, the 30-day rule was introduced whereby the same investment cannot be bought back within 30 days of sale or the sale is deemed null and void from a CGT perspective. But this doesn’t rule out purchasing investments that are similar but not identical.
Same fund, different share class
At first glance, one idea for fund-based investments could be to sell the income share class and replace this with the accumulation share class and hold it for 30 days (or vice versa). It’s a murky area of legislation though and difficult to check whether the rules are being adhered to. To avoid uncertainty and complexity, it’s easiest is to avoid switching into a different share class of the same fund.
PortfolioMetrix have a specific method for harvesting gains for investors. Firstly, the target gain for an investor is understood using a specific formula. The next step is to identify the most efficient way to trade the portfolio in order to release the target gain. This is done by switching the funds with the largest gains (up to the target gain) into ‘mirror funds’. These funds give a very similar asset class exposure to the fund that is being sold, but are completely different funds and so successfully trigger the gain in the eyes of HMRC. The portfolio must remain out of the original funds and in the mirror funds for 30 days in order to meet the HMRC rules. After the 30-day period has elapsed, the portfolio will be traded again to return it to the preferred implementation.
Whilst DFMs offering bespoke portfolios for clients are able to harvest CGT on an individual basis, advisers with clients in model portfolios can’t deliver the same process. However, the investment portfolios delivered by PMX via their in-house software tool, WealthExplorer™, are customised, held on third party platforms and the technology supports a simple and quick process for financial advisers to undertake tax planning for all their clients – no matter the level of investment and no matter how many clients they have.
For more information on the CGT harvesting approach from PortfolioMetrix you can download their whitepaper on CGT Harvesting here.