... and the legitimate ways to avoid it.
If your investments grow in value then one day you may find that you have to pay capital gains tax (CGT) as and when you sell them. CGT is charged at either 18% or 28%, depending upon your income tax rate, but your losses will reduce your taxable gains and, in any event, the first £10,600 of gains in the current tax year are not subject to CGT.
Many assets are exempt from CGT, notably your primary residence and chattels (personal possessions) if they are sold for less than £6,000 -- and when it comes to your portfolio, there are several legitimate ways to avoid CGT. Let's have a look.
Jumping through hoops
In my previous career in the financial services industry, I came across several cases where a person had jumped through a metaphorical flaming hoop solely to avoid CGT.
At the time, the CGT rate of 40% was clearly enough to entice many people into things that they would ordinarily have refused to touch with a barge pole. Many of these 'investments' performed so badly that people would have been better off if they had paid the tax!
As I often pointed out, having 60% of something is better than 100% of nothing. Fortunately, today's investors can shelter their portfolio from CGT in two very straightforward schemes where they aren't investing solely to avoid the tax.
The easy way to avoid CGT
The most popular ways in which shareholders avoid having to pay CGT are by investing through spread-betting accounts and Individual Savings Accounts (ISAs). That's because, under the current legislation, gains made in these accounts are not subject to CGT.
If you don't use these accounts, you can still avoid CGT by ensuring that your gains realised within the current tax year do not exceed your capital gains allowance of £10,600.
You could also consider complex tax avoidance schemes such as moving to Belgium, a country that doesn't have CGT as we know it, or running your investments through a company in a Caribbean tax haven. But, for most private investors, these arrangements are impractical because they cost more than the tax that would be saved.
ISAs are for the future, not for the now
The CGT benefits of an ISA are often overlooked by investors. But as your ISA grows, particularly if you keep adding to it every year, then hopefully it will eventually grow to the point where CGT would have become a factor if you had instead invested outside your ISA.
For me, the CGT benefits of an ISA far outweigh the income tax advantages, as I saw quite clearly in September 2010 when Dana Petroleum was bought by the Korean National Oil Corporation (KNOC) for £18 a share.
Normally in bids like these, the buyer has an alternative of shares or loan notes, which allows shareholders to roll over their capital gains into the new investment and then use their personal CGT allowance over several years to avoid the tax. KNOC offered neither.
Fortunately, all of my Dana Petroleum shares were held in an ISA so there was no CGT to pay. If they had been held outside an ISA, I'd would have been several thousand pounds worse off because of the CGT that would have fallen due.
However, shares that are listed on the Alternative Investment Market (AIM) cannot be sheltered in an ISA unless they are also listed on a recognised foreign stock exchange. This leads to the situation where many private investors hold AIM-listed shares in an ISA solely because they are also listed in Toronto, whereas their London-only shares are excluded.
To ISA or not to ISA
Some of my larger shareholdings, notably Dragon Oil (LSE: DGO), contain a lot of capital gains and are not held in an ISA. If I sell any Dragon Oil shares in the current tax year, virtually all of the gains will be subject to CGT -- something that concentrates the mind wonderfully and deters me from selling them.
But my other holdings with substantial capital gains, such as Soco International (LSE: SIA), are exempt from CGT because they are held within my ISAs. Since I expect Soco to be taken over in a few years, the CGT exemption will be a great benefit.
I view CGT as something that gives the British government a contingent claim over some of my assets; namely the CGT liability that arises if I sell. This is a deferred tax liability, but it is also an asset of sorts, because I'm still getting the dividends and capital growth on the money which would otherwise go to the government if I sold the shares.
Warren Buffett said in Berkshire Hathaway's (NYSE: BRK-B.US) 1989 annual report that investors should think of the deferred tax that would be charged on unrealised capital gains as being equivalent to an interest-free loan from the state which they may never need to repay.
Change of government
If you are an investor with substantial unrealised capital gains, one thing that should get your attention is the possibility that there will be changes to the CGT regime. In the last few months I've started to think about whether a future Labour or Labour/Liberal Democrat coalition government would raise CGT rates and/or cut the personal allowance? I suspect that they will.
So I can see myself making a trip to Ladbrokes (LSE: LAD) to place a bet on the next General Election purely as a hedge against rising CGT rates. While they produce very nice beer and chips in Belgium, the cost of moving there for a year-long tax avoidance holiday is more than the tax that I would save as a result!
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> Tony owns shares in Berkshire Hathaway, Dragon Oil and Soco International.