Quick guide: How to overcome CGT annual exemption limitations

Matthew Stephens, head of product and sales technical at Prudential, explains how to overcome limitations of the capital gains tax annual exemption.

The annual exempt amount is a powerful weapon in the armoury of Capital Gains Tax (CGT) planning but on its own it can have its limitations.

It is a “use it or lose it” exemption. The first £10,600 (2011/12 tax year) of realised gains is exempt from CGT but if you do not realise gains, and use the exemption, in a tax year it is not possible to carry forward any unused exemption to a later tax year.

If you are sitting with a portfolio of assets with significant gains the exemption will not, therefore, allow you to take out all of the money immediately without a CGT liability. It can take a number of years to get the money out free of CGT – for example, for a share portfolio sitting with total gains of £60,000 it would take six years to take the money out, using the annual exemption, without incurring a CGT liability.

But what if that is too long?

Gifting assets to a spouse or civil partner is one option. Each get their own annual exemption, which reduces, by half, the time it takes to extract the money tax efficiently. However, that would still take some time to realise the gains made without paying CGT.

An extension of utilising multiple annual exemptions is to use a discretionary trust. It is an approach that can allow a greater number of annual exempt amounts to be used in a tax year and works particularly well when paying for school or university fees.

For CGT purposes a claim to ‘holdover relief’ can be made, under section 260 Taxation of Chargeable Gains Act 1992, where an asset is disposed of and that disposal is a chargeable transfer for Inheritance tax (IHT) purposes. A disposal includes the gift of an asset.

A transfer/gift of assets into a discretionary trust is a chargeable transfer for IHT, so a claim to CGT holdover relief can be made under section 260. The effect of the relief is that no CGT will be payable at the time of making the gift – instead it is held over, hence the name, until the assets are eventually sold and the gains realised.

Take the example share portfolio. Assume it is worth £360,000, the original investment being £300,000. £60,000 is retained, carrying a £10,000 gain that is covered by the individual’s annual exemption. Those assets could be sold immediately without a CGT liability arising. The balance of £300,000 is transferred into discretionary trust. There is no actual inheritance tax charge, because the amount is below the IHT nil rate band (£325,000), but it is still a chargeable transfer for IHT purposes. CGT holdover relief is therefore available, and is claimed, so no CGT liability arises at the time.