Can anyone explain how this indexation relief actually works in an example?
I will approach it from a general business perspective than SA2:
Indexation Relief (or Indexation Allowance) is a key concept in tax legislation. It appears under Capital Gains Tax (and some Inheritance Tax) calculations.
Aim:
It is a relief/allowance and works to the taxpayer's (company or person) favor to reduce possible tax burden on realizing a gain.
Its aim is to eliminate the part of the gain attributable to pure inflationary movement from the time of purchase of the asset to the point of sale (or calculation). So it sounds like the tax man is being lenient here in attempting to tax only the pure capital appreciation rather than everything.
How it works
To calculate the gains changeable to tax (a.k.a. Chargeable Gains):
- Original cost (a.k.a Purchase Price or Book Value) of the asset is deducted from the sales proceeds (or market value at calculation date), this is before indexation relief so we will call Unindexed Gain which may be positive or negative.
Indexation Relief is calculated in various ways, typically: Original Cost x (RPI(t)/RPI(0) -1), where t is the calculation date and RPI is the value of the retail price index.
The Indexation Relief calculated above is deducted from a positive Unindexed Gain subject to zero. So indexation relief cannot be used to create a negative chargeable gain. Recall negative gain (i.e. losses) are typically carried forward to offset future gain so can be advantageous hence the restriction on the extent of Indexation allowed.
If Unindexed Gain is negative then indexation relief becomes completely irrelevant (i.e. not allowed at all, consistent with 3rd bullet point.
Example:
Asset bought 5 years ago for £6000 when RPI value was 300, current market value is £8000 and RPI value is 350. Calculate the current gain chargeable to tax on this asset, assuming its realized now.
Unindexed Gain = £8,000-£6,000 = £2,000
Indexation Relief = 6000 x (350/300-1) = £1,000
Chargeable Gain = MAX(Unindexed Gain - Indexation Relief, 0) = £1,000
Application in Life Assurance:
As per the CMP, this features in the Capital Gain component of the "I" calculation for BLAGAB and Trading Profit calculation under OLTB.
It's long but hopefully you find it helpful.