This article was first published at the author's website Tax Notes, and can also be downloaded at Academia.edu. This question was also discussed at the Any Answers Session at the Practice Excellence Conference held on 24 September 2015.
Entrepreneurs have been taking a bit of a battering this year, with three Budget measures being introduced in 2015 to stop them from using the relief in a way in which it wasn’t intended by the likes of HMRC (the rules on joint ventures and partnerships, associated disposals and the restrictions on incorporation relief). So it’s a welcome change to be able to write about some good news.
This is about a measure concerning the deferral of CGT, known as reinvestment relief. A person who has incurred a capital gain on another asset can defer his tax liability by subscribing for shares or securities under the various Enterprise Investment Schemes. For two of these schemes a gain that qualified for entrepreneurs’ relief couldn’t be deferred unless the investor gave up his claim to the 10% rate and paid the higher rates when the tax was eventually due.
This will no longer be the case – one can now defer the gain AND benefit from the 10% rate. In other words, you can have your cake and eat it.
But one needs to tread with caution, as the legislation contains a small trap…
The rule changes affect the Enterprise Investment Scheme (“EIS”) and the Social Enterprise Investment Scheme (“SITR”). The Seed Enterprise Investment Scheme (“SEIS”) is not affected, for reasons that shall become apparent later in this article.
In the following discourse we shall refer mainly to the EIS Scheme but the analysis applies equally to the SITR rules.
Note that for the SITR scheme, investments can take the form of debt or equity. However, save where the context requires otherwise, we shall use the term “shares” to include both.
How does reinvestment relief work?
In order to shelter a CGT liability, an investor must subscribe for shares or securities in the relevant EIS company. The conditions to be satisfied depend on which type of scheme is involved:
- For SITR, investors also need to be eligible for upfront income tax relief – however, there is no need to actually claim the relief;
- For EIS, the conditions are similar to those that apply for claiming the upfront relief, though it is not an exact match. It is quite possible to shelter the capital gain without qualifying for the income tax relief.
The relief is given by taking an appropriate amount of the “qualifying expenditure” – that is, the amount subscribed for the EIS shares – and applying it as a set off against the capital gain that is to be deferred. The result is:
- The amount of the sheltered gain is deemed not to have arisen at the time of the disposal of the original asset, or other event giving rise to the relevant tax liability; but
- Instead, the deferred gain is brought back into the tax net on a subsequent “chargeable event”.
(EIS: TCGA 1992 Schedule 5B, paragraphs 2, 4; SITR: TCGA 1992 Schedule 8B, paragraphs 4, 5.)
What is a chargeable event? A chargeable event includes a number of events, the most obvious one being when the shares are sold, or, for SITR, when debt investments are redeemed. Chargeable events also include the case where the relevant conditions no longer apply to the shares into which the gain has been rolled over.
(EIS: TCGA 1992 Schedule 5B, paragraph 3(1); SITR: TCGA 1992 Schedule 8B, paragraph 6(1).)
For SITR, reinvestment relief is currently available only for gains that have accrued between 6 April 2014 to 5 April 2019. This reflects the fact that at present, the SITR Scheme is temporary and will come to an end in 2019.
The old rules – why couldn’t you claim entrepreneurs’ relief and reinvest in an EIS scheme?
There is a specific provision that states that gains subject to the 10% entrepreneurs’ rate cannot be reinvested in EIS shares. This doesn’t mean that a gain that satisfies the entrepreneurs relief conditions is disqualified – it is only disqualified if the relief is actually claimed, for only on a claim does the 10% rate arise in the first place.
(EIS: TCGA 1992 Schedule 5B, paragraph 1(5A); SITR: TCGA 1992 Schedule 8B, paragraph 1(7).)
In other words, you couldn’t have your cake and eat it at the same time.
But now, it is possible to shelter such gains and also claim the 10% rate when the gain is brought back into the tax net. The new rules apply to gains on disposals made on or after 3 December 2014.
(TCGA 1992 Part 5 Chapter 4 – inserted by FA 2015 s 44.)
BUT...this is what you should not do
Under no circumstances should a claim for the 10% rate be made when selling your business, or otherwise making a disposal which qualifies for entrepreneurs’ relief. This is because the original provision forbidding reinvestment still exists. Yes that’s right – it hasn’t been repealed!
So how does one go about eating one’s cake?
Sheltering the gain under the EIS rules and claiming the entrepreneurs’ rate – how do the new rules work?
This is how one can claim both reinvestment relief and still benefit from the 10% rate:
- First defer the gain by subscribing for EIS shares and making a claim for reinvestment relief;
- When the gain is eventually taxed due to a chargeable event, then – and only then – claim entrepreneurs’ relief.
When a deferred gain comes back into the tax charge, it can be rolled over again by subscribing for another set of EIS shares. One can continue in this way for as long as possible – the 10% rate will still apply when the tax is eventually paid, provided a claim is made in time.
The time limit for claiming the 10% rate is the first anniversary of the 31 January following the tax year in which the deferred gain is triggered under the reinvestment rules.
(TCGA 1992 s 169U.)
Why didn’t they just abolish the original rule forbidding a claim for entrepreneurs’ relief when the business is originally sold?
Even if this rule didn’t exist, it isn’t entirely clear that the 10% rate would have been available. For example, consider a person who has sold his business and is eligible for the entrepreneurs’ rate which he claims within the relevant time limit. He subscribes for EIS shares, so that no tax is payable until he sells the shares a few years later.
The gain has just been brought back into charge, but what is the tax rate? The original gain on the business sale has been brought forward to a later date, but the original disposal that gave rise to that gain stays where it is:
- Recall that when the business is sold, no gain is deemed to have arisen to the extent that the gain is rolled over – so how can this be a gain that accrued on a business sale?
- The legislation then says that when a chargeable event occurs, a chargeable gain shall accrue;
- The legislation then goes on to tell us how much that chargeable gain shall be – which of course, turns out to be the amount that was rolled over into the relevant EIS shares.
But this gain exists in a vacuum – there is no corresponding asset attached to it. In particular, there is no deeming provision that states that the gain is deemed to have arisen under a disposal that qualifies for entrepeneurs’ relief.
The effect of the new rules is to provide the appropriate deeming provision. The deferred gain is deemed to have accrued on a relevant business disposal if the original disposal would also have qualified.
(TCGA 1992 ss 169U(4), 169U(9), 169V(2), 169V(3).)
What about SEIS reinvestment relief?
The new rules don’t apply to the case where a gain is deferred via an SEIS investment. This is for the simple reason that there were never any restrictions on claiming entrepreneur’s relief at the same time.
This may seem odd at first. However, it makes sense when considering that for SEIS reinvestment, only half the gain can be deferred and that half can be extinguished entirely. So there isn’t much point in restricting entrepreneurs’ relief on a gain that may never be taxed.
I have just sold my business – when do I have to decide whether or not to claim EIS rollover relief?
This question gives rise to some awkward timing issues.
Let us suppose that you have sold your business towards the end of the tax year, on 1 April 2015. You are in a position to claim entrepreneurs’ relief, but are wondering whether it’s worth deferring the tax by an EIS investment.
First of all, you have three years in which to make an investment, or the sale proceeds can be allocated to an investment made within the previous year – this is the “three years forward, one year back” rule. In this case we are looking at the time period running from 1 April 2014 to 1 April 2018 (exclusive).
( EIS: TCGA 1992 Schedule 5B, paragraphs 1(2), 1(3); SITR: TCGA 1992 Schedule 8B, paragraph 1(6).)
Whatever you do, don’t claim entrepreneurs’ relief at this stage!
If you’ve already made an EIS investment in the previous year, and the conditions for rollover relief apply, then all well and good. But what if some of the gain is still left over? Or what if you haven’t found something suitable?
We have three years left, but remember the entrepreneurs’ clock is also running. The time limit for claiming entrepreneurs’ relief is “on or before the first anniversary of the 31 January following the tax year in which the disposal is made.”
In other words, if we do want to claim entrepreneurs’ relief we have until 31 January 2017 to do it.
(TCGA 1992 s 169M(3).)
And this leads to a little conundrum:
- It is coming up to 31 January 2017 and I still haven’t found an EIS investment. What shall I do?
- I couldn’t find an EIS investment and I decided to claim entrepreneurs’ relief by the 31 January 2017 date. But just afterwards, I did come across an EIS opportunity – but it’s now too late.
The better option would be to claim the 10% rate while you can. However, there is some hope even in this case. For once a claim is made, it is not set in stone – it can be amended or even withdrawn, provided one is still within the time limit (in this case 31 January 2017).
(HMRC Manual CG63970)
But do you really want to claim EIS relief at all?
This is a message to all those people who have sold their own business and are thinking of an EIS investment.
Why do you want to defer the gain in the first place? You’re only paying a 10% rate. What’s so wrong about paying the tax now while you can? You’ll still have plenty of money left – why risk it all?
EIS and the other venture capital schemes are not a safe haven. The tax breaks are attractive, but this is the reward for investors for taking on the risk of losing all their money.
Entrepreneurs’ relief is another type of reward for risk taking. It rewards those people who have taken the decision to forego the comparative security of paid employment, in return for the uncertainty of running one’s own business. Not only are they risking their own capital, they are also required to make a lot of personal sacrifices.
So to all those of you who have finally been rewarded for your efforts: Are you sure you want to risk the fruits of all that hard work? The money that’s left over after paying the expenses of selling the business may be enough to feed you and your family – you may never need to work again. Do you want to risk it all, simply in order to defer paying what is a relatively small amount of tax?
Of course, there may be very good reasons for making an EIS investment. You may feel that, having achieved your own success you wish to support other people who are starting their own business for the first time. Absolutely nothing wrong with that. But at least make sure you protect yourself first and only invest what you can afford to lose. For once the money’s gone, it’s gone.
About Satwaki Chanda
A tax lawyer with more than 15 years of tax experience, having worked for City law firms and a Big Four accountancy practice.