This idea has legal legs but it also carries significant risks for the taxpayer.
In an earlier article, Rebecca Cave outlined an idea for reducing CGT by 8% points on residential property, by using the CGT deferral relief offered by the Enterprise Investment Scheme (EIS). Not only does this idea defer the gain to a later date, but it has the effect of reducing the tax rate from 18%/28% to the new standard rates of 10%/20%.
Why does this work in tax terms?
In order to shelter a capital gain under the EIS Scheme, a person must subscribe for shares in a company which satisfies the relevant conditions. The investment must be made within three years of the gain arising, or the gain can be sheltered behind an investment made in the previous 12 months.
Although most people would normally claim the upfront income tax relief on the EIS shares, it isn’t actually necessary to do so. In fact the conditions for the CGT deferral relief under EIS, while similar, do not exactly match those necessary for the income tax relief.
The deferred gain is always brought back into charge, usually when the shares are sold, but also if and when the relevant conditions for EIS have been broken. It is also possible to rollover the gain into another EIS investment.
The key question for the taxpayer is: “What tax rate will apply to the gain when it is eventually taxed?
For residential property gains, there are two options (TCGA 1992 Sch 5B, paras 2, 4):
- since the gain is one that arose from the disposal of residential property, the 18%/28% rates should apply; or
- standard rates should apply on the basis that the gain has become divorced from the original disposal. The gain is said to accrue, and the legislation gives instructions for calculating how much is to be taxed, but there is no specific provision that deems the gain to be one arising from a particular asset disposal (the residential property).
Support for the second option can be found by comparing the position to the way that gains are deferred when the original asset disposal qualifies for entrepreneurs’ relief. In order to benefit from the special 10% rate when the deferred gain is brought back into charge, the legislation specifically deems this to be a gain that qualifies for entrepreneurs’ relief (TCGA 1992 ss 169T–169V).
How could you use EIS to defer a property gain?
The following is an outline of how a taxpayer could use a series of EIS investments to reduce the tax rate on a residential property gain to standard CGT rates, while withdrawing the sale proceeds over a period of time. The individual would need to subscribe for a mixture of EIS shares as follows:
- Subscribe for EIS shares which qualify for the CGT deferral relief, with no claim being made for the income tax relief. These shares can be sold at any time within the three-year lock-in period that normally applies to an EIS investment – no income tax relief is clawed back because none is given. There is of course CGT to pay on any gains made on the EIS shares themselves.
- Subscribe for EIS shares which qualify for the income tax relief, which can be sold after the three-year lock-in period is over and when the relief can't be clawed back. Gains on these EIS shares are also exempt from CGT after three years.
What are the downsides?
This is not a venture that should be undertaken without a great deal of thought.
The most important downside is that of investment risk. The taxpayer is exchanging a relatively safe investment (property) for something a lot riskier, which could end up losing a significant amount of money. Also the tax on the original gain still has to be paid at some point.
There are also practical difficulties. Who will actually buy the EIS shares? There isn’t a ready market for EIS shares which allows the investor to realise his investment on demand. While EIS shares can be quoted on AIM, they aren’t liquid stocks.
Should the taxpayer make the investment?
There are considerable downsides as just discussed. Investing in EIS just to shelter a tax gain isn’t really a good reason for investing in EIS. There are plenty of other tax breaks associated with EIS, but remember it’s an investment first and should be approached in this light. However, for taxpayers who are already planning to make an EIS investment, if they also have a substantial property gain, using a tax shelter may be a viable option, provided the taxpayer is willing to take the risk.
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.