While the ability to claim capital gains tax deferral relief has been around for some time, it is now attracting more interest from investors. The Chancellor recently announced a reduction in the capital gains allowance from £12,300 down to £6,000 in the 2023/24 tax year, with a further fall to £3,000 in the 2024/25 tax year. Consequently, the disposal of assets held outside of a tax-exempt investment vehicle will be more likely to pay capital gains tax in the future. However, capital gains tax deferral relief effectively allows you to indefinitely defer payment on a capital gain.
How can you defer capital gains?
The first thing to remember about capital gains tax deferral relief is that this does not remove your capital gain. It is a means of deferring the gain until further down the line; however, in theory, potentially indefinitely if you maintain an investment in qualifying EIS companies.
What are EIS companies?
The Enterprise Investment Scheme (EIS) was introduced in 1994 to attract investment in small high-risk UK-based companies in exchange for capital gains and income tax relief. There are various criteria for EIS relief which relate to the size of the company, age, assets held and the fact that it needs to be based in the UK. The scheme has been highly successful, raising over £22 billion of investment (as of May 2020) for more than 31,000 qualifying early-stage companies.
The capital gains and income tax relief provide a hedge against the increased risk of investing in early-stage, potentially high-risk small companies based in the UK. Tax relief can be claimed on a maximum of £1 million a year invested into EIS-qualifying investments, although in some circumstances it can be increased to £2 million. We will now look at the process of claiming capital gains tax deferral.
What is capital gains tax deferral relief?
Before looking at capital gains deferral relief in more detail, it is crucial to identify how capital gains tax is paid. The capital gain on a taxable investment is added to your income for the tax year of disposal and taxed at the following rate after deducting allowances:-
Basic income tax band, standard 10% on gains (18% on residential property)
Above basic income tax band, standard 20% on gains (28% on residential property)
When looking at capital gains tax deferral relief, it is the taxable profit from the disposal of an asset, not the potential capital gains tax charge, which needs to be reinvested into an EIS to receive relief. So, if you made a £100,000 profit after deducting your capital gains allowance, then it is the £100,000 which must be invested into a qualifying EIS scheme investment to receive the relief.
Claiming capital gains tax deferral relief
Before we look at a case study, it is essential to recognise who is eligible for EIS capital gains tax deferral relief. The criteria are as follows:-
- UK residency
- Not an employee of the company
- Sufficient capital gains tax liabilities
- Held for a minimum holding period
Interestingly, while you need to be a UK resident to benefit from EIS-related tax deferral relief, you do not need to be a UK resident to invest in EIS-qualifying shares.
We have put together a case study to demonstrate how capital gains tax deferral relief is used and claimed.
Asset purchase price: £50,000
Asset sale price: £150,000
Sale date: 2023/24 tax year
Capital gain: £100,000
Capital gains tax allowance 2023/24: £6000
Taxable gain: £94,000
In this scenario, the £94,000 would be added to income for the year and taxed at the default rate, 20%, or 28% if the gain derived from the sale of residential property (not main residence). Consequently, the capital gains tax bill would be as follows:-
Rate of 20%: £18,800
Rate of 28%: £26,320
Under normal circumstances, this capital gains tax charge would be due by 31 January 2025, although it is possible to defer this indefinitely using an EIS investment.
Claiming relief on a capital gain
To defer the capital gains tax charge on the above disposal, the individual would need to invest the entire £94,000 into a qualifying EIS scheme company. The capital gains charge remains deferred as long as the individual holds the EIS company shares. An EIS investment can also be rolled over into a new EIS investment without losing the deferral.
The EIS shares must be held for at least three years to qualify for capital gains tax deferral relief. The deferral relief will be void if the shares are sold before the three-year period. EIS shares are not traded on the stock exchange, and it can be difficult to liquidate your holding at short notice.
Some EIS companies may provide an exit route for investors, allowing them to sell part or all of their shares. Assuming they are sold after the three-year qualifying period, it may be possible to stagger any capital gains tax liability over different tax years using your capital gains allowance.
What are the 12-month and 36-month qualifying periods?
When looking to defer capital gains tax, there is a window of opportunity concerning the purchase of EIS-qualifying shares. You must subscribe for new EIS shares either 12 months before or 36 months after the taxable disposal in question. For example, if you realised a substantial capital gain on 1 June 2023 and subscribed to EIS shares between 1 June 2022 and 1 June 2026, you can use these to defer all or part of a capital gains tax charge. The EIS investment must at least cover the element of profit from the disposal on which tax would typically have been charged.
While the EIS subscription shares have a 48-month window of opportunity, there is a five-year period during which you can claim capital gains tax deferral relief. This period ends five years after the first 31 January, following the end of the tax year in which the EIS-qualifying shares were issued. You can only claim once the relevant EIS certificate has been produced to show that the investment qualifies under the EIS scheme.
Additional issues concerning EIS investment
Even though capital gains tax deferral relief is most associated with EIS investments, there are also other tax implications to consider.
Income tax relief
There are income tax benefits when investing in EIS shares which allow you to claim up to 30% income tax relief. This is usually taken in the year of the EIS investment, although unused relief can be backdated to the previous tax year.
EIS investments are also exempt from inheritance tax after they have been held for a minimum period of two years. Consequently, they can be a helpful element of inheritance tax planning.
The various tax reliefs available via EIS-qualifying investments are used to offset the higher-than-normal risk to funds when investing in these companies. While a significant range of EIS investments are available, these should be seen as an investment (do your research) and not just a source of tax relief.
Even though it is possible to defer capital gains tax indefinitely, it is essential to remember that the element of profit, as opposed to just the tax charge, would be tied up in the EIS investment.
As with any tax planning/investment, it is crucial to take advice from your accountant to ensure you make the right decision for your situation.