Enterprise Investment Scheme
Written by Ray Coman
Capital gains on disposal of a property or shares can be deferred where proceeds are reinvested into the enterprise investment scheme. The EIS scheme offers cash and tax benefits to the investor.. It also provides cash for the budding enterprises.. It has particular benefits to the high earner who may have used pension allowance . Unless the investor is 54 or older, an EIS also provides an oportunity for capital to be returned sooner than a pension.. EIS has particular impact where a property investor is seeking to downsize or invest in a different asset class.
Can EIS be used for residential property?
Capital gains tax exemption on EIS shares
Tax relief on any capital loss from share disposal
Transfer of shares to a spouse
Income tax relief on EIS
The Enterprise Investment Scheme provides the investor with a reduction on tax. At the time of writing the tax reducer is equal to 30% of the amount invested and it applies to any investment up to a limit of £1 million.
If tax relief is a key objective, investment should be measured out over tax years if required.. Tax relief is wasted to the extent that the tax reducer exceeds tax liability.
It is possible to treat the investment as occurring in the preceding tax year.. This will be beneficial where tax available for reduction in the investment year is lower than that of the previous year.
For certain Knowledge Intensive Companies, the investment limit referred to above is increased to £2 million.
Tax liability is different from tax payable.. This means that an investor usually receives a refund of PAYE if taxed mainly as an employee.
Income tax relief withdrawal
If the shares are disposed of within three years, the original income tax relief is withdrawn at a rate of 30% on the amount of the proceeds.. More specifically, the income tax withdrawal rate is the same as the income tax relief rate (which has been 30% since April 2011.). A disposal will occur either if the shares are sold, or given away, or if the EIS company liquidates.
Where the EIS shares are sold at a loss within the three years, only part of the income tax relief will be withdrawn.. This is because 30% of proceeds, will be less than 30% of original cost.. Where the shares are sold for a gain within three years, income tax to be clawed back is capped at the amount of tax reducer originally obtained.
Income tax relief is also withdrawn if the investment no longer meets the criteria to be treated as EIS.. An EIS company must be unquoted, and must not have any substantial involvement (20% of the business) from excluded activities.. Trading in property or financial instruments, leasing, accountancy or legal services and hotel management are all secluded activities.. If a company ceases to be qualify within three years of purchase, the investor will not have an opportunity to protect relief by disposing of shares prior to the EIS becoming ineligible.. As explained above, disposing of the shares before three years of purchase results in withdrawal of income tax relief.
Income tax relief is not withdrawn where no value is received for the shares, even if the company enters liquidation within three years of original purchase.
Capital gains tax deferral
Capital gains occurring in the same tax year as the year of investment can be deferred to the extent that they are reinvested in a qualifying shares.. This does not mean that the original gain is no longer taxable.. The gain is deferred until the replacement EIS shares are disposed of.. Deferral therefore provides a cash flow benefit, and to that extent the means with which to invest in EIS.
Claiming EIS deferral does not affect any other tax relief claims made on the EIS investment, such as income tax reducer on initial purchase.
There is no limit on the amount of gain that can be deferred through EIS investment.. The £1million limit only applies to the amount of investment on which income tax relief can be obtained.
An investor can claim to limit the amount of investment on which gain is deferred.. A tax saving could be achieved if the taxpayer treats to choose an amount of gain equal to any unused annual exemption as not being deferred.
If the investor becomes non-UK resident the original gain will crystallise.
The reinvestment must take place no earlier than 12 months before or within three years of the disposal of the original asset.
Can EIS be used for residential property?
The gain can have arisen in any type of asset, so that includes buy-to-let property or second homes.. EIS capital gains tax deferral is especially effective on property because:
Residential property is taxed at a higher rate than other types of gain.
A property gain is more likely to be over the annual exemption and any basic rate tax.. Unlike shares, a property cannot usually be disposed of in portions.. Share disposals can be stretched out over several tax years, so that the gain is equal (or closer to) to the annual exemption.. A property disposal is realised all at once.. Anti-tax avoidance prevents property from being disposed of in sections, for instance if gifted to a family member.. A series of transactions are treated for tax purposes as occurring in full on the day of the first disposal.. A basic rate taxpayer has even more to lose from a gain being taxed suddenly.. A higher rate of tax applies to the extent that income and gain exceed the higher rate tax threshold.
Shares are usually more liquid and held for a shorter period.. Property which tends to represent a larger single purchase takes longer to convey.. A property gain can be built up over a number of years but realised in a single transaction.
There is a prevailing opinion that when the gain comes back into charge, the original gain will be taxed at the general capital gains tax rate (of 10%/20%) rather than the higher rate that applies to residential property.. The reasoning for this is that the tax acts are silent on whether the gain that crystallises is a gain of the original asset.. The opinion of Coman&Co is that this is an interpretation which favours the taxpayer in the absence of any legislative stipulation.. However, an HMRC interpretation to the contrary would have equal weight.. In the usual meaning of the word deferred gain, the gain deferred is that of the original asset.. As a minimum, the taxpayer should keep a provision to settle the additional 8% should the mater be disputed by HMRC and the cost of any appeal outweighed by tax saved.
Capital gains tax exemption on EIS shares
Known as disposal relief, any gains made on the disposal of EIS shares will be exempt from tax.. This is provided the shares have been held for at least three years.. Where only part of the shares are disposed of within three years, it is only that portion that is taxable.. Capital gains tax exemption (£12,300 at the time of writing) is available as usual to reduce taxable gains.
It is also a condition that at least some income tax relief was obtained on the purchase of the shares.. HMRC have stated that disposal relief will not be restricted, if the full tax reducer was not obtained in the year of purchase.. Provided at least some income tax relief was given in the year of purchase all of the qualifying EIS shares will be exempt from capital gains tax.
However, if income tax relief was not available because the maximum subscription was exceeded (of £1 million at the time of writing), a portion of the gain will be subject to tax.
EIS is available on subscription of shares only.. In the rare instance where further shares are purchased second hand, those shares would not automatically be exempt, even if in the same company as the EIS shares.
Tax relief on any capital loss from share disposal
A loss arsing on disposal of EIS shares can be set against either capital gains or in some cases income tax.
The loss available for relief is decreased by any income tax relief obtained on the shares.. Let us say that £100,000 was originally invested, and £30k of income tax relief was obtained. The shares are later sold for £40,000. However only £10,000 of loss will be available for relief.
Loss relief will be available even for shares that are disposed of within three years.. This is because the conditions for loss relief differ from the conditions for EIS.
As previously covered by this report, income tax relief is withdrawn if shares are sold within three years of purchase.. Accordingly, the loss is only reduced by so much of the income tax as is still reduced.
Share loss relief enables an individual to set a capital loss against taxable income. The loss must have arisen from a subscription in an unquoted trading company. The conditions for a company to qualify for EIS will also qualify a company for share loss relief. Unlike EIS, however there is no minimum holding period required for share loss relief.
Share loss relief is an all or nothing claim. It cannot be restricted in a tax year to optimise its effectiveness. Therefore, let’s say a loss exceeds personal allowance, in that case the personal allowance would be wasted. A loss can however be set against income of the tax year preceding that in which the loss occurred.
There are therefore two tax years against which capital loss on EIS shares can be relieved: the year of the loss and the preceding year. If the loss exceeds income for a given tax year, the balance of loss can be set against income of the other year. There is no strict order of tax years to which the loss can be relieved. Priority between tax years would be given so as to maximise loss relief. Any balance of loss will be relieved against capital gains of the tax year of loss. If there are no capital gains, or there is still unused loss after allocation against capital gains, the balance of loss is set against any capital gains of a future tax year after the annual exemption has been used.
If, in the year of disposal, tax relief on income tax is lower than on capital gains tax, the loss should be relieved against capital gains. The loss is used against capital gains occurring in the same tax year as that in which the loss arises. Any unused losses are carried forward and set against the next available taxable gains after application of the annual exemption.
Where shares value reduced in value to such an extent that their value is negligible it might not be possible to dispose of the shares. This is usually because there is simply no buyers. In this case, the investor should consider making a negligible value claim. The negligible value claim treats the share as being disposed of for tax purposes. A negligible value claim will allow share loss relief, even where the shares are still owned by the claimant.
Share loss relief on income combined with EIS tax reducer makes EIS investment more attractive for higher and additional rate taxpayers. At the time of writing, an additional rate taxpayer is subject to tax at a marginal rate of 45 pence in the pound. Continuing the earlier example, where shares were sold with an allowance loss of £10,000, a further £4,500 of income tax relief would be available. Even though the shares have decreased in value from by £60,000, the taxpayer is only £25,500 out of pocket.
For an additional rate taxpayer, the maximum cash loss on an investment of £100k is £55k. Provided held (and the EIS company is still qualifying) for at least three years, the loss in cash term will be £38,500, even if the shares are worthless at the end.
Since 2013/14 the amount of income tax loss relief is restricted to £50,000 or if greater 25% of the income against which loss is being relieved. An individual with income below £200,000 and losses of over £50,000 should seek to obtain income tax loss relief for two tax years.
Inheritance tax relief
An EIS share will potentially qualify as a business asset for inheritance tax purposes. Provided the shares are held for at least two years by the donor, no inheritance tax will arise on a gift of EIS made either in the donor’s lifetime or on death.
Transfer of shares to a spouse
Where an EIS share is transferred to a spouse, no disposal is treated as having taken place for tax purposes. The spouse will inherit the holding period of the shares for income tax and capital gains tax purposes. If the combined holding period is less than three years (or the shares become ineligible), the new owner will be responsible for paying back any income tax originally reduced. The acquiring spouse will also be liable for tax on any capital gains tax deferred.
A transfer will be tax efficient where share loss relief is more valuable to the acquiring spouse. To recap, if by the time of disposal the spouse is taxed at a higher marginal rate, the couple would save tax by a spouse transfer.
The acquiring spouse will need to hold the shares for at least two years to qualify for inheritance tax business property relief, regardless of the length of ownership of the disposing spouse.
Transfer of shares on death
A deceased person will not suffer income tax withdrawal on EIS where the minimum holding period is less than three years. Death creates a capital gains tax free uplift in value, and therefore there is no capital gains tax to pay on the inherited shares.
Following death of the original owner, the EIS shares are no longer exempt from tax. Capital gains tax is calculated in the hands of the new owner by reference to probate value. Disposal relief is no longer available and any realised loss after death of the original owner can therefore only be set against capital gains.
Deferred gains do not crystallise by reason of death, and the beneficiary is not liable for any capital gains tax deferred either. Deferred gains are said to have been ‘washed out’ of the investment on death.
As explained above, EIS shares will eligible for business property relief if held for at least two years. Where transferred to a spouse the two years holding period is based on combined ownership.
Risk of EIS
EIS shares are high risk. They are better suited to high income individuals from whom greater tax relief offsets more of loss suffered from any fall in value of the investment.
