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Mitigate CGT when you make a disposal

There are a number of ways to mitigate the capital gains tax incurred by a disposal
June 23, 2017

Last week we reported that private equity investment trust SVG Capital (SVI) plans to wind-up, and if shareholders approve this they will receive a distribution that will be treated as a a disposal. This means it could give rise to a chargeable gain potentially incurring capital gains tax (CGT).

For SVG Capital shareholders, or any other investors who have disposed of assets and incurred a gain, there is no CGT to pay if the shares or assets were held in a self-invested personal pension (Sipp) or an individual savings account (Isa).

If you made a gain on assets held outside one of these tax-efficient wrappers, the gain can be offset against any losses made in the same tax year. After this, you have a capital gains tax (CGT) allowance, which currently allows you to make gains of £11,300 a year before paying any tax on them.

If your gains exceed this you can carry forward losses from previous tax years to offset your gains. Losses have to be registered on a tax return within four years of the tax year you made the loss.

Above that, gains which when added to taxable income fall into the basic rate tax band are taxed at 10 per cent, and those which when added to taxable income fall into the higher or additional rate tax band are taxed at 20 per cent.

 

Mitigating CGT with an EIS

You can defer CGT by reinvesting gains in Enterprise Investment Schemes (EIS), which are a type of private equity investment. The gain is deferred until the EIS investments are cashed in, or if you die before this happens the CGT liability dies with you. The deferral can be applied to gains that occurred up to three years before the date of the EIS investment or one year after.

You can use an EIS for offsetting a capital gain in a number of situations such as as selling shares or funds, exiting a buy-to-let property, extracting profits from a business or mitigating a tax bill when you surrender an investment bond.

EIS benefit from a number of other tax reliefs, such as a 30 per cent income tax break if you hold them for a minimum of three years, and they do not form part of your estate for inheritance tax (IHT) purposes if you hold them for at least two years.

You can invest up to £1m a year into EIS and there is no lifetime limit.

However, EIS are a very different kind of private equity investment to a large fund of private equity funds such as SVG Capital, and most mainstream investments such as shares, funds, investment trusts and exchange traded funds (ETFs). So by reinvesting in an EIS you are likely to be moving up the risk scale.

EIS give you exposure to small, early-stage companies rather than some of the larger, more mature businesses a private equity investment trust may have exposure to. Some EIS hold only one investment, making them even higher risk, and even the ones which take a portfolio approach are likely to offer exposure to less than 10 companies, in contrast to the hundreds or thousands of investments a private equity fund of funds holds.

EIS are unlisted so you can't sell their shares on the market, as you would be able to with a private equity investment trust. And you can't cash in the units with their manager when you feel like selling as is possible with an open-ended fund. You have to wait until the underlying investments are sold.

Because EISs and the companies they invest in are not listed on the stock market, it can also be harder to get information on them.

Because of the risks, Philip Rhoden, director at discount stock broker Clubfinance, argues that you shouldn't just invest in an EIS because of the tax relief or because it meets a particular deadline for tax purposes. Rather your decision to invest in it should be based on its underlying merits as an investment. "Investors should understand what they are investing in and do their research before making a decision," he adds. "If unsure, seek advice from a professional adviser."

He also thinks investors should seek to diversify their EIS investments.

However, EIS benefit from loss relief, so the maximum loss a 45 per cent taxpayer will suffer in a single investment is 38.5p in the pound. You only invest 70p per pound in EIS investments because of the 30 per cent income tax relief. If this is all lost due to the investment failing then you qualify for loss relief at your marginal income tax rate. The loss can be offset against income tax of the same year or preceding tax year.

Alternatively, the loss can be set against your capital gains at the prevailing rate of 20 per cent for higher-rate taxpayers, or 28 per cent for certain assets such as residential property. It can be offset against capital gains of the same year or carried forward to be offset against future gains.

 

Loss relief against income tax for a 45 per cent tax payer

Initial investment£100,000
Less income tax relief @ 30%-£30,000
Net cash outlay for investment£70,000
If investment fell to £0 net loss
Loss relief of 45% of the loss£31,500
Net loss-£38,500
Percentage of original outlay38.50%

Source: Enterprise Investment Scheme Association

 

Loss relief against income tax for a 40 per cent income tax payer

An investor puts £10,000 into EIS and gets £3,000 income tax relief. The EIS goes bust and the shares are worthless, so the investor's loss is £7,000 because that's been their net outlay after the income tax relief received.

However, if they were a 40 per cent tax payer then they could claim a loss relief of £2,800 - 40 per cent of the £7,000 loss. So, in this doomsday scenario of a total equity wipe-out, the investor would still be left with £5,800 of their original £10,000.

Source: Tilney Group

 

Picking an EIS

There are three main types of EIS:

■ Capital preservation, which invest in lower-risk companies, usually asset-backed or with strong revenues.

■ Exit focus, which aim for a predictable exit as soon as possible after the three-year minimum holding period.

■ High growth, which target rapid organic growth.

Martin Churchill, editor of the Tax Efficient Review, says that because liquidity is relatively important to investors wanting to defer CGT lower return offers with more of a capital preservation focus are probably a better option. This is because the exit potential of these should be better than EIS focused on higher growth opportunities. "Lower return offers should offer a realisation at least every four to five years allowing you to crystallise your CGT liability, or reinvest it and defer it again," he says.

However, there are fewer of these available because of a number of rule changes in recent years, which have prevented EIS from investing in lower risk areas such as renewable energy.

"The challenge for EIS providers targeting lower returns is to find lower risk trades that can provide enough upside to remunerate investors for the risk, and will pass review by HM Revenue & Customs (HMRC) and receive advance assurance [that they qualify as EIS investments]," says Mr Churchill. "Providers also need to find lower risk trades with a pipeline of deals sufficiently large to justify both the manager set-up costs, and the investment of time by advisers and investors in properly evaluating the offer."

Mr Rhoden suggests that before investing check if the EIS investments have HMRC advance assurance, in particular, whether it is already in place for any of the planned investments, and whether it is always in place before the fund makes an investment.

If the EIS investments don't have advance assurance there is a risk that some of them won't qualify as an EIS.

"The outcome is that most offer providers targeting lower returns have been late to launch this year, and most providers will be targeting trades which are new and therefore will not come with a track record of previous EIS investment," says Mr Churchill. "Investors also cannot be certain of the trades that their chosen EIS will invest in. So we expect demand to be high and supply constrained for lower return EIS offers in the current tax year."

A lower return area that EIS can still invest in is media, and examples of schemes in this space include Ingenious Broadcasting and Shelley Media.

If you want to defer CGT, David Goodfellow, head of UK financial planning at Canaccord Genuity Wealth Management, suggests investing in EIS which could provide fairly definitive exit timescales . He highlights Earthworm EIS Fund which invests in waste management and recycling facilities. He says that while this is not lower risk it has very defined exit strategies, and the underlying investments should have asset backing.

But more EIS offerings are expected to launch later in the year so there could be a better choice in a few months.

Mr Rhoden says that if using an EIS to defer a capital gain the key issue at the start is to match the time of the gain you are seeking to defer with the issue of EIS-qualifying shares. "The EIS shares must be issued within 12 months before and three years after the accrual of the gain on which relief is claimed," he explains. "So the issue for the investor is when the EIS will make the underlying investments to qualify for the relief. If the timing looks tight or you are unsure, check first. Investors also need to be aware that they may need to file their tax return and pay the CGT before they have the paperwork to claim the deferral relief."

Mr Rhoden also points out that you need to consider what happens when the gain is revived, usually when you dispose of the EIS shares or they cease to be EIS qualifying. "In terms of disposal, this will usually be when an exit happens, but the timing of an exit is unpredictable. The expected or typical time to an exit also varies, while timings are never guaranteed and things can change."

When your capital gain is revived you may be able to use some or all of your annual CGT allowance in that tax year to offset part or all of the gain, or make a new EIS investment to defer the gain again.

Tax rates can also change, so although CGT is currently 20 per cent for higher and additional rate tax payers, when you revive your gain the rate might be higher. For example, up until April 2016 the top rate of CGT was 28 per cent.

But at the moment, investors who realised capital gains between three years ago and 5 April 2016, and were liable for capital gains tax at 28 per cent, could still defer this via EIS and pay a rate of 20 per cent if there are no changes to this rate over the next few years.