It appears that an unfortunate consequence of the proposed changes to the capital gains tax ("CGT") rules which were announced in the recent emergency Budget may be that fewer individuals will be willing to invest in small businesses under the enterprise investment scheme ("EIS").
Prior to the Budget, entrepreneurs' relief worked by reducing the level of gain which came in to the charge to tax, with the result that the effective rate of tax which applied on the original gain was 10%. Entrepreneurs' relief now works by simply applying a 10% rate of tax to a qualifying gain.
Before the proposed Budget changes it was possible for an individual with a qualifying chargeable gain to claim entrepreneurs' relief in respect of that gain, which had the effect of reducing the level of gain subject to CGT, and then to defer payment of tax on the reduced gain by subscribing for shares in an EIS qualifying company. The effect of this combination of events was to defer assessment of the reduced gain until the occurrence of a "chargeable event" in relation to the EIS shares, such as the individual selling their shares in the qualifying company, at which point the reduced gain was assessed to CGT at an effective rate of 10%.
The proposed changes to entrepreneurs' relief means that it will no longer be possible for individuals with gains which qualify for entrepreneurs' relief at the time of disposal of the original asset to defer payment of the tax liability arising on that disposal by investing in an EIS company and still benefit from entrepreneurs' relief on the original gain at the time of disposal of the EIS shares. Instead, an individual will have to decide whether to claim entrepreneurs' relief on their original gain and pay tax on that gain at 10%, or to benefit from CGT deferral by investing into EIS shares and then subsequently pay tax on the original gain at 18% or 28% on the disposal of the EIS shares.
It is considered unlikely that many individuals with gains which qualify for entrepreneurs' relief will claim EIS deferral relief, as doing so will ultimately result in a higher tax charge. Therefore, it is likely that fewer individuals may seek to invest in EIS qualifying companies.
Similar rules as described above will also apply where an individual disposes of shares in a qualifying company and receives non-qualifying corporate bonds as consideration for the disposal of their shares.
It should be noted that this will only be an issue for individuals with gains realised on or after 23 June 2010 which qualify for entrepreneurs' relief and that transitional rules will apply to those who realised gains before that date and deferred them using an EIS investment.
The Finance Bill is currently at the committee stage and as such these provisions may be amended before coming into force.
Disclaimer
The material contained in this article is of the nature of general comment only and does not give advice on any particular matter. Recipients should not act on the basis of the information in this e-update without taking appropriate professional advice upon their own particular circumstances.
