EIS and Capital Gains Deferral Relief Explained

The Enterprise Investment Scheme (EIS) is a tax-efficient government-backed programme that offers incentives for investors to invest capital into qualifying early-stage and unlisted businesses – with capital gains deferral as one of the tax reliefs available.

While EIS income tax benefits and EIS loss relief are perhaps better known, capital gains deferral can be a valuable tax treatment. It enables investors to postpone capital gains liabilities indefinitely, including obligations of up to £2 million per year.

Knowing how to claim capital gains tax deferral and how to use this allowance strategically can make a significant difference to an investor’s tax bill and enhance the value of an EIS investment.

How Does EIS Capital Gains Deferral Work? A working example

Deferral relief means that an investor can reinvest profits and gains exposed to capital gains tax into an eligible EIS fund or company, deferring the tax charge as long as the gain remains reinvested. The reinvested funds only need to be the taxable gain, not the original investment value.

For example, if an investor had shares worth £100,000 and earned a taxable 20% return of £20,000, they would need to reinvest the £20,000 rather than the full investment amount to be able to defer the capital gains charge.

Investors can defer any gain by investing it into an EIS fund or shares. In effect, that means an investor can defer a capital gains tax liability for the duration of their EIS reinvestment and make use of all the tax allowances available to manage their personal tax obligations.

Chargeable assets include anything that would be subject to capital gains tax on sale or disposal, excluding only primary residential homes and personal possessions. Capital gains tax is payable on gains above the £6,000 annual allowance for the 2023/24 tax year and £3,000 from April 2024.

Limitations apply, with a capped EIS annual investment per individual of £1 million. However, EIS-qualifying entities or funds that are categorised as knowledge-intensive have a higher yearly investment limit of £2 million. Therefore, an investor can defer up to £2 million a year in capital gains tax by reinvesting the gain.

Claiming Capital Gains Tax Deferral Relief Through the EIS

The investor must reinvest the gain into EIS shares but can do so as much as one year before the profit is released and up to three years after. The advantage for an investor is that they can defer their capital gains bill by investing in EIS shares up to 12 months before they expect a liability to arise. Read more about EIS deferral relief here.

Investors can also defer a capital gains charge up to three years after making the gain.

As an example, a taxpayer might sell an asset on 1st September 2023 and make a taxable gain of £100,000 liable for capital gains tax. The standard tax obligation based on 28% for an additional-rate taxpayer would be £28,000. The taxpayer can defer the liability against any EIS investment made from 1st September 2022 until 1st September 2026.

If they then sell or transfer the EIS shares or fund shares, the capital gains tax will become payable. But, if they repeat the same process and continue reinvesting the original gain, the capital gains tax will be deferred indefinitely.

Eligibility for EIS Capital Gains Deferral

The EIS has various qualification criteria for both investors and businesses. To use the tax reliefs and allowances available, investors must be:

Resident within the UK
Not employed or otherwise linked with the EIS company
Subject to a capital gains liability within the parameters described
Holders of EIS shares for at least three years

Note that if an investor successfully claims deferral relief but does not retain the EIS shares for the three-year minimum period, the deferral relief will cease to apply, and the full capital gains tax obligation will become payable.

The Tax Advantages of Capital Gains Deferral

EIS deferral relief is flexible and has several benefits. Investors can use deferral relief to manage their tax affairs, forecasting gains and planned asset sales or transfers to time their investments to fall within the four-year window.

Examples might include a scenario where an investor has another expected gain within the same tax year and knows that two collective profits would exceed the annual capital gains allowance. By deferring some or all of the gain until the following period, they may be able to structure their capital gains to ensure they remain below the tax-free allowance.

Provided they reinvest the full gain back into the EIS scheme, they can continue doing so for as long as they wish. Selling the original reinvestment does not mean the capital gains tax falls payable, provided the same gain is invested again into another qualifying company or fund.

If an investor were to pass away with a deferred capital gains tax obligation, this would be removed and would not pass to a beneficiary or inheritor as part of their estate.

Potential Risks of Using Deferral Relief to Postpone Capital Gains Tax Charges

The EIS is widely seen as a good investment option for investors keen to diversify, engage in early-stage business with strong growth potential, or access the many tax advantages and favourable treatments available.

There is, however, an inherent risk linked with unlisted and early-stage companies since they have a greater likelihood of failing. Investors can use loss relief to minimise their exposure, but there remains the possibility of the company failing, meaning capital is lost, and the investor does not achieve a return.

Investors should also consider their plans if there is any potential for them to become ineligible for EIS tax allowances. That could include changes to their residency position within the minimum three-year investment period or changes to eligibility for the EIS scheme – either related to the investor or the business they invest in.

Finally, there is the possibility of governmental reforms impacting the tax allowances and reliefs permitted through EIS investment. Although there have been no proposed changes since the EIS was first introduced, this cannot be ruled out as an impossibility.

Any prospective EIS investor is advised to seek independent and expert guidance to ensure they select the optimal investment products to take full advantage of these tax reliefs and allowances and to work with a tax adviser to structure their claims and capital gains tax deferrals in the most advantageous way.