Failed EIS share sale results in large tax bill

As the Government and HMRC seem determined to clamp down on anything they perceive as ‘tax avoidance’, making use of HMRC approved tax shelters is usually a sensible course of action.

Subscribing for shares in a company that qualifies under The Enterprise Investment Scheme (or EIS for short) can be a very tax effective investment and happens to be one that is also endorsed by HMRC (see above!).

The big attraction for many investors is that they obtain income tax relief on their initial investment and if they sell their shares after having held them for 3 years, broadly speaking, any capital gain on the share sale is tax-free.

However it’s easy to come a cropper if you don’t follow the rules closely and an investment which you assumed was tax-free could end up surprising you with an unexpected tax bill.

This fact was highlighted recently in a case that went before the tax tribunal.

So what went wrong exactly?

Well firstly let’s look at the facts:

• Mr Ames was a skydiver and together with other individuals devised the idea of an indoor skydiving simulator - this sounds a more attractive concept to us than the real thing!
• Mr Ames originally invested £50,000 for shares in Skyventure UK Ltd, a company which qualified under the EIS scheme. This went through a clearance process and subsequently received approval from HMRC.
• The company grew to become very successful and this was good news for Mr Ames (EIS can be a risky investment). He then decided to sale his shares for £333,200 in 2011.
• Because the gain on the sale of an EIS investment is usually free of Capital Gains Tax (see above) Mr Ames did not think it was necessary to disclose the capital gain on his tax return. However, he did make a disclosure in the additional information section of his tax return.

Mr Ames therefore assumed he had made a tax-free capital gain of over £280,000.

So what was the problem?

Well, possibly as a result of Mr Ames including a note in the additional information section of his tax return, HMRC decided to open an enquiry into Mr Ames tax return. After reviewing the information, it was HMRC’s view that the gain on the share sale was fully taxable and so they amended his tax return.

Why did HMRC think the gain on the EIS share sale was taxable?

Well, Mr Ames hadn’t made an income tax claim under EIS when he bought the shares because he had no taxable income in the year of investment. (As an aside, given that the income tax relief was potentially worth £15,000 we’re left scratching our heads on this one!).
HMRC’s interpretation of the taxes legislation was that an EIS share sale is exempt from Capital Gains Tax (or CGT for short) only when income tax relief has been claimed on the original investment.

Naturally Mr Ames was very upset about HMRC’s decision - though we would have also been miffed about losing £15,000 worth of income tax relief. Mr Ames therefore appealed against HMRC’s decision and took the case to the Tax Tribunal.

Unfortunately, The Tribunal dismissed his appeal stating that CGT was in actual fact payable on the share sale. The Tribunal agreed with HMRC’s interpretation of the taxes acts which stipulated that the CGT exemption was only available where income tax relief had actually been claimed (and received) on the original purchase of the shares.

The Tribunal decided that a person with no taxable income to relieve an EIS investment against will pay full CGT on a share sale, whereas a person with, say, only £1 of taxable income will pay nothing at all.

Even though Mr Ames had no taxable income in the year he bought his shares, with some clever tax planning he may have been able to obtain some (if not all) of the tax relief available on this investment.

The irony of this was not lost on Mr Ames, though we suspect he didn’t see the funny side of this result - which he described as an ‘absurdity’.

The above decision underlines why it’s so important to consider the tax implications of a new business venture before, if you’ll pardon the pun, diving in with both feet…

If you’d like to discuss EIS generally and how it could benefit your business, or you have a tax issue you’d like to discuss, simply email our friendly tax adviser, [email protected] or give us a call on 01202 048696.