EXPLANATORY NOTE

1. These provisions amend the rules which enable investors to defer chargeable gains when they make qualifying investments in companies under the Enterprise Investment Scheme (EIS). They provide for capital gains tax (CGT) taper relief to apply on a cumulative basis where an investor who makes a gain on disposing of one EIS investment defers the CGT charge on making a second EIS investment. This means that where the deferred gain comes into charge on the sale of the shares in the second company, it will be treated for taper relief purposes as though the holding period began when the shares in the first company were issued and ended when the shares in the second company were sold. If there was a gap between the disposal of the shares in the first company and the issue of the shares in the second company, the holding period does not include the gap.

2. The CGT charge may be deferred again if the investor makes further EIS investments. In such cases, when the deferred gain comes into charge on the sale of the shares in the last EIS company in the series, it will be treated for taper relief purposes as though the holding period began when the shares in the first company were issued and ended when the shares in the last company were sold, but excluding any period in which no shares were held.

3. These changes to the EIS deferral relief rules apply where the shares in the first company were issued after 5 April 1998 and disposed of after 5 April 1999.

_________________________________

4. Subsection (1) inserts a new section, section 150D, in the Taxation of Chargeable Gains Act (TCGA) 1992. The function of section 150D is to give effect to the new Schedule 5BA to that Act. Details of Schedule 5BA, which provides the rules for taper relief to be given on a cumulative basis for successive EIS investments, are given in paragraphs 10 to 18 below.

5. Subsection (2) gives effect to Schedule 7 to the Bill.

6. Subsection (3) makes some minor consequential amendments to the taper relief rules in section 2A of, and Schedule A1 to, TCGA 1992.

7. The change made to section 2A provides for the definition of "qualifying holding period" which applies generally for taper relief purposes to be subject to the modification made by Schedule 5BA for EIS purposes. Except where this modification applies, the qualifying holding period is the period for which the asset was held after 5 April 1998, excluding any periods which do not count for taper relief purposes. The period is extended by one year if the asset was held on 17 March 1998. The EIS modification is described in paragraph 12 below. When an asset is disposed of, the number of complete years in its qualifying holding period is used to determine the percentage of the gain which is chargeable.

8. The change made to Schedule A1 adds paragraph 4 of Schedule 5BA to the list of provisions which define periods that do not count for taper relief purposes. Paragraph 4 of Schedule 5BA is described in paragraph 13 below.

_____________________

9. The Schedule inserts a new Schedule, Schedule 5BA, into TCGA 1992.

_______________________

10. Paragraphs 1 and 2 provide for the CGT taper relief rules to be modified in accordance with the rules in paragraphs 3 to 5 where the following circumstances apply—

an investor disposes of shares to which EIS income tax relief or deferral relief (or both) is attributable;

these shares were issued on or after 6 April 1998 and the disposal took place on or after 6 April 1999;

the whole or part of the gain arising on this disposal is deferred under the EIS because it is reinvested in shares in one or more companies: any part of the gain which is deferred in this way may be wholly or partly deferred again under the EIS on subsequent reinvestments; and

a "revived gain" which is derived from the original gain arises on the disposal of some re-investment shares, and the whole or part of the revived gain is not deferred again under the EIS.

11. EIS income tax relief is attributable to shares, in relation to an individual, if he or she obtained it for the investment and it has not subsequently been withdrawn in full. EIS deferral relief is attributable to shares if expenditure on them has been set against part (or all) of a chargeable gain and there has not previously been a "chargeable event" in relation to those shares. A "chargeable event" occurs in relation to shares if, for example, they are disposed of, or the investor ceases to be resident or ordinarily resident in the United Kingdom within five years after acquiring the shares while still holding them.

12. Paragraph 3 defines the qualifying holding period which applies for taper relief purposes for the revived gain to the extent to which it is not deferred again under the EIS. It begins when the original shares were issued and ends when the re-investment shares which triggered the revival of the gain were disposed of. This is subject to the exclusion of any periods which do not count for taper relief purposes.

13. Paragraph 4 applies in relation to the revived gain to the extent to which it is not deferred again under the EIS. It provides that any period falling between the date of issue of the original shares and the date the gain is revived in which neither the original shares nor any "relevant re-investment shares" were held does not count for taper relief purposes. The meaning of the expression "relevant re-investment shares" is given by paragraph 7 of Schedule 5BA - see paragraph 16 below.

14. Paragraph 5 also applies in relation to the revived gain to the extent to which it is not deferred again under the EIS. It provides rules which are used to determine how much of the gain qualifies for the business asset taper and how much qualifies for the non-business asset taper. The first step is to trace the path of successive holdings of shares which begins with the original shares and ends with the shares whose disposal triggered the revived gain. The second step is to treat the relevant part of the revived gain as though it were a gain on the disposal of an asset which in turn assumes the character of each shareholding in the path for the period in which the shares in question were held. If there is a period in which two successive shareholdings are simultaneously held, the character of the one which was acquired earlier is assumed until it is disposed of, at which point the character of the later acquisition is assumed instead. Examples illustrating how these rules work are given in paragraphs 27 and 28 below.

15. Paragraph 6 secures that the special taper relief treatment of the revived gain has no bearing on the taper relief treatment of any other gain which arises at the same time as the revived gain on account of the disposal of the re-investment shares in question.

16. Paragraph 7 defines "relevant re-investment shares". As far as the revived gain is concerned, relevant re-investment shares are any of the shares, other than the original shares, which are comprised in the path of successive holdings of shares which begins with the original shares and ends with the shares whose disposal triggered the revived gain.

17. Paragraph 8 provides the rules which determine whether a gain is derived from another gain for the purposes of Schedule 5BA. In the simple case, a later gain is derived from an earlier gain if the earlier gain is deferred under the EIS on the acquisition of some re-investment shares and the later gain is revived when those shares are disposed of. In more complex cases, the later gain is derived from the earlier gain if the earlier gain is deferred under the EIS on the acquisition of some re-investment shares and there is a path of successive holdings of shares which begins with those shares and ends with the shares whose disposal revives the later gain.

18. Paragraph 9 provides interpretation for the meaning of some expressions used in Schedule 5BA. Such expressions have the same meaning as they have in Schedule 5B to TCGA 1992 (which provides the rules for EIS deferral relief) apart from the expression "the original gain", which is used in Schedule 5BA to mean the gain which arises on the disposal of the original shares.

________________________________

19. The EIS is designed to help small higher-risk, unlisted trading companies raise start-up and expansion finance by the issue of eligible shares to investors. Individuals previously unconnected with a qualifying company can obtain:

income tax relief (at 20 per cent) on the amount invested up to £150,000 per year and relief from capital gains tax on disposal of the shares, provided they are held for at least five years; and

relief for any allowable losses on the shares against either income or chargeable gains.

20. The scheme also enables individuals, whether they are outside investors or connected with the company, and trustees of certain trusts to defer the charge to capital gains tax on chargeable gains arising from the disposal of any asset where the gain is reinvested in a subscription for eligible shares in a qualifying company. There is no annual limit on the amount of chargeable gains which an investor can defer in this way, although the gross assets rule (see paragraph 23 below) sets a limit on the amount of qualifying investment which may be made in any particular company. It is possible for individuals to defer a gain in respect of an investment for which they obtain income tax relief. In such circumstances, the shares in question will be shares to which both income tax relief and deferral relief is attributable (see paragraph 11 above).

21. The company has to exist primarily for the purpose of carrying on a qualifying trade or be the parent company of a qualifying trading group. Most trades qualify, but there are a number of exceptions, including banking, insurance and other financial activities. EIS income tax relief and deferral relief are available only for investments made in newly-issued ordinary shares which, during the period of five years after their issue, carry no preferential rights.

22. The money raised through the issue of the shares must be used by a company, or a subsidiary, for the purpose of carrying on, or preparing to carry on, a qualifying trade, or for research and development which is intended to lead to a qualifying trade which will be carried on by the company or a subsidiary.

23. The company must satisfy a number of conditions, some of which must be satisfied at or before the time the shares are issued, and others during the period of three years following that time or, where the money is used to prepare for carrying on a trade, the time at which the trade commences. In particular, the gross assets of the company must not exceed £15 million immediately before the shares are issued, and must not exceed £16 million immediately afterwards. This is known as the gross assets rule, and where the company is a member of a group, the rule is applied to the assets of the group, taken as a whole.

24. As mentioned in paragraph 20 above, the EIS rules permit a chargeable gain arising on the disposal of an asset to be deferred where the investor makes a qualifying investment. In such circumstances, the investor makes a claim for expenditure on the shares in question to be set against the gain, and the CGT charge on the gain is, in effect, put into suspense until the shares are disposed of or until some other event (such as the investor becoming non-resident in the circumstances described in paragraph 11 above) occurs.

25. When the gain that was deferred is revived, it is treated for taper relief purposes under the existing rules as though it is, in effect, the original gain. This means that the holding period, for taper relief purposes, is the period for which the original asset was held, irrespective of the length of time for which the shares in the EIS company were held.

26. The new rules apply where the asset whose disposal gives rise to the original gain is itself a qualifying holding of shares in an EIS company. This means that the shares must be shares to which EIS income tax relief or deferral relief is attributable. (In cases where income tax relief is attributable to the shares, the new rules will be of benefit only to the extent that the gain arising on the disposal of the shares is not exempt from CGT.) Where the deferred gain is revived on the disposal of the shares in the second EIS company, the holding period for taper relief purposes for the revived gain is the period which begins with the acquisition of the shares in the first EIS company and ends with the disposal of the shares in the second EIS company. If the deferred gain is revived for some other reason while the shares in the second EIS company are held, the holding period for the revived gain ends with the disposal of the shares in the first EIS company.

27. The following example illustrates a simple case where there is a gap between the disposal of the shares in the first EIS company and the issue of the shares in the second EIS company.

Arthur disposes of some shares in ABC Ltd to which EIS deferral relief is attributable at a gain of £50,000. He held the shares from 1 March 1999 until 1 March 2004, and they do not qualify as a business asset for taper relief purposes for any part of that period.

He invests £50,000 in shares in XYZ Ltd, and obtains deferral relief by setting the expenditure on these shares against the £50,000 gain. The shares are issued to him on 1 September 2004 and he disposes of them at a gain of £30,000 on 1 September 2009. The shares qualify as a business asset for the whole of that period.

The £50,000 gain is revived on 1 September 2009. The qualifying holding period for taper relief purposes begins with 1 March 1999 and ends on 1 September 2009, but the period between 1 March 2004 and 1 September 2004 (when Arthur did not hold any of the shares) does not count. For taper relief purposes, Arthur is treated as having disposed of an asset which was a business asset shareholding for five years and a non-business asset shareholding for five years. The £50,000 gain is, therefore, split into a £25,000 gain on a business asset which has been held for ten years, and a £25,000 gain on a non-business asset which has been held for ten years.

The amount of this gain which is chargeable is £21,250, being:

25 per cent of £25,000 for the business asset part = £6,250; plus

60 per cent of £25,000 for the non-business asset part = £15,000.

The gain of £30,000 on the disposal of the shares in XYZ Ltd qualifies for five years’ taper relief as a business asset. This means that 62.5 per cent of it (£18,750) is chargeable.

28. The following example illustrates a simple case where the disposal of the shares in the first EIS company takes place after the shares in the second EIS company were issued.

Guinevere disposes of some shares in DEF Ltd to which EIS deferral relief is attributable at a gain of £100,000. She held the shares from 2 May 1998 until 2 May 2005, and they qualify as a business asset for taper relief purposes throughout that period.

She invests £100,000 in shares in UVW Ltd, and obtains deferral relief by setting the expenditure on these shares against the £100,000 gain on the DEF shares. The UVW shares are issued to her on 1 September 2004 and she disposes of them at a gain of £50,000 on 2 May 2008. The shares do not qualify as a business asset for any part of that period.

The £100,000 gain is revived on 2 May 2008. The qualifying holding period for taper relief purposes begins with 2 May 1998 and ends on 2 May 2008. For taper relief purposes, Guinevere is treated as having disposed of an asset which was a business asset shareholding for the seven years from 2 May 1998 until 2 May 2005, and a non-business asset shareholding for the three years from 2 May 2005 until 2 May 2008. The £100,000 gain is, therefore, split pro rata into a £70,000 gain on a business asset which has been held for ten years, and a £30,000 gain on a non-business asset which has been held for ten years.

The amount of this gain which is chargeable is £35,500, being:

25 per cent of £70,000 for the business asset part = £17,500; plus

60 per cent of £30,000 for the non-business asset part = £18,000.