Stolkin v HMRC [2016] EWCA Civ 447

This case concerns the application of mathematics to capital gains tax computation.

Although the two tax concessions have since changed form, the principle concern of this case - being in what order a taxpayer should apply two separate but applicable tax concessions is an important issue.

The tax concessions

There are two tax concessions in question here, both relating to qualifying business assets:

The Entrepreneur Investment Scheme (EIS):  Allowed small business investors to rollover capital gains into other qualifying assets.

Taper relief:  Allowed investors to reduce the effective tax rate of a capital gain if it had been held for more than one year (usually to a rate closer to 10%).

The transactions

This case concerned the sale of a property in 2005 which was used for business and personal use.  The tax at stake was £480k.

The law

Tapered relief

In 2005, the mixed use apportionment rules for determining access to the tapered rate of capital gains tax were found in paragraph 3 of Schedule 9 to the TCGA 1992.  Specifically p3(5)(a) provided that the 'business' and 'non-business' portions of the asset's use should be split into two different capital gains:

"the two gains shall be treated for the purposes of taper relief as separate gains accruing on separate disposals of separate assets"

The taxpayer used these rules to determine a business use percentage of the property, around 50%, and then split the two 'uses' into two separate gains in the self-assessment tax form as per p3(5)(a).

EIS

The EIS concession was found in Schedule 5B of the TCGA 1992.  It provided that capital gains made on 'qualifying investments' could be deferred until a later date - if the proceeds were invested in other qualifying investments.

For example if an entrepreneur made a £1m capital gain, and re-invested £900k of that in qualifying investments, only capital gains tax on the £100k would be payable now, with the rest deferred until a later sale of the replacement assets.

The issue

This is where the mathematics begins.  Assume an entrepreneur makes a £10m capital gain on a property which was 50% used for business purposes.  Further assume the entrepreneur will reinvest £2m of these funds in other business assets.  Then assume he or she elects to utilise the two separate tax concessions listed above...  The tax treatment of that kind of transaction is in dispute, the two methods are as follows:

The HMRC calculation

The HMRC would first deduct the £2m pounds from the £10m gain for EIS purposes, reducing it to £8m.

Then the HMRC would tax the business portion of the remaining gain at the tapered rate of 10% and the non-business portion at the normal rate at the time of 18%.  The resulting tax payable would be (£4m * 10%) + (£4m * 18%) = £1.12m.

The taxpayer calculation

The taxpayer preferred to split the gain into two parts first, resulting in two £5m gains.  The taxpayer then chose to use the EIS amount to reduce the 'non-business' portion from £5m to £3m.  The result was a £5m business gain and £3m non-business gain.  The tax payable according to this method would be (£5m * 10%) + (£3m * 18%) = £1.04m.

Thus, a saving of £80k in the above example.

The decision

The Court of Appeal stated that the taxpayer's approach involved mixing the two methods together in order to get a better result.  The judge could not find a legislative basis for this approach and thus ruled in favour of the HMRC:

"I would draw this together as follows. EIS relief applies in priority to taper relief. The first task in the case of a mixed use asset is to calculate the overall gain on the sale of the real asset and apply EIS relief to calculate the gain which accrues in the year of assessment. It is to the net gain that taper relief applies. The net gain must be divided according to the proportions of business and non-business use. At that stage the taper relief is to be calculated on the basis of the fiction that there have been separate disposals of separate assets giving rise to separate gains, applying the provisions of section 2A. This does not mean that there are deemed to be separate disposals of separate assets at the earlier, EIS stage."¹

"I do not think that the taxpayer's approach is based on a correct interpretation of how the EIS and taper relief provisions are intended to operate. One must start with the overall charging provision, section 2. The tax is chargeable in respect of chargeable gains accruing in the year of assessment. The effect of a valid claim to EIS relief is that, to the extent of that claim, gains are deferred and do not accrue in the year of assessment. Thus when section 2A says that chargeable gains are reduced by applying taper relief, it is the gains accruing in the year of assessment to which the relief is applied, and those gains are those which appear after the application of EIS relief. "²

Current Law

Capital gains legislation under the TCGA 1992 has been altered since the transactions in this case occurred.  Tapered relief is gone, however a 10% rate of capital gains tax for entrepreneurs can be found in s.169N.  The EIS still remains, but for the most part in relation to 'shares' in qualifying EIS companies as opposed to 'assets'.

Notes

Case [2016] EWCA Civ 447:  http://www.bailii.org/ew/cases/EWCA/Civ/2016/447.html

1.  p35
2.  p30

Legislation

Taxation of Chargable Gains Act 1992