Capital gains rollover relief: ‘Hidden’ wrinkles

Alan Pink looks at the hidden dangers and opportunities underlying the basic scheme of this very valuable capital gains relief.

To summarise capital gains rollover relief, where an asset used for a trade is disposed of at a gain, and another asset is acquired within a set period (being one year before the disposal and three years after) the gain can be ‘rolled over’ against the cost of the new asset, thus reducing or eliminating the tax on that gain. 

What this basically means is that the cost of the new asset, for the purpose of calculating a gain on a future disposal, is ‘artificially’ reduced by the amount of the gain. In this article, I’ll be concentrating on the position of assets bought and sold by individuals, rather than by limited companies where the rules differ in some respects.

You can’t get rollover relief on the gains from selling any old asset. For a start, of course, it has to be an asset within the scope of capital gains tax (CGT) – what you might call a ‘fixed’ asset of your trade. You can’t roll over the profit on selling current assets like trading stock. This might seem sufficiently obvious perhaps, but many times in practice I am asked by clients whether they can roll over the profit they have made from selling a property development which they have done, where the proceeds of the development have been ploughed back into another property development. 

Secondly, within the category of assets subject to CGT you have the restriction to certain specified types of assets. There are some fairly exotic assets in this list, but in practice for individuals the most common class of assets for which rollover claims are entered are those for properties used for a trade, and (more rarely) sales and purchases of goodwill. 

Interestingly (and usefully), whilst the legislation refers to property as being one of the assets, and implies that you can only roll over into the acquisition of a property you previously owned, HMRC accept that improvement work on an existing property, which you already owned, can be treated as expenditure available for the relief. Consider the example of Thaddaeus below.

Thaddaeus has made a capital gain from selling a division of his business, with the gain arising from the sale of the goodwill of that division. 

Rather than paying tax on this gain, he reviews all the expenditure he has been incurring, and plans to incur, on building an extension to his factory. This improvement expenditure is eligible for the relief, and the gain can be offset against any expenditure incurred up to twelve months before and three years after the sale of the division.

How does the relief work, though, where not all of the proceeds of the disposal are reinvested? And logically, prior to this question is the further question: ‘does it have to be the actual proceeds (i.e. the same pounds and pence) received from the old asset that have to be spent on the new asset? 

Very fortunately, for the sanity of taxpayers and their advisers, HMRC accepts that there needs to be no actual link in cash flow terms between the proceeds of the old asset and the expenditure on the new. This is, indeed, a necessary logical inference from the fact that the rules allow you to claim relief against reinvestment expenditure up to a year prior to the disposal. So, even if you have actually borrowed the money from the bank to fund the whole of the new acquisition, this is all treated as reinvestment expenditure, effectively, which can be set off against the proceeds of the gain.

Let’s extend the example of Thaddaeus above to illustrate how it works when the new expenditure is less than the proceeds from the old disposal.

Having ransacked his records, Thaddaeus establishes that he has spent £75,000 on the extension to the factory and other miscellaneous capital improvements in the period of four years starting one year before the disposal of the trade division. 

The division he sold had actually cost him £100,000 to buy (or at least the goodwill had) several years previously, and the sale proceeds just now were £300,000, meaning that he has realised a £200,000 gain. 

The way the rules work is that the deemed non-reinvested proceeds are deducted from the amount of the gain that can be rolled over. So, given that he has proceeds of £300,000 and ‘reinvestment’ expenditure of only £75,000, this means that there is a shortfall of £225,000 in the reinvestment. 

This is more than the gain that he seeks to roll over and, therefore, the result is that none of the gain can be relieved.

In fact, the effect of these rules, as can perhaps be seen from the above example, is that until you have reinvested at least as much as the original base cost for the old asset, no rollover relief is due. This can be a frustrating tax trap for entrepreneurs. 

There is a tricky point here as well, which needs to be borne in mind in deciding on how to structure ownership of the new asset. 

If the old asset was owned by the individual but used for the purposes of a trade carried on by his limited company, which is a common situation (e.g. where the company’s factory or office building is owned by the individual shareholders), this situation has to be matched by the new asset. 

For example, if Stephen sells the personally held property used for his company’s trade, and buys a new asset used for the purposes of a different trade carried on by him personally, rollover relief won’t apply. What Stephen needs to do, in order to get the relief, is ensure that the new trade is also conducted by the same company. 

The one year before and three years after time limits are not necessarily absolutely rigid. HMRC can (and often does, in my experience) extend these limits where there is a good reason to do so. 

For example, where a person has been doing their best to acquire a new asset but doesn’t manage to do so until shortly after the three-year time limit has passed, it is probably still worth asking HMRC for relief as a matter of practice.

Another key timing point is that, when the individual comes to do his self-assessment tax return, it may be that there is still plenty of the three-year post-sale reinvestment period to elapse, and he hasn’t yet managed to incur the ‘new’ expenditure. In these circumstances, you can apply to defer payment of the tax on the basis that you intend to roll over the gain – a very useful cash flow benefit. 

Watch out for the following traps:

On the other hand, consider the position where the old asset and the new asset are both trading assets, but the new asset ceases to be used for a trade (perhaps it ceases to be used as a furnished holiday letting (FHL) property and becomes a long term let property) at some time after acquisition. Interestingly, the rolled over gain does not crystallise in these circumstances.

Another interesting feature of the rules is that the old asset and the new asset don’t have to be used in the same trade. A trade carried on by the taxpayer in the future will do. And, as the above illustration shows, furnished holiday letting is treated as a trade for these purposes. So, if you want to claim rollover relief on either the old asset or the new asset and it is a residential property, it can be a very good idea to qualify under the FHL rules, by making it available for short-term lets only as holiday accommodation for the requisite periods.