Don’t make a pig’s ear out of investing
Don’t make a pig’s ear out of investing
A Guide to: The Enterprise Investment Scheme (EIS)
The tax reliefs available benefit the investor rather than the company.
The annual maximum is £2 million when investing companies which invest heavily to creating intellectual property or long-term research
Monies raised under EIS must be used for the growth and development of the company
What you need to know:
The Enterprise Investment Scheme (EIS) is intended to provide a targeted incentive for new equity investment in unquoted trading companies by outside individuals, to help overcome the problems faced by such companies in raising small amounts of equity finance.
This is one of the most generous investment incentives ever introduced in the UK but the legislation is complex and many investors and companies disqualify themselves unknowingly. It is therefore vital to seek expert advice to ensure that the investment qualifies for the reliefs and to enable you to avoid the common pitfalls that could result in the tax relief being withdrawn.
The good bits…
As the scheme is designed to incentivise investors the tax reliefs available benefit the investor rather than the company. The benefit to the company is the ability to raise funds more easily, or to raise more funds, than would have been possible if the investment did not qualify for EIS relief.
The tax incentives to the investor are three fold – there is an immediate reduction in income tax and the potential to defer capital gains in the year of investment and there is also beneficial treatment of any eventual capital gain on the sale of the shares.
A deduction against your income tax liability of 30% of the investment is given to investors who subscribe for new ordinary shares in qualifying companies, provided that the shares are retained and the company continues to qualify for at least three years.
The maximum annual investment for income tax purposes is restricted to £1 million so you can reduce your income tax liability by up to £300,000 for the year of investment. From 6 April 2018 the annual maximum is increased to £2 million (giving a tax reduction of up to £600,000) provided any amount over £1 million is invested in one or more knowledge-intensive companies (broadly these are companies which invest heavily to creating intellectual property or long-term research, but there are strict conditions to be met).
EIS subscriptions can also be carried back to the previous tax year, subject to the above investment limit for the prior period.
In addition to the EIS income tax relief a gain arising on any other capital disposal can be “rolled over” into the base cost of the EIS shares acquired, thereby deferring the associated CGT. Unlike the income tax relief the CGT deferral is not limited to £1million.
You must make the EIS investment no more than one year prior to, and up to three years after, the gain arises. The deferral effectively means that no capital gains tax is payable on the disposal of the old asset until the new shares are sold.
If a gain that is eligible for Business Asset Disposal Relief (BADR, formerly Entrepreneurs’ Relief) is reinvested into investments under EIS on or after 3 December 2014 it will still benefit from BADR when the gain is realised. This means you potentially can defer the gain without losing your entitlement to BADR and the associated lower rate of CGT. However, it should be noted that the gain will be taxed according to the legislation in place at the time it comes back into charge, therefore there is a risk that the BADR available will reduce in the interim resulting in a larger CGT bill when the time comes.
If EIS shares have been held for at least three years, any gain on their sale will be exempt from CGT provided that the qualifying conditions have been met throughout that three year period.
However, should a loss arise on the sale of the shares, the balance of the loss (i.e. after deducting the initial tax relief at 30%) can either be claimed as a capital loss or alternatively be offset against general income for the year.
The not so good bits… (and there are quite a few!)
Given the generous tax reliefs available it should come as no surprise that there are a number of conditions that must be satisfied for the above incentives to be available. The company needs to qualify before the share issue and for the following three years.
Qualifying companies must carry on “qualifying activities” (broadly, and subject to various limitations and exclusions, commercial trading activities). Unfortunately, not all trades qualify for EIS relief. Generally speaking, you can’t get tax relief for shares in property investment or dealing companies, businesses in the financial sector and other asset-based businesses. Some of the excluded activities are:
- Dealing in shares or other financial instruments
- Leasing or hiring
- Property development/investment
- Owning and operating nursing and residential care homes or hotels
- Any form of renewable and non-renewable energy generating activity
The company must remain independent (that is, not under the control of any other company) and cannot be listed on a recognised stock exchange, nor can arrangements be in place for the company to become listed. For these purposes, a listing on AIM is not treated as a quotation.
The company (or group) must have gross assets not exceeding £15 million immediately before issue and £16 million afterwards, and can have no more than 250 full-time employees (500 for knowledge intensive companies) at the time of the issue of the shares.
A company must raise its first EIS investment within seven years of making its first commercial sale (or 10 years if the company is a knowledge-intensive company).
There must be a genuine risk to capital – an investment that is considered by HMRC to be tax–motivated will be excluded from relief. This applies where the investment is structured to provide a low risk of return for investors.
As the investor, you must not be “connected” with the company (unless you are only seeking EIS CGT deferral relief).
You are connected with the company if you or your associates (broadly close family members and business partners) hold a total of more than 30% of the ownership of the company, or are employed by the company or any subsidiary (although there is a limited exemption for new working directors).
The shares must essentially be the lowest ranking shares in issue. They must not be, for example, preference shares or redeemable.
As an investor, you will not be eligible for EIS if you already hold shares in the company – unless your existing shares were themselves EIS or SEIS shares or, in limited circumstances, subscriber shares.
There is an overall cap of £5 million on funds raised by the company under the EIS, Seed Enterprise Investment Scheme (SEIS) and Venture Capital Trusts in any 12 month period, subject to an overall lifetime maximum of £12 million (or £20 million for knowledge intensive companies).
Monies raised under EIS must be used for the growth and development of the company. They may not be used to purchase shares of another company, a trade, goodwill or intangible assets.
The money raised by the share issue must be used for the purpose of qualifying trade within two years of the issue of the shares (or, if later, within two years of the date the trade starts).
It’s important to know that HMRC can withdraw the EIS relief
HMRC can withdraw the relief if the qualifying conditions cease to be met within three years of the issue date of the shares, or three years after the company’s trade started.
This means it is important to continue monitoring the activities of the company after making the qualifying investments.
There are other situations in which EIS relief will be withdrawn. One of these is if the investor “receives value” from the company either after the shares are issued or within one year before the share issue. “Receiving value” is widely defined but would include the repayment of any loan made before the shares are issued. Thus the common situation of a potential investor lending money to a company to tide it over, pending agreement of investment terms, will cause loss of relief if the loan is subsequently repaid.
It’s complicated so ask us for help.
The above is a broad summary of the major points of the legislation but the law contains a number of detailed terms and conditions and we would always recommend that professional advice was sought before investing or implementing a scheme.
It is possible to seek advance assurance from HMRC that a share issue will meet the conditions for EIS – this reassures the potential investors that the tax reliefs will be available and is common practice.