Summary of EIS benefits
EIS is broadly comprised of four core reliefs. On the basis that an investment and the investor satisfies certain conditions, then the following reliefs may be available to the investor:
- Income tax relief @30% on up to a maximum of £1m invested in a tax year;
- Unlimited capital gains deferral;
- Exemption from Capital Gains Tax (CGT) on the sale of shares which attracted income tax relief;
- Income tax or capital gains tax loss relief for losses on sale of the EIS shares.
- There are also other potential reliefs which may be in point:
- Business Property Relief (BPR) for Inheritance Tax (IHT) purposes once shares have been held for at least two years;
- Business Investment Relief (BIR) may be available for non-domiciled investors using their foreign income and gains to invest.
Of course, investment in unquoted trading companies is not for the faint-hearted. It does, by definition, carry a high degree of risk. The undoubtedly attractive tax reliefs that underpin the EIS schemes are intended to offer a partial safety net to investors who are contemplating any such investment.
EIS offers reliefs in respect of income tax and CGT to investors who subscribe for shares in qualifying trading companies. One might therefore say that the scheme offers a ‘subsidised’ source of equity finance to companies. It is aimed at Companies which might otherwise find the cost of finance prohibitive or, indeed, impossible!
This guide to Enterprise Investment Scheme is a summary of some of the key features of the reliefs which investors might seek when investing. This might be income tax relief or the deferral of CGT by reinvestment of gains. Of course, in many cases, it might well be both.
Qualifying conditions – cross-over in to other reliefs
It is worth mentioning that the qualifying conditions set out for EIS companies in this guide are also used as the basis for qualifying companies under the Seed Enterprise Investment Scheme (‘SEIS’), the Enterprise Management Incentive Scheme (‘EMI’) and for Venture Capital Trusts (‘VCT’).
As a result, there are a number of potential opportunities for tax efficient funding for these types of companies.
Similarly, these rules are mirrored in BIR. This relief allows non-UK domiciled individuals to remit their foreign income and gains without being subject to tax. Usually such a course of action would result in a tax charge. This is a handy relief to make these funds available for use in UK commercial activities. Generally the EIS rules are more restrictive, so many investments that qualify under the EIS scheme should qualify for BIR. One should check that a proposed investment met the conditions for BIR before undertaking such a course of action. [LINK – BIR]
It is also possible that some EIS qualifying companies may also meet the requirements to be considered a qualifying investment in order to secure a Tier 1 Investment Visa. Again, a would-be investor should check that themselves before investing. [LINK – TIER 1]
Investors may also be able to claim BPR for IHT purposes once the EIS qualifying shares have been held for at least 2 years. [LINK – BPR]
A risk warning
EIS might well be a statutory relief but that does not make it a simple relief. In fact, it is far from simple and contains many traps for the unprepared. Investors and companies should not take any action without obtaining specific professional advice.
Income tax relief
For the 2015/16 tax year onwards, income tax relief is available at a maximum rate of 30% in respect of a subscriptions of up to £1,000,000 in any tax year, i.e. a maximum of £300,000 of income tax relief is available.
An investor may elect to carry back to the previous tax year the amount he subscribes in a tax year, subject to the applicable annual limit, and his income tax liability for the year. Relief will be given at the rate applicable to that previous year.
The CGT reliefs are presented in two different forms and engage at two different times.
Firstly, on investment, an investor may claim to defer capital gains up to the amount of his investment. There is more on this below.
Secondly, on disposal, if the conditions for income tax relief have been met then any gain (other than a deferred gain) on the sale of the EIS shares is exempt from CGT. If there is a loss, capital gains tax relief is available as an alternative to the income tax relief mentioned above.
Deferral relief is available for gains arising on the disposal of any asset. It is obtained by reinvesting part or all of the gain by subscribing for shares in an EIS qualifying company.
After making a claim, the relief will be given as a deferral of the chargeable gain, by matching it with a subscription for eligible shares. The result is that the capital gain is deferred or ‘held-over’ until the EIS shares are sold. The gain will also re-crystallise if EIS relief is withdrawn due to a ‘disqualifying event’.
CGT deferral relief cannot be claimed on gains that where Entrepreneurs’ Relief is claimed.
The EIS investment must be made in the period which commences one year before, and ends 3 years after, the capital gain. HMRC has discretion to extend this period in certain circumstances.
Deferral relief is only available where a gain arises on an actual disposal of an asset or on a clawback of relief given on an earlier investment under the EIS, reinvestment relief or VCT provisions.
Income tax loss relief
Finally, income tax relief may be claimed where there is a loss on the final sale of the EIS shares if income tax relief was claimed or, alternatively, it was available on but was not claimed.
This provides the final part of the ‘safety net’ meaning that an investor who lost all of his investment would obtain income tax relief of up to 61.5% of his assuming he was a 45% income tax payer.
The provisions relating to tax relief against income for losses on shares in unquoted trading companies permit a claim for the year of loss or the previous year. Therefore, if a loss arose in 2015/16, a claim could be made for loss relief in 2014/15 and 2015/16 respectively.
The Finance Act 2013 introduced (with effect from 6 April 2013) for the tax year restrictions on the amount of income tax reliefs including for losses on disposal of shares in unquoted trading companies.
These restrictions will apply to losses arising on the disposal of shares where Deferral Relief only has been claimed. There is an exclusion from these rules for shares where EIS income tax relief has been claimed and not withdrawn.
The limit on the total income tax relief where relevant in a tax year will be £50,000 or, if greater, 25% of the taxpayer’s adjusted total income for the year.
Example of income tax relief and deferral relief
Mrs Miggins sells a painting on 3 July 2015 making a capital gain of £250,000.
On 3 October 2015 she subscribes the full £250,000 for 25% of the ordinary shares in Piemakers Limited, an unquoted trading company manufacturing world leading meat pies.
Piemakers Limited is a qualifying company for EIS purposes and Mrs Miggins claims EIS relief.
Her taxable income in 2015/16 is expected to be £300,000 so is likely to pay income tax at a rate of 45% on the majority of her income. She has made no other EIS investment during 2015/16.
- Income tax 2015/16 £250,000 30% £75,000
- CGT deferred 2015/16 £250,000 28% £70,000
- Total tax saving and deferral on £250k invested 58% £145,000
If Mrs Miggins and Piemakers Ltd continue to meet the qualifying conditions for EIS income tax relief purposes until 3 October 2018, Mrs Miggins will be able to sell her shares in Piemakers Ltd with no liability to capital gains tax on any profit which arises on those shares.
The deferred gain of £250,000 will become chargeable at the rate of capital gains at the rate applicable when the Piemakers shares are sold. Currently, this would be 28%.
What are the main conditions for the relief?
The following section sets out some of the main conditions applicable to:
- both EIS Income Tax and CGT Deferral Relief, and
- the conditions which apply specifically in relation to only one or the other .
Conditions relating to both income tax and CGT deferral
- The investor must be an individual who subscribes in cash for new shares in a qualifying company. The investment may be made by direct subscription, by a nominee or through an EIS Fund. Trustees of certain settlements may obtain CGT deferral relief only.
- The maximum amount a company may receive in a twelve-month period from EIS or certain other state aid supported sources is £5m.
- A cap on the total size of a company is imposed via the ‘gross assets test’
- If either the investor or the investee company do not meet certain requirements during the ‘relevant period’ then relief will be denied or withdrawn. The ‘relevant period’ ends three years after the issue of the shares or, in the case of a company not trading when the shares are issued, three years from commencement of trade.
EIS income tax relief specific
- The maximum amount for which an individual may obtain income tax relief in any tax year is £1m (2015/16). This limit has steadily climbed over the last decade.
- There is no longer a minimum amount an investor can invest.
- Conditions also apply in respect of the individual and their relationship with the company. This is often a key restriction on an individual investor being able to obtain the income tax relief.
Deferral relief specific
- The investor must be a UK resident individual who subscribes in cash for new shares in a qualifying company. The investment may be made by direct subscription, by a nominee or through an EIS ‘Fund’. The trustees of most UK settlements may also be eligible to claim obtain CGT deferral relief.
- Deferral relief can be used to defer capital gains that arise on disposals of assets of any description.
- Usually, the gain must be reinvested within the period beginning one year before and ends three years after the relevant disposal.
What conditions must the investor meet?
Income tax relief
If an individual is to obtain (and retain) EIS income tax relief and benefit from a CGT exempt disposal they will need to:
- Subscribe for qualifying shares on his own behalf. However, the subscription may be made via a nominee;
- Continue to hold the shares until three years after subscription or three years after commencement of trade if later;
- be unconnected with the company at any time in a period of restriction. This period:
- commences 2 years before the issue of shares or, if later, with incorporation of the company;
- ends three years after the subscription for shares, or, if later, three years from commencement of trade.
Broadly an individual is or becomes connected with the company if he or an associate (broadly a spouse, lineal relative or member of the same partnership):
- Is an employee of the company which issues the shares or of any subsidiary of the company;
- Is a paid director other than a business angel;
- Has voting control over more than 30% of the company’s share capital.
- Would, on the winding up of the company, be entitled to more than 30% of the assets of the company available for distribution to the holders of ordinary shares (or loan creditors who have made a loan other than a normal commercial loan).
The concept of a business angel is an important one. This is both in terms of the individual and also the company. A business angel is an individual who has no pre-existing connection with the company and subscribes for shares. In such circumstances it is acceptable for him to be appointed as a director entitled to receive reasonable remuneration for his services to the company.
This offers an individual the opportunity to be involved with the company in which he invests and for him to still obtain income tax relief with the possibility of an exempt capital gain. It also allows the company to attract both the management skills of an individual as well as their money!
Investors eligible to claim deferral relief are:
- Individuals; and
- Trustees of certain trusts and settlements. Broadly:
- Trustees of a discretionary trusts should be able to claim deferral relief, assuming that all of the potential beneficiaries are individuals; and
- Trustees of of interest in possession trusts may claim if any of the beneficiaries are individuals.
The investor must be resident and ordinarily resident in the UK both at the time the gain arises and when he makes the subscription for shares in respect of which deferral relief is claimed.
The connection tests described above which apply to an investor for the purpose of a claim for income tax relief under the EIS do not apply where the relief claimed is capital gains deferral only.
Therefore, an individual may control a company and obtain deferral relief only under the EIS for his subscription.
What shares will qualify?
- The shares must be newly issued ordinary shares and:
- Must carry no preferential rights to dividends;
- Must carry no preferential rights to assets on a winding up; and
- Are not redeemable.
A right is ‘preferential’ with regard to dividends if the amount or date of payment of the preferential right may be determined to any extent by the company, the holder of the share or any other person. The shares must meet these conditions for the ‘relevant period’ described below.
- As noted earlier, these tax reliefs are given to encourage investment in riskier companies. It therefore stands to reason that, where there are provisions included to ‘de-risk’ an investment it will no longer qualify for relief. There are known as “specified arrangements” and include arrangements for:
- Subsequent repurchase or disposal of the shares;
- Cessation of the trade;
- The disposal of the company’s assets; and
- Providing protection from risk for investors, other than normal commercial protection arrangements.
‘Arrangements’ are broadly defined and will include any arrangements even if they are not legally enforceable.
HMRC takes the view that anti-dilution clauses and conversion rights are prohibited by this legislation.
Conditions relating to the company
‘Control and independence’ and the activity requirements
In order to be a qualifying company for EIS purposes it must, throughout its ‘relevant period’:
- Not be under the control of another company or control another company other than a qualifying subsidiary;
- Carry on a qualifying activity or be the parent company of a group of companies the business of which consists of qualifying activities; and
- No other person may carry on the qualifying activity, and therefore companies which carry on their trade through a partnership will not meet the qualifying conditions.
The ‘relevant period’ commences with the issue of the EIS shares and ends on the third anniversary, or, if later, three years after the trade commences.
The ‘Unquoted’ requirement
The company must be unquoted at the time that the shares are issued and there must be no arrangements in place for this to change.
The definition of ‘unquoted’ permits companies whose shares are quoted on the Alternative Investment Market (‘AIM’) at the time they are issued to qualify.
The ‘Gross assets’ requirement
The company may not have gross assets of more than £15m immediately before it receives a subscription for eligible shares or more than £16m immediately after.
The number of employees requirement
To qualify, investee companies (or groups) must have fewer than 250 full-time employees at the date the shares are issued to investors.
The maximum amount raised annually through risk capital schemes requirement
For shares issued on or after 6 April 2012, an investee company may receive not more than £5 million from EIS investors (or from a mixture of Seed EIS, EIS and Venture Capital Trust investors) in a 12-month period.
Also included within the £5m limit is any investment made in the company from a source regarded as EU State Aid within a definition.
If the limit is exceeded, none of the shares or securities within the issue that causes the condition to be breached will qualify.
The financial health requirement
A company which is regarded as an ‘enterprise in difficulty’ under the EU Guidelines on State Aid for Rescuing and Restructuring Firms in Difficulty (2004/C244/02) is not eligible to receive funding under the EIS.
The UK permanent establishment requirements
The company that issues shares to investors is required to have a permanent establishment in the UK.
The ‘no disqualifying arrangements’ requirement
This is described further in the ‘Prevention of Avoidance’ section.
The spending of money raised by the SEIS requirement
A company that qualifies under the EIS may already have raised money under the SEIS scheme.
If this is the case, then at least 70% of the monies raised under the issue of shares to SEIS investors must have been spent, before it may issue shares that qualify under the EIS.
What is a ‘qualifying trade’ or business activity?
Most trading companies will be regarded as carrying on a qualifying trade and business activity for EIS purposes.
The main restriction is that Company cannot operate any of the following activities:
- Dealing in land, in commodities or futures, or in shares, securities or other financial instruments;
- Dealing in goods otherwise than in the course of an ordinary trade of whole or retail distribution. There are specific rules about dealing in goods to ensure that relief is available only where the company’s trade is genuine, and not a disguised investment activity;
- Banking, insurance, money lending, debt factoring, hire purchase financing or other financial activities;
- Most leasing activities and some letting of ships on charter;
- Receiving royalties or licence fees, except royalties or licence fees resulting from the exploitation of particular intangible assets described below;
- Providing legal or accountancy services;
- Property development;
- Farming or market gardening, forestry and timber production;
- Operating or managing hotels or guest houses, nursing or residential care homes;
- Coal production, Steel production or Shipbuilding
- Subsidised generation or export of electricity.
Royalties and licence fees
The EIS legislation defines certain types of intangible assets from which royalties and licence fees may be received without prejudice to the company’s qualifying status.
Broadly, the intangible asset (or at least the greater part of its value) must result from the company’s own research and development work. Research and development from which it is intended a qualifying trade will be derived may of itself be a qualifying business activity.
Intangible assets for this purpose are assets treated as such under normal accounting practice. Where the intangible asset is intellectual property the right to exploit it must rest with the company. Intellectual property means any patent, trademark, registered design, copyright, design right, performer’s right or plant breeder’s right.
This exemption for receipt of royalties and licence fees is important, as certain technology companies might not otherwise qualify under the EIS.
Application of funds and commencement of trade
The funds raised under the EIS must be applied by the company to the qualifying activity within two years of subscription or, if later, commencement of the activity.
Commencement of trade must occur within 2 years of the share issue.
Claiming the reliefs
A very useful non-statutory advance assurance (clearance) service is offered by HMRC for companies wishing to raise funds from investors who, in turn, wish to avail themselves of EIS relief.
Such companies will need to supply certain details about themselves, their business and the proposed terms of the investment. On reviewing this information, HMRC will confirm whether the company will be a qualifying company for EIS purposes, prior to the issue of the shares.
HMRC will not confirm whether a specific individual will qualify for the tax reliefs.
However, provided subscribers meet the conditions applicable to them, they may subscribe with the comfort that relief is available. This assumes that the company does what it told HMRC it would do, and subject to satisfactory completion of form EIS 1. HMRC is bound by the advance assurance it has given and the EIS relief will be available for qualifying investors.
We always recommend that companies should seek an advance assurance where investors are hoping to obtain tax reliefs. Clearly, having a piece of paper from HMRC confirming qualification is a useful marketing tool to provide to investors!
Once the shares have been issued, there are two stages to the claim for relief.
- Initially, the company must make a claim that it is a qualifying company.
- Subsequently, the individual investors may claim relief.
The company makes its claim using the Compliance Statement (also referred to as EIS1). The formal claim by the company for relief cannot be made until the company has carried on the qualifying trade (or research and development) for at least four months. The claim must be made within two years after the end of the tax year in which the subscription for shares was made, or, if later, two years after the end of the period of four months of trading mentioned above.
Once HMRC is satisfied that everything is in order with the information on the form EIS1, form EIS2 will be issued to the company. This authorises the company to issue form EIS3 to the investors.
Once the investors have forms EIS3, they may make the relevant claims in their self assessment tax returns. The claim must be made not later than the fifth anniversary of 31 January following the year of assessment for which the relief is claimed. If the investor does not hold form EIS 3 he may not claim to defer payment of tax because of his EIS investment.
If form EIS3 is received during the year of assessment for which the relief is claimed, investors may apply to HM Revenue & Customs to adjust their PAYE code, or to amend their payments on account if appropriate.
Withdrawal of reliefs
EIS income tax reliefs
Income tax relief may be withdrawn if within a specified period:
- The company ceases to be a qualifying company;
- The investor ceases to be a qualifying individual;
- The shares cease to be eligible shares;
- The investor disposes of his shares other than to a spouse or to a new company which issues its own shares in exchange; or
- There is a significant receipt of value which is not returned.
The specified period is one which:
- commences with the issue of the shares; and
- ends after three years, or if later, three years from commencement of trade by the company.
Relief may also be withdrawn if the company does not apply the funds raised and commence to trade within the timescale set out above.
A deferred gain will recrystallize and be subject to CGT if within the period specified above if:
- The company ceases to be a qualifying company;
- The shares cease to be eligible shares;
- The investor becomes non-resident, otherwise than for an employment all the duties of which are outside the UK and in which he will become resident again within 3 years, still owning the shares; or
- There is a significant receipt of value that is not returned.
Deferral relief will also be withdrawn if:
- The funds raised have not been applied for the purpose of the qualifying activity within two years of the share issue or two years of the commencement of trade, if later. Commencement of trade must occur within two years of the share issue; or
- The investor disposes of his shares at any time other than to a spouse or to a new company which issues its own shares in exchange.
A chargeable gain will arise at the time of the event which causes the relief to be withdrawn.
Interaction with Entrepreneurs’ Relief (ER)
The prevailing rate of CGT is currently either 18% or 28% for higher rate taxpayers. However, this may effectively be reduced to 10% where ER is available.
Previously, although there may have been a cash flow advantage in making a claim for deferral relief under the EIS, there may be an absolute cost depending on the taxpayer’s situation. This is because ER could not be claimed on the gain that recrystallized on the subsequent sale of the EIS shares.
However, from 2015/16 this position has been remedied such that ability to avail oneself of ER may also be deferred.
Prevention of tax avoidance
There are other provisions that act to deny relief either at the outset or clawing back such relief where it has already been given.
For EIS Income Tax Relief, these include provisions relating to reciprocal arrangements and replacement capital. For both EIS Income Tax Relief and Deferral Relief there is a general provision denying relief where the motive is tax avoidance.
A loan raised specifically to acquire EIS or Deferral Relief shares may, depending upon its terms, prevent relief being available.
The ‘no disqualifying arrangements’ requirement
This was introduced to prevent the reliefs being used to deliver tax avoidance products to investors where the underlying company has little or no other commercial purpose.
The intention is to disqualify companies which would have been unlikely to exist in the first place, or would have been unlikely to carry on the particular activities in question, were it not for the wish to claim the relief.
The ‘No disqualifying arrangements’ requirement is wide-reaching in its effect and great care is needed in seeking advance assurance for companies as to ensure sufficient information is given to HMRC to enable them to determine if this requirement is met.
The EIS scheme offers individuals really attractive income and CGT reliefs to invest in qualifying unquoted trading companies.
Before raising such funds from investors, these companies may in their set up phase have received funding from individuals who claimed reliefs under the Seed Enterprise Investment Scheme (“SEIS”).
Due to the overlap between the qualifying conditions, the company might receive funding from a Venture Capital Trust as well. It might also issue options to employees under the Enterprise Management Incentive (EMI) Scheme.
Small and growing companies can now go to market armed with a host of attractive tax incentives when looking to raise funds. We would be delighted to advise on any of these tax efficient opportunities. It should be noted that the legislation is quite complex and both the investor and the company should take care when looking at obtaining these reliefs.