The Enterprise Investment Scheme has proved a valuable tax relief both for those entitled to the relief on their investment and the improved attractiveness afforded to qualifying companies in generating equity investments.
The EIS forms part of a number of tax relieved schemes under the heading of venture capitalism. Other such schemes include Venture Capitalist Trusts (“VCTs”) and Seed Enterprise Investment Scheme (“SEIS”). However here we will focus on the EIS scheme.
These schemes were introduced to influence the movement of private funds into small and generally more risky trading companies in the UK with the view to enhancing business activity within the UK. The ultimate objective here is to promote the growth of UK business and recently, there has been a particular focus on growth and innovation companies.
What are the benefits of the EIS to the Company and to the Investor
The key benefit to the ‘small’ company hoping to raise investment is derived from the benefits afforded to the investors.
Where a qualifying investment is made under the EIS scheme, the benefits are generous (subject to holding periods and other restrictions). These include:
• Income Tax relief of 30% of the investment in either the tax year of investment or the previous tax year. As such, the cost of any investment is 70% of the investment amount.
• The shares invested in are exempt from Capital Gains on a future disposal. Effectively, any capital growth in the investment may be realised tax free.
• An amount of gains in the year of investment equal to the investment amount may be deferred for up to 10 years. Any such gains are deferred until the earlier of:
– The disposal of EIS shares
– The shares ceasing to qualify for EIS;
– 10 years
The benefit to the company derives from the generous reliefs afforded to individual investors. Where the company qualifies, an investor will be more inclined to invest into such a company.
To illustrate this, consider the following example.
Company X is a new trading company looking to generate £300,000 to develop, manufacture and retail its new autonomous lawnmower. As the company has no proven track record, it is finding it difficult to persuade investors to finance its idea.
Jane is a highly paid international IT consultant who has an Income Tax liability of £150k. She recently sold an investment property realising a capital gain of £200,000 with a potential Capital Gains Tax liability of £56,000.
Should Jane invest the full £300,000 in Company X:
• Income Tax relief of £90,000 would be available reducing her Income Tax liability for the year to £60,000
• The Capital Gains Tax liability of £56,000 would be mitigated until a future date allowing her to utilise the idle funds to say, invest in other commercial ventures.
The company was very successful and after three years Jane’s original investment is now valued at over £1m. The founders offer to purchase Jane’s shares at their market value. As such, Jane has realised a gain on her investment of £700k which is tax free.
Alternatively, Jane may opt to retain the shares and continue to hold a right to dividends as opposed to realising capital value.
Of course, this would be an ideal scenario, and it may not always be the case that all elements of relief will be available for offset. However, it illustrates the point.
The Main Conditions
There are a number of pitfalls and bear traps within what is notoriously prescriptive legislation. Below I outline the steps and particularities which would form good practice in raising an EIS investment.
However, first it is appropriate to outline the main conditions pertaining to the type of shares which may be issued, the requirements for the company and the requirements for the investor.
The legislation sets out when one is eligible for EIS relief and requires the following
1) The Risk-to-Capital Condition is met (a new condition introduced by FA 2018)
2) The Investor is a Qualifying Investor
3) The company is a qualifying company
4) The general conditions are met; and
5) The relevant shares are issued to the investor before 6th April 2025
I wrote about the new Risk-to-Capital condition in my article [here]. As a brief overview, this is a principles-based gateway test to ensure the EIS rules are not being abused by structuring (sometimes artificial) investments in a risk free manner by preserving the initial capital and unwinding the investment after the minimum holding period.
I was somewhat amused when I first read these provisions as they are heavily principles based and open to interpretation. The anomaly – if you will – of the prescriptive EIS legislation
I will focus on the general requirements as well as the conditions pertaining to the investor and company.
There are a number of general requirements which need to be met. Many of these will be met in most circumstances:
• The maximum amount that may be raised annually under EIS is £1m and £12m over the company’s lifetime. The limits are greater for knowledge intensive companies
• The purpose of the issue must be to promote the growth and development of the business and the money ‘employed’ within two years
• The company must be less than 7 years old
• The shares must be fully paid up at the time they are issued. Shares are (generally) treated as issued when they are recorded in the register of members. If a payment is received to soon or to late, this can lead to EIS being denied.
• There must be no arrangements for a pre-arranged exit
• The shares must be issued for genuine commercial reasons and not for which one of the main purposes is tax avoidance
There are four conditions which need to be met in order for an investor to meet the description of a ‘qualifying investor’.
These conditions consider the proximity of the investor to the company. Again, these are highly prescriptive are intended to ensure genuine risk investments are being made.
The investor must not be connected with the company in question in the two years before the investment until three years after the shares are issued (three years being the minimum holding period). A common concept in tax law, but for the purposes of EIS legislation, the connection test is failed where the investor or an associate is
– An employee, partner or director of the company or its subsidiaries (a relaxation applies to directors who, amongst other tests, receive reasonable remuneration)
– Interested in the capital of the company (30% of the shares, voting power or capital on a winding-up or other circumstance)
– Involved in arrangements for another person not connected with the company to subscribe for shares and provides for another person to subscribe for shares in another company with which any party to the arrangements is connected
No linked loan is to be made by any person in the same period as the above to the investor or an associate of the investor which would not have been made if the investor had not subscribed for the relevant shares or proposed to do so. This appears to ensure that financing arrangements to not undermine the objectives of the EIS scheme or facilitate only tax motivated investments. As such, one should look at the commerciality of any financing arrangements.
Any existing shareholdings must be from a risk finance investment or subscriber shares which have been held continuously since they were issued or subscriber shares which were acquired at a time when the company had only issued subscriber shares and had not begun to carry on or make preparations for carrying on any trade
The relevant shares must be subscribed for genuine commercial reasons, and not as part of a scheme or arrangement the main purpose (or one of) which is the avoidance of tax.
The main conditions pertaining to the company include:
• The company must be an unquoted trading company with a permanent establishment in the UK carrying on the qualifying business activity
– This seeks to restrict the type of companies which may qualify in line with the aims of the scheme to influence the flow of finance into small UK trading companies
• The company must not have gross assets exceeding £15m before the investment and £16m afterwards.
• The company must not have more than 250 full time equivalent employees, or 500 full time equivalent employees where the company is a knowledge intensive company.
Whilst the scheme itself is very attractive to investors, care needs to be taken in relation to any EIS investment. My intention with this article was to introduce you to some of the key conditions for EIS relief whilst highlighting the prescriptive nature of the legislation. For example, the requirement for the shares to be fully paid up at the time they are issued.
There are a number of practices which would generally be recommended in ensuring a watertight EIS claim such as submitting a detailed advanced assurance application to HMRC and evidencing the intentions of the parties via a well-prepared business plan, especially where there is question over whether the new principles-based risk-to-capital condition is met.
I intend to follow this article up with an overview of some of the more common pitfalls in making an EIS claim, HMRCs approach to such errors and the aforementioned good practice which an adviser would hope are in place before an EIS investment is made.
Enterprise Tax Consultants can advise on all aspects IHT & Private Wealth
For more information on EIS see this article or check out this post on the Spring Statement 2018: Entrepreneurs’ Relief & EIS