Tax benefits of EIS for start-up companies
The tax benefits of EIS (Enterprise Investment Scheme) can be a useful incentive for attracting investment in your company if it is still in the start-up phase or has previously raised funds under the Seed Enterprise Investment Scheme (SEIS).
Introduction
In order to obtain the tax benefits of EIS, qualifying shares in a qualifying company must be issued to a qualifying investor. There are also some other general requirements which need to be met to obtain the relief. These are discussed later in this post
What are qualifying shares?
In order to qualify for the tax benefits of EIS, the shares must be fully paid up ordinary shares offered for subscription (rather than purchased 'second hand'). At the time of issue and for the subsequent three years they must not carry any current or future:
Should any bonus shares be issued (free shares), in proportion to the existing shareholding, they will simply be treated as being the same asset as the original shares. Therefore (and subject to conditions being met), the shares will benefit from Income Tax relief, Capital Gains Tax (CGT) deferral relief and be exempt from CGT on disposal.
Because of the requirement for the shares not to carry any preferential or redemption rights for three years after their issue care should be taken when making any future changes to your company's articles or share capital as this could cause the relief to be withdrawn which happened as a result of this recent tax case.
Definition of a qualifying company
The company issuing the shares must either be a qualifying trading company or the parent of a trading group. The majority of trades are likely to qualify, unless they fall within the definition of excluded activities - for example property development.
A qualifying business activity can also include research and development which is intended to lead to a qualifying trade. For example the creation of an intangible asset by your company such as 'know-how'.
In addition, your company must fulfil the following criteria in order to qualify:
The 'risk to capital' condition
Much like the SEIS, this condition is designed to exclude artificial investments that have no real prospect of risk from benefitting from the tax advantages of venture capital reliefs. It is not intended to affect genuinely entrepreneurial start-ups. HMRC consider all factors together in the round when determining whether or not to apply these anti-avoidance rules.
Who is a Qualifying Investor?
An individual is a qualifying investor if:
Connected individuals
Between the period commencing two years before the issue of EIS shares and the later of three years after the investment was made, and the date your company commences trading, an individual investor cannot be ‘connected’ with the qualifying EIS company. They cannot:
Who are associates?
‘Associates’ include business partners, the trustees of any settlement of which the investor is a settlor or beneficiary, lineal relatives: e.g. spouses and civil partners, parents and grandparents, children and grandchildren. However brothers and sisters, cousins, uncles and aunts are not considered associates.
What about directors?
The rules regarding directors need careful attention particularly where they are intending to obtain the tax benefits of EIS. We'd strongly recommend becoming a shareholder prior to becoming a director if the intention is that payment will be made for any services provided.
General Requirements
In addition to the requirements for the company, investor and shares there are a number of other ‘general requirements’ to be met for EIS to be available.
Investment limits
Companies
The maximum amount of investment that a qualifying company can receive in any year is capped at £5 million or £10 million for 'knowledge intensive' companies 'KIC's'. This limit is applied by adding up all relevant investments in a 12-month rolling period (i.e. not by reference to calendar year or the company's accounting period end).
There is also a maximum lifetime limit. Relevant investments must not exceed £20 million for KIC's and £12 million for other companies over their lifetime.
Individuals
The maximum investment an individual can make is £2 million, provided that at least £1 million is invested in KICs.
Individuals who subscribe for shares in an EIS qualifying company may claim Income Tax relief of 30% on the cost of the shares. This relief is offset against the individual’s Income Tax liability for the year in which the investment is made.
There is no requirement for the individual to be UK resident, they simply need a UK Income Tax liability.
Three year holding period
The individual must retain the shares for a minimum of three years if the company is trading when the shares are acquired in order to retain the tax benefits of EIS.
A qualifying business activity includes preparing to trade (for a period of up to 2 years), the three year holding period runs from the date the trade commences if the company was not trading when the shares were acquired. This can therefore extend the required holding period to 5 years if the company starts trading after 2 years of preparing to trade.
If the shares are disposed of within this minimum holding period, the relief will be clawed back. The exception to this is where the disposal is to a spouse or civil partner, in which case the spouse or civil partner is deemed to have subscribed for them.
If the disposal consideration is less than the relief then the claw back will be at the level of the consideration only and an element of relief will be retained. The amount of relief here is the amount utilised by the investor against Income Tax on the acquisition of the shares and not the total amount invested.
Timing of investment
Companies must raise their first investment under EIS within seven years of making their first commercial sale or 10 years if the company is a KIC.
No age limit applies to companies raising an investment where the amount of the relevant investment together with any other relevant investments made within a 30-day period is at least 50% of the company’s annual turnover, averaged over the previous five years, the company uses the funds to enter into a new product/geographical market and the company has previously met this condition (entering into a new market etc) and at least some of the funds will be used for the same activity.
Use of funds raised and time limit
Any funds raised via a qualifying EIS issue must be employed for the purposes of a qualifying business activity by either:
It is a specific requirement that money raised from EIS investments must be used to promote your company’s growth and development. This phrase is not defined and so must take its ordinary meaning. must be used to do more than maintain your company’s current status.
Therefore in order to obtain the tax benefits of EIS the capital raised cannot simply be used to fund pre-existing day-to-day expenditure or to acquire all or part of an existing business. Repayment of a loan is not sufficient by itself to meet the condition. HMRC consider that indicators of growth would be increased revenues, customer base and/or number of employees.
Withdrawal of relief
Income Tax relief given may be withdrawn in a later year if the ongoing requirements are not met as set out in the legislation. For example the investor becomes connected with the company or the company ceases to be a ‘qualifying’ company.
Capital Gains Tax Benefits
No CGT is charged on a gain on disposal of EIS shares, on which Income Tax relief has been given, after the minimum holding period of three years, provided the company is trading at the time the shares were acquired. This period runs from the date that the company starts trading if that start date is 2 years after the share issue and the company has been preparing to trade.
If disposal takes place within the minimum holding period the gain is not exempt. Where Income Tax relief was not given on the entire EIS subscription, the CGT exemption is restricted pro-rata, unless full Income Tax relief was not available simply because the taxpayer’s Income Tax liability was too low.
Deferral relief
CGT can be deferred if capital proceeds are invested in EIS shares even if the investor is connected with the company
The gain can be realised from any asset but the share investment must take place in the period of one year before or three years after the disposal of the asset (i.e. the gain to be deferred must be made in the period three years before or one year after the EIS investment).
There is no upper limit on the total amount of qualifying reinvestments which can be made in a year, but the amount that can be invested in a single company is limited to £5m
A deferred gain can come back into charge if the EIS shares are disposed of, other than to a spouse or civil partner. The shares cease to be qualifying EIS shares, the investor becomes non-resident, with a limited exception where this is due to employment. This revived gain can be deferred by making further qualifying investments and claiming relief again.
Loss Relief
If EIS shares are disposed of at a loss at any time, the loss, after any Income Tax relief has been taken into account, can be offset against income for that year and the previous year instead of being offset against capital gains.
A loss can be claimed on the disposal of EIS shares even if the Income Tax relief has not been withdrawn. The loss is reduced by the amount of any Income Tax relief which remains attributable to the shares sold.
HMRC Advance assurance
Given the complexities surrounding the tax benefits of EIS this process should be considered as an opportunity to obtain assurance regarding the applicability of EIS relief, particularly where any of the anti-avoidance provisions might apply. This is a topic we will be covering in a separate post.
For more useful information, check out our Ebooks here.
And if you'd like to know how we can help you with all of this, or with anything else, feel free to give us a call on 01202 048696 or email us at [email protected].
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