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).

benefits of EIS

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:

  • Preferential right to dividends.
  • Preferential right to the company’s assets on a winding-up.
  • Right to be redeemed.

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taken when making any future changes to your company's articles or share capital as this could cause the relief to be withdrawn which happened as a result of this recent tax case.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:

  • Be unquoted at the time of the share issue. This means your company can't be listed on the London Stock Exchange or any other recognised stock exchange. The Alternative Investment Market (AIM) is not regarded as a recognised market under EIS rules
  • Be a ‘small company’: gross assets cannot exceed £15 million before the share issue or £16 million immediately after
  • Be a company that employs fewer than 250 full-time employees at the time of the share issue. For Knowledge Intensive Companies from 18 November 2018 this is less than 500 full-time employees.
  • Not be in financial difficulty at the time the shares are issued
  • Is not controlled by another company
  • Does not have any subsidiaries that are not qualifying subsidiaries (broadly a 51% subsidiary not controlled by anyone else, special rules apply to property managing subsidiaries).
  • Have a permanent establishment in the UK

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:

  • They are not connected to the investee company (see below).
  • There are no linked loans to them. Broadly speaking this is a loan which, but for the investment, would not have been made, or would have been made on different terms.
  • They subscribe to the shares for genuine commercial reasons and not as part of a tax avoidance scheme or arrangement.

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:

  • Be remunerated as a company employee, partner, or director unless they are an unremunerated director, or potentially a paid ‘business angel’ investor.
  • Directly or indirectly possess or be entitled to acquire more than 30% of the company's (or any subsidiary's ordinary share capital, issued share capital, voting rights or rights to assets on winding up.
  • The rights of an individual's associates (see below) are attributed to the individual for the 30% test referred to directly above.

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.

  • The company must have been carrying on a trade for either at least four months prior to the share issue, or for at least four months at any point following the share issue.
  • The shares must be issued in order to raise money for the purpose of the qualifying business activity within a certain time limit and to promote business growth and development
  • There must be no ‘pre-arranged exit’ for the investor.
  • The shares must be issued for genuine commercial reasons and not as part of a tax avoidance scheme or arrangement.
  • There are no ‘disqualifying arrangements’. Broadly speaking this would be a scenario where shares are issued to access the relief and either the benefit of the investment is passed to another party, or the business activities would otherwise be carried on by another party

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:

  • The end of 24 months commencing with the share issue date, or if later
  • The end of 24 months commencing with the start of the qualifying trade i.e. where the company is preparing to carry on the trade at the time of the issue date.

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.

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