In the second in our 4-part series on some of the tax-efficient investment strategies that help plan for and mitigate eventual capital gains tax (“CGT”) liabilities, we’re looking at the Enterprise Investment Scheme (“EIS”), the bigger brother of the Seed Enterprise Investment Scheme (“SEIS”).
To read our article on the benefits of SEIS, click here
THE ENTERPRISE INVESTMENT SCHEME
The EIS is indeed the bigger brother of the SEIS, having been established more than 20 years ago as an evolution of previous tax-favoured investment schemes. Much like the SEIS, the EIS was introduced to help drive investment in UK SME companies.
It offers similar tax-efficient incentives as SEIS does to the investor but, in a trade off with a relaxation of the qualifying company criteria, the available reliefs can be less financially rewarding than under SEIS.
But, for those companies that don’t meet the SEIS qualifying criteria relating to trade and age, the EIS can still be a useful tool in attracting that all-important funding and business expertise needed to help a business thrive. In addition, as with SEIS, the tax reliefs on offer to the investor are afforded a useful level of flexibility, meaning that the benefits of investment aren’t restricted to the EIS shares.
For those companies that meet the SEIS qualifying criteria, or have previously utilised SEIS, it is possible to move from SEIS to EIS, provided the necessary criteria are met.
Recent legislation has introduced a distinction between ‘knowledge-intensive’ companies and ‘non-knowledge-intensive’ companies for EIS purposes, and applied separate rules to each.
A knowledge-intensive company is defined as one that meets certain criteria relating to:
- the % of its operating costs spent on Research & Development and innovation;
- the creation of intellectual property and how said property forms or will form the greater part of the business within 10 years of the share issue date; and
- the % of its staff who qualify as full-time skilled employees.
Throughout this article we have referred to the rates applicable to non-knowledge-intensive companies and put the rates applicable to knowledge-intensive companies in brackets.
Anyone looking to raise EIS funds through a knowledge-intensive company should contact us for more detailed advice regarding their options and the particular rules applicable to such companies.
INITIAL INVESTMENT INCENTIVES
The EIS offers some generous CGT tax advantages, both on making the investment and on an eventual disposal of it, but, like SEIS, it also offers immediate income tax incentives to qualifying investors.
Subject to meeting all necessary requirements (which are explored later in the article) the EIS provides income tax relief to the investor of 30% of the value of their investment, subject to an annual subscription limit of £1M (£2M). That means that, at maximum value, a subscriber could claim up to £300,000 (£600,000) in income tax relief each tax year as a result of making an EIS-qualifying investment.
The relief is applicable to the investor’s total income tax liability, so can be claimed against income tax arising on any source of income, be that through PAYE; tax on profits from a trade; or profits from a rental business, for example.
As with SEIS, the relief works as a credit against the investor’s total tax liability in a given tax year. So, for example, if a taxpayer has paid tax of £120,000 under PAYE and invested £300,000 into an EIS-qualifying company, they can claim £90,000 of the PAYE as a repayment back from HMRC, immediately reducing the cost of their investment.
Although EIS income tax relief can be built into a PAYE tax code, giving relief at source, in most cases it will be claimed through the self-assessment tax return process, where it will be offset against tax that hasn’t already been paid at source and is only arising at the end of the tax year, for example when income tax arises on profits of a property business. In which case, the credit simply acts as a tax liability reducer, lowering the amount of tax needed to be paid out by the taxpayer.
It’s important to note that EIS investments offer income tax relief and so can only act as tax-reducers, not income generators. In order for the relief to be of maximum benefit, investors need a sufficient income tax liability against which the relief can be claimed.
For example, in the illustration above, the £300,000 investment only generates the maximum relief of £90,000 because the taxpayer had a tax liability of more than £90,000.
What, then, would happen if the investor had a total tax liability of, say, £70,000 for the year – £20,000 less than the maximum relief available?
Although EIS income tax relief is initially given in the year of subscription, the subscriber is permitted to treat some or even all of their investment as having been made in the immediately preceding tax year.
A taxpayer has paid £60,000 income tax under PAYE during the 2016/17 tax year and £90,000 income tax on trade profits in respect of the 2017/18 tax year. During the 2017/18 tax year, the taxpayer invests £550,000 into Investinme Limited, an EIS-qualifying company.
Now, whilst the total relief available on an £550,000 investment is £165,000, the investor has a total tax liability of £150,000 across both the investment year and the immediately-preceding year. They can therefore elect to split their investment and have it treated as being an investment of £300,000 in 2017/18, sufficient to generate a credit of at least the £90,000 tax liability for that year, and an investment of £200,000 in 2016/17, being enough to generate a credit of £60,000 in that year and wipe out their tax liability for that year. The remaining unclaimed relief of £15,000 is lost and cannot be carried back further or carried forward.
It should also be noted that dividend income earned on EIS investments carries no special treatment and is taxable under the normal income tax principles attributable to dividend income.
CGT RELIEFS AVAILABLE THROUGH EIS INVESTMENTS
The CGT reliefs afforded to EIS investments are two-fold: CGT exemption on any profit from the disposal of the EIS shares themselves (or qualifying CGT loss if the shares are disposed of at a loss); and CGT deferral relief for unrelated gains.
The first relief is relatively straight forward. When it comes to selling the EIS shares, provided the investor has held them for the qualifying period (which is 3 years from the date of investment) and the company and shares have remained qualifying throughout that period, then there should be no CGT payable on the profit made on disposal. If, as is possible when investing in companies, the shares are disposed of at a loss, the loss (normally equivalent to the investment value if nothing is realised on disposal) will be available to offset against other taxable capital gains arising in the same or future tax years.
Unlike SEIS, it’s also possible for an investor to choose whether to claim an EIS capital loss against gains subject to CGT, or income subject to income tax. Given the higher rates of income tax, this is a generous relief and one that could go so far as to provide 45% income tax relief, thereby recovering almost half of the original investment.
In order to qualify for the CGT exemption, a claim for EIS income tax relief must have been made in relation to the investment and said relief must not have been withdrawn.
The second relief is slightly more complicated, but the rules are perhaps less strict than the other tax reliefs available and many investors will qualify for it without qualifying for income tax relief.
For example, the conditions applicable to the investor are also more relaxed – they must simply have been UK resident at the time the gain was made and at the time the EIS investment was made. There is no ‘connection test’ (see below reference income tax relief conditions) applicable to this particular EIS relief. The investment cap is also greater and is limited only by the permitted EIS annual maximum applicable to each company, which is currently £5m (£10m).
The relief is available in respect of any gains chargeable to CGT and does not have to relate to the EIS investment or, in fact, be in respect of a disposal of shares at all. In order for a disposal to qualify, the EIS investment must have been made during the period beginning one year prior to the date of the disposal of the asset and ending three years after that date. That provides a useful window for anyone looking to relieve a large, historic CGT bill.
The effect of the relief is to defer the CGT arising on the disposal. Tha amount of relief available is based on the qualifying amount, being the lower of the EIS investment value; the CGT gain made; and a lower amount specified by the taxpayer.
The gain is then effectively wrapped up with the EIS investment and frozen, only then crystallising at a later point in time when the EIS investment itself crystallises, like on a disposal of the EIS shares, for example. It is therefore not a permanent form of relief, but one that provides a means of turning a tax bill into a potentially cash-generating asset.
During 2017/18, a taxpayer disposes of a residential investment property for proceeds of £170,000, making a £70,000 taxable gain on the disposal (before CGT annual allowance). In the same tax year, the taxpayer makes a £100,000 EIS-qualifying investment. Without a claim for relief, the gain is chargeable to 28% CGT.
Regardless of whether or not the taxpayer makes a claim for EIS income tax relief, they are able to claim EIS CGT deferral relief on their investment. In this scenario, the relief is automatically limited to £70,000 (being the lower of the investment value and the gain), but the taxpayer is permitted to claim a lower amount of relief if they so choose; for example in order to utilise their CGT annual allowance.
The gain will eventually crystallise and become taxable when the EIS investment becomes taxable, which in most cases will be when it is sold.
Some investors may be happy to pay the CGT arising on a disposal of an asset, especially if it qualifies for Entrepreneurs’ Relief, meaning a 10% tax rate. However, it should be noted that, depending on the date of disposal of the asset, these two reliefs can work in tandem. This has the benefit of deferring the taxation of the gain to a later point in time whilst still being assured of its tax-efficient status when it crystallises.
QUALIFYING COMPANIES AND QUALIFYING INVESTORS
Like the SEIS, EIS was designed to encourage investment in unlisted companies, helping them to find alternative finance when banks wouldn’t be so receptive to supporting their business ambitions. It also aims to match experienced business folk (those likely to have the type of money required to help the company) with inexperienced entrepreneurs, assisting them to manage their way in turning an original idea into a viable business.
Given the generous tax reliefs afforded by the scheme, the rules dictating qualifying companies and investors are relatively strict and are heavily policed by HMRC. The rules are also quite detailed, but the key provisions are analysed below.
For investors to qualify for the EIS income tax and CGT exemption reliefs, they, or their associate(s), must:
- not be connected with the company, either through employment or by holding a substantial interest in the company;
- not hold an interest in the company that is not also SEIS or EIS-related, or founder shares; and
- not have received a loan that is dependent on their investment (i.e. it wouldn’t have been provided or would not have been provided on those terms were it not for the investment).
The connection tests are applied during the period beginning two years prior to the date of investment and ending three years after. For the purpose of these tests, an associate includes an investor’s relatives (but not siblings) and a substantial interest is anything more than 30% of the company’s issued share capital / voting power / rights to assets on a company winding up.
The employment connection test may put off potential investors, especially if they are coming on board to provide business knowledge or want more visibility of the business’ operations and finances. To address this, the legislation does allow a relaxation of the employment connection test for ‘business angels’.
The business angels rules allow an investor to become a director but retain the EIS-qualifying status of their investment, provided they haven’t previously been connected with the company in any way, or been involved with carrying on the same trade that the company is. They also allow for an EIS director to be paid, provided the payments are qualifying, such as reasonable remuneration. The business angel rules are a delicate area and require careful planning as to the timings of investments and appointments.
The motives behind making an investment must also always be considered, as it is not permitted for the investment to be part of an arrangement or scheme that has tax avoidance purposes. First and foremost, an investor should look to use EIS as a means of supporting a business with its growth and development, getting behind an idea that has taken their interest.
For investors to qualify for any of the EIS tax reliefs, the company must:
- at the date of investment, have objectives to grow and develop its trade, giving rise to a significant risk that the investor could lose money on their investment;
- not be under the control of another company;
- be unquoted, with no plans to become quoted at any time in the foreseeable future;
- be less than 7 years old (10) when it receives its first EIS investment;
- have less than £15m gross assets at the date of investment;
- have fewer than 250 (500) employees at the date of investment;
- receive no more than £5m (£10m) in risk finance (e.g. SEIS; EIS; VCT; etc.)
- have a permanent establishment in the UK; and
- exist for the purpose of carrying on a qualifying trade.
For the purpose of these tests, a qualifying trade is one that does not include, to a substantial amount, any ‘excluded activities’, such as banking, property development, or trading in shares.
Enterprise Investment Scheme money raised must be used within two years of the investment and be spent for the purpose of the qualifying business activity.
It is possible for companies to apply to HMRC for advanced clearance of their EIS status. This requires the directors of the company to share details of the business and spending plans with HMRC so that they can make a full and informed assessment of the company’s eligibility. It is also only possible if specific investors have already been identified by the company, as HMRC will want to know details about them too.
Withdrawal of Enterprise Investment Scheme relief
Given the generous nature of the reliefs, it shouldn’t be surprising to learn that it is possible for Enterprise Investment Scheme relief to be withdrawn from a taxpayer, meaning any tax relief received could be repayable in full and with interest. This can occur if either the individual or the company are found to have breached the rules during any of the relevant periods, or the initial approval was given based on false or misleading information. Any withdrawal will be costly, and so getting the structure soundly setup and approved at an early stage is always key.
The end is nigh…?
Finally, for those long-term planners, it’s worth noting that there is currently a ‘sunset clause’ in the Enterprise Investment Scheme legislation which dictates that income tax relief will only be given to subscriptions made before 6 April 2025. This is subject to review by future governments and could be renewed if the investment market and economy in general still required boosting with incentivising investment schemes.
If you’re interested in understanding more about the Enterprise Investment Scheme, or have more general questions about setting up or funding a business, contact us today for an initial, free-of-charge meeting.