The Enterprise Investment Scheme
Danny McMullan
14-Jul-06
Let’s face it, the more money you make, the more complicated your taxes become. Or rather, the more time must be spent in determining ways to offset personal and corporate taxes through the guidance of professional advisors and taking full advantage of various government tax breaks, schemes and optimised tax allowances.
Perhaps the single most important thing to know about for any angel investor is The Enterprise Investment Scheme and how this can impact your investments from a tax perspective. We highly recommend to all angel investors, and start-up companies, to consult professional advisors to fully take advantage of this scheme. As an angel, it will provide added incentives when investing and as an investee company, it will assist you in raising the capital you need.
Outlined below is an article written by Danny McMullan from Grant Thornton Advisors and is presented as an excellent overview of the scheme. For more detailed information, visit: http://www.hmrc.gov.uk/eis/eis-index.htm
The Enterprise Investment Scheme offers generous income tax and capital gains tax reliefs to investors in certain companies. The reliefs are available to ‘qualifying individuals’ who subscribe for ‘eligible shares’ in ‘qualifying companies’ undertaking ‘a qualifying business activity’.
What are the investment limits?
Individuals may invest any amount in EIS shares. However, only the first £400,000 invested in any one tax year (£200,000 prior to the tax year 2006/07) will qualify for income tax relief and capital gains tax exemption. For this purpose a husband and wife are treated separately. Individuals must subscribe a minimum of £500 in any one tax year. Several subscriptions can be combined to meet these limits.
Who are ‘qualifying individuals’?
A qualifying individual is any individual who has subscribed for shares wholly in cash in the company unless they are connected with that company. This connection can be by way of employment, partnership, or by being an associate (eg a spouse or child; but not a brother or sister) of such a person. In addition, the individual will be connected if he/she owns or is entitled to acquire, directly or indirectly, more than 30% of the issued ordinary share capital, loan capital, issued share capital or voting power of the company or a subsidiary. The investor must also be a qualifying individual for the two years prior to the share issue and three years after the share issue date or if later, three years from the date trading commences. These connection conditions do not apply to the capital gains tax (CGT) deferral mentioned below.
What are ‘eligible shares’?
Eligible shares are any new ordinary shares issued in the EIS company for bona fide commercial reasons, which, throughout the period of three years beginning with the date on which they are issued, carry no preferential rights to dividends or assets on liquidation of the company. The shares must be fully paid up at the time of issue and they cannot be redeemable.
What are ‘qualifying companies’?
A qualifying company need not be resident in the UK for tax purposes but it must be unquoted and the funds raised must be used by the issuing company or by a direct 90% subsidiary in carrying out qualifying activities.
Companies listed on the Alternative Investment Market are treated as unquoted for the purpose of this relief. The gross assets of a non-group company, or aggregate gross assets of the group, must not exceed £7m prior to investment nor £8m post investment (previously £15m and £16m respectively for shares subscribed for before 22 March 2006 or issued before 6 April 2006).
Where a parent company is raising funds, it must only have 51% subsidiaries to be a qualifying company, with the exception of property management subsidiaries which must be held 90%. However, the funds can only be used by 90 % subsidiaries.
What is a ‘qualifying business activity’?
Broadly speaking, the business activity for which the money is being raised should be conducting a qualifying trade wholly or mainly in the UK during the three years from when the shares are issued or, if later, three years from when the company commences to trade. Research and development undertaken with the intention of starting a trade is also treated as a qualifying business activity.
Qualifying trades encompass all forms of trading except for certain prohibited businesses which include dealing in land, financial activities, legal/accountancy services and property backed activities.
What are the tax benefits of an EIS investment?
20% income tax relief This relief takes the form of a credit against an individual’s personal tax liability. It is given at the lower rate, currently 20%, of the sum invested subject to there being sufficient tax liability to absorb the relief. Thus the maximum tax credit available to an individual is £80,000 in each tax year.
For shares issued between 6 April and 5 October up to half of the investment, subject to an overall maximum of £50,000 (£25,000 prior to 6 April 2006), can be treated as being made in the previous tax year. Other reliefs are as set out below.
No capital gains tax on disposal
If a qualifying individual holds eligible shares for more than three years from the date of issue (or from the date of commencement of trading, if later), then any capital gain on the disposal of the EIS shares after that period will be taxfree, subject to any withdrawal of the relief as mentioned below. (For inheritance tax purposes, the shares should attract 100% business property relief after two years.)
Further, if a loss arises on the disposal of EIS shares then, subject to adjusting for the income tax relief previously claimed, that loss will be available to the investor. This relief can either be claimed as a capital loss or as a loss for income tax purposes.
Deferral of tax on other capital gains
CGT (currently at a maximum of 40%) on a gain from the disposal of any asset can be deferred against an EIS share subscription. The tax on any gain rolled over in this way only becomes due on disposal of the EIS shares or if the individual ceases to be UK resident within 3 years of issue of the shares. There is no requirement to obtain income tax relief to qualify for capital gains tax deferral and the amount of the gain which can be deferred is unlimited.
To qualify for deferral relief the investment must be made during the period one year before the realisation of the gain to three years after.
Investors who defer a gain from one EIS investment to another will be able to calculate their taper relief from the earliest acquisition of EIS shares. This is an exception to the normal rule that taper relief is calculated by reference to the holding of the original asset and frozen at the point of disposal of that asset. This relief is also available to trustees of some trusts.
Are there any further requirements?
Yes, the money raised by the issue of EIS shares must be wholly applied in qualifying business activities. The funds must be applied within 12 months of the share issue, or where it is a new trade, within 12 months of the start date.
Can I oversee my investment?
Yes! To a certain extent. The EIS rules allow investors to become directors of companies into which they have invested as long as they become directors after the issue of the shares. Such a position may be executive in nature and the individual may be remunerated accordingly.
What if I sell the shares early?
A disposal of EIS shares within three years of issue could have three effects:
- there may be a restriction of the EIS reliefs previously given and, if so, the relief will be clawed back
- any capital loss arising can be set against income for the same or the preceding tax year or against capital gains in the same or subsequent tax years
- the CGT exemption will be lost.
Can the tax relief be taken away?
Yes! There are a number of conditions and time limits to be met. EIS relief may be withdrawn if the company ceases to be a qualifying company during the three year period from the date of issue of the shares or the start of trading if later. In addition, the company could lose its EIS status if there are arrangements at the beginning of the relevant period for the company to become quoted during the three year period.
The main conditions are:
- shares must be fully paid up when issued
- the company must not be controlled by another company or companies, although for shares issued on or after 21 March 2000 this should not prevent financial institutions having a stake in the form of preference shares as the test is based on the number of shares or voting power. This restriction applies to any arrangements for another company to acquire control at some time in the future (such as share options)
- if the individual investor becomes connected with the company during the relevant period, relief is withdrawn
- problems may arise and cause a restriction or withdrawal of the EIS relief if companies redeem or repurchase non-EIS shares during the period commencing two years before and ending three years after an EIS issue
- investors who receive any value from the company within a period commencing two years prior to the issue of the EIS shares and three years after may find their relief being adjusted or withdrawn. This restriction does not apply to normal salaries for new directors, nor does it apply to interest given at a commercial rate on monies lent by the investor, dividends representing a normal return on investment or other normal commercial arrangements between the investor and the company.
Who should I contact?
This factsheet has dealt with some of the rules and regulations for EIS relief and broadly outlines the scheme. Investment in EIS is high risk and both investors and issuers should seek professional advice before undertaking such investments. If you need guidance on this subject or other matters please contact a professional adviser or Danny McMullan from Grant Thornton at the local office below.
UK member of Grant Thornton International, a leading international organisation of independently owned and managed accounting and consulting firms. Grant Thornton International is not a worldwide partnership.
This publication has been prepared only as a guide. No responsibility can be accepted by Corporate Publishing Limited or Grant Thornton for loss occasioned to any person acting or refraining from acting as a result of any material in this publication.
