The Enterprise Investment Scheme (“EIS“) is a government scheme that provides a range of tax reliefs for investors who subscribe for shares in qualifying companies. The Chancellor, George Osborne, has recently announced his intention to relax the regulations on EIS to encourage more investment in small companies.
The Chancellor has proposed the following changes which are all subject to EU state aid clearance:
- Income tax relief for investors will rise from 20% to 30% with effect from 6 April 2011.
- The amount of investment for which investors may claim income tax relief each year will rise from £500,000 to £1,000,000 with effect from 6 April 2012.
- The amount of EIS and Venture Capital Trust (“VCT”) investment that may be made in a single company or group over a 12 month period will be increased from £2 million to £10 million with effect from 6 April 2012.
- The maximum size limit for investee companies will be increased from gross assets of less than £7 million (£8 million after investment) to £15 million (£16 million after investment) with effect from 6 April 2012.
- The maximum threshold for investee companies of less than 50 full time employees will be increased to 250 employees with effect from 6 April 2012.
There are currently five separate EIS tax reliefs:
- Income tax relief – provided an EIS qualifying investment is held for no less than three years from the date of issue, or if later until three years from commencement of trade, an individual with no more than a 30% interest in the company may reduce their income tax liability by an amount equal to 20% of the amount invested (30% with effect from 6 April 2011). The minimum subscription is £500 per company and the maximum in respect of which a subscriber may obtain income tax relief in any year is £500,000 (£1,000,000 with effect from 6 April 2012). Relief is limited to the amount which reduces the individual’s income tax liability for the year to nil. Investors may elect to treat their subscription for EIS shares up to their maximum annual allowance as if made in the previous tax year thereby effectively carrying income tax relief back one year.
- CGT relief – no capital gains tax is payable on a disposal of shares after three years, or if later three years after commencement of trade, provided the EIS initial income tax relief was given and not withdrawn on those shares.
- CGT deferral relief – tax on gains realised on a different asset can be deferred indefinitely, where disposal of that asset was less than 36 months before the EIS investment or less than 12 months after. Deferral relief is unlimited so the relief is not limited to investments of £500,000 per annum and can also be claimed by investors whose interest in the company exceeds 30%.
- Loss relief – if EIS shares are disposed of at any time at a loss, after taking into account income tax relief, such loss can be set against an investor’s capital gains, or his income, in the year of disposal or the previous year.
- Inheritance tax relief – shares in EIS qualifying companies will generally qualify for business property relief for inheritance tax purposes at rates of up to 100% after two years of holding such investment so that any liability for inheritance tax is reduced or eliminated in respect of such shares.
The shares issued to investors must be paid up in full in cash when they are issued. They must be “full risk” ordinary shares with no preferential rights to dividends, or to the company’s assets in the event of a winding up. There must also be no arrangements to protect the investor form the normal risk associated with investing in shares, and no arrangements for the shares to be purchased by anyone else after the end of the relevant period.
An investor will not be eligible for tax reliefs if he is connected with the company. An investor is deemed to be connected if he is a director, unless the business angel exemption applies (see below), or an employee of the company. This restriction applies if the investor was connected to the company in the two year period before the shares being issued and three years after the issue of shares or if later the three years after commencement of the trade.
An exemption applies if an investor is only connected with the company as a director and he/she has not received, and is not entitle to receive, any remuneration as a director. This “business angel” exemption applies to investors who subsequently become paid directors if: (a) the investor is not connected with the company when the shares are issued and his/her directorship is the only connection; (b) the investor had not previously been involved in carrying on the trade of the company; and (c) the investor’s pay as a director is reasonable.
An investor will also be deemed to be connected with a company if he/she, and his/her “associates”, hold more than 30% of the share capital, or share and loan capital taken together, or voting rights or is entitled to more than 30% of the assets of the company on a winding up. These conditions apply for the period beginning two years before the issue of shares and ending three years after the issue, or if later the commencement of trade. “Associates” are defined as business partners, trustees of any settlement where you are a settlor or beneficiary and relatives. “Relatives” are spouses or civil partners, parents, grandparents, children and/or grandchildren – brothers and sisters are not counted as associates for these purposes.
The company will have to satisfy the following criteria:
- The company must be a “small company”: it must have gross assets of less than £7 million (£8 million after investment) and have fewer than 50 full time employees at the time of investment. These limits will be increased to gross assets of less than £15 million (£16 million after investment) and fewer than 250 full time employees with effect from 6 April 2012.
- The company must not raise more than £2 million from EIS and VCT investment in any 12 month period but with effect from 6 April 2012 this limit will be increased to £10 million.
- The company must carry out a “qualifying trade” (see below) or be the parent company of a trading group which owns at least 90% of the subsidiary carrying on the qualifying trade.
- For shares issued before 6 April 2011 the “qualifying trade” must be carried on wholly, or mainly in the UK. For shares issued on or after 6 April 2011 this condition is removed although the company will still be required to have a permanent establishment in the UK
- The company must not be controlled by another company and if it has subsidiaries it must own more than 50% (or 90% in the case of a property management subsidiary) of each subsidiary.
- The company must not be traded on any recognised stock exchange (eg Official List) – AIM and PLUS companies will therefore qualify.
- The investment must be employed for the purposes of the trade or research and development within two years of the shares being issued or if later within two years of the trade commencing.
- The shares must be subscribed for genuine commercial reasons and not for tax avoidance.
The trade must be conducted on a commercial basis with a view to the realisation of profits.
The following activities are termed “excluded activities” and are not “qualifying trades”:
- dealing in land, in commodities or futures in shares, securities or other financial instruments;
- dealing in goods, other than in an ordinary trade of retail or wholesale distribution;
- financial activities such as banking, insurance, money lending debt factoring, hire purchase financing or other financial activities;
- leasing or letting assets on hire, except in the case of certain ship-chartering services;
- receiving royalties or licence fees (unless if these arise from the exploitation of an intangible asset which the company itself has created);
- providing legal or accounting services;
- property development;
- farming or market gardening;
- holding, managing or occupying woodlands, any other forestry activities or timber production;
- coal production;
- steel production;
- operating or managing hotels or comparable establishments or managing property used as an hotel or comparable establishment;
- operating or managing nursing homes or residential care homes, or managing property used as a nursing home or residential care home;
- providing services to another person where that person’s trade consists to a substantial extent of excluded activities and the person controlling the trade also controls the company providing the services.
Trades involving feed in tariffs commencing on or after 6 April 2012 will also be deemed to be “excluded activities” which will probably affect most renewable energy companies.
A company may carry on “excluded activities” but these must not be a “substantial” part of the company’s trade. HMRC interprets “substantial” to mean more than 20% of the company’s activities.
The company must comply with EIS criteria set out above on an ongoing basis in order for investors to benefit from tax reliefs for the three year qualifying period. There are two exceptions to this:
- Qualifying status will not be lost if the company floats on a recognised stock exchange unless arrangements were already in place for it to float at the time the shares were issued; and
- The “small company” requirements only apply at the time of the investment.
The EIS is administered for HMRC by the Small Company Enterprise Centre. Companies may apply for “advance assurance” from HMRC before shares are issued to give comfort to potential investors about obtaining the relevant tax reliefs. For relatively straightforward applications assurance can usually be obtained within two weeks.
The proposed changes to the EIS rules referred to above are all subject to EU state aid approval so cannot be relied on until this has been obtained.
For more information please contact Andrew Bretherton at Edwin Coe LLP on 020 7691 4038 or by email at Andrew.Bretherton@edwincoe.com.
Edwin Coe LLP was awarded the EIS legal adviser of the year award at the EIS Association Awards 2011.