Note: We are not tax advisors, and you should refer to your financial advisor before making any investment decisions.
Governments are keen to bolster their economies, and one of the most effective ways to build up a strong economy is by investing in innovation and new business ventures that can challenge the status quo. Capitalism is built upon competition, and greater competition translates to more efficient services and higher-quality goods. Of course, if new companies cannot amass funding for their projects, they go nowhere.
In the spirit of government-supported capitalism, many governments offer tax incentives to investors who are willing to fund high-risk ventures that pose substantial risks of capital losses. One such incentive is the Enterprise Investment Scheme (EIS) offered by the UK government.
What is EIS and what Benefits Does it Confer?
The EIS, along with its sibling incentives SEIS, VCT, and SITR, is not a single tax relief but a set of reliefs offered to investors of qualified companies. This set of reliefs are concerned with direct income tax relief, relief related to capital gains, estate taxes, and loss relief in the event of capital losses (which are certainly possible with EIS-qualified companies, as they must be high-risk by nature). The shares must be held for 3 years from the date of purchase to remain eligible and failing to hold for three years subjects previously-granted benefits to clawbacks.
EIS also only applies to fundraising, so the shares must be newly issued and not purchased on the secondary market. Any shares purchased on the secondary market are ineligible for EIS benefits.
Income Tax Relief
The income tax relief portion of EIS is meant to reduce the investor’s tax liability. For those with high incomes, this could be a major relief package. For investors who control less than 30% of the target company, up to 30% of their investment can be applied to their income tax liability. This can also be applied retroactively for one year, so taxes owed from the year prior to the investment can be reduced as well.
For example, say an investor had a tax liability of £26,000 in 2016 and £32,000 in 2017. This individual also made a £100,000 investment through EIS in 2017. The investor could then apply £26,000 of tax relief to 2016 and a remaining £4,000 to the 2017 bill, bringing their two-year taxes owed (for 2016 and 2017) to £28,000 from an original £58,000.
Capital Gains Freedom
CGT stands at 20% for most assets in the UK, though some have a rate of 28%. However, for EIS investments, the capital gains tax is entirely waived, as long as the receiving company maintained its EIS-qualifying status and the shares were held for three years.
The best part about the CGT freedom incentive is that it applies even if the investor holds the shares for over three years. The sale of the assets could occur 5, 10, or even more years after the initial investment and still be eligible for CGT freedom. A highly successful company might return multiple hundreds of percentage points on the initial investment, all of which is tax-free.
An example would be an initial investment of £50,000 and a sale value of £250,000. That is a 400% return, and in non-EIS situations, the investor would be liable for 20% CGT on £200,000, or £40,000. However, an EIS-qualifying investment will demand a grand total of £0 of CGT.
Capital Gains Deferrals
A rather interesting incentive of EIS investments is the ability to defer CGT on other assets. The deferral persists as long as the EIS shares are held by the investor, and the incentive can be applied forward 12 months after the purchase of the EIS shares and 36 months backwards. The date of the disposal of the shares is the determining factor in the timing question, not the purchase date.
Another enticing feature of the deferrals relief is that the deferral exists for those who own more than 30% of the receiving company, and there is no upper limit on the amount of the investment.
This incentive is partially meant to entice those who recently took gains on an investment to reinvest that capital into a high-risk venture, thereby moving funds from one investment into another within 3 years (the 36 months backwards limit).
Inheritance Tax Relief
For those concerned with estate taxes coming due in the medium term, EIS offers an attractive way to invest in high-risk assets and simultaneously protect the estate from high inheritance taxes.
As long as the EIS shares are held for two years before death, the value of the shares are not subject to the IHT, in addition to the benefits conferred by the EIS shares in general (income tax relief at the time of purchase, capital gains tax avoidance, etc.). The EISA website above has a nice example of the difference between holding cash and an EIS investment, with the main point being only the leftover cash (from the income tax relief) is subject to the IHT and the shares themselves, whatever the value, are not.
Loss Relief
Since the EIS is designed for high-risk investments, there is a high probability of capital loss. The EIS encourages investment in one last way: by allowing losses realized on EIS investments to offset income taxes from other sources. This incentive offers relief up to 45% for personal income tax and 20% (or 28%) for capital gains.
An example will be illustrative here. An individual enters into a £50,000 qualifying investment and sells the shares 9 months later at a sale value of £15,000. The initial outlay of cash, after considering the 30% income tax relief incentive, is £35,000. Then the realized loss on the venture is £20,000, and up to £9,000 can be used to relieve personal income liability or £4,000 can be used for CGT relief. If CGT is levied at 28%, the relief becomes £5,600.
It is important to note that the loss relief incentive only applies to the portion of losses after taking into account the income tax relief benefit. For the purposes of loss relief, the initial outlay of cash is 70% of the actual cash payment. Of course the investor must pay the full amount of shares initially. Moreover, the applicable relief rate is subject to the payer’s tax band, which will often be 45% (the highest band) for EIS investors, but not always.
Restrictions for Investors
There are a few restrictions for investors, and violation of these restrictions would result in the loss of tax benefits.
Connections
One such restriction is a connection to the company and the use of the personal income tax relief portion. Those who are connected to the company are not eligible for personal income tax relief (though they may qualify for other sections of EIS).
A financial connection is established when an individual controls more than 30% of the company. An employment connection arises when one is employed by the company. This means directors, partners, and employees. Moreover, associates of these people are not eligible, with the term associates covering business partners (from other firms), trustees, and relatives.
Investment Limits
There is a £1 million limit on investments that are eligible for tax relief under EIS in one year. This is for each individual, so a married couple can claim up to £2 million of investment under EIS income tax relief. There is an exception for “knowledge-intensive companies”, which have specific qualifications. Namely, they are engaged in research or development of intellectual property, expect to derive most of their business revenue from that IP, and at least 20% of their staff are engaged in research roles for 3 years from the investment date, and those roles require a minimum education level of a Master’s degree.
Restrictions for Companies
Not all companies are eligible to issue EIS shares. In fact, when an investor purchases EIS shares, they’re not actually EIS shares – more on this in the Advanced Assurance section below.
As for the companies themselves, there are some restrictions they must follow to remain eligible for EIS, and investors would be wise to perform due diligence on the offering company and stay regularly updated on progress.
Limits on Investment
Companies may only raise £5 million per year through EIS, and there is a lifetime limit of £12 million over the lifetime of the company. It is also required that EIS, as a venture capital scheme, be implemented within 7 years of the company’s initial sale or trade. EIS is meant to boost growth companies, not mature ones. On the company side, there is also an exception for knowledge-intensive companies, with yearly limits of £10 million and a lifetime limit of £20 million.
Use of Capital and Ownership
As for uses of the money raised through EIS, it must be used within 2 years of the investment for the growth and development of the company, and it cannot be used for buying other companies. Regarding ownership and other companies, the offering company must be independent (i.e., not owned by another company and it cannot own other companies). The only exception is “qualifying subsidiaries”, which must be at least 50% owned, and wholly controlled, by the offering company. If the money is to be used for the subsidiary, such subsidiary must be 90% owned by the offering company.
Risk of Capital Loss
An important feature of EIS, which makes it a venture capital scheme, is the risk to capital. There must be a substantial risk of capital losses, and any arrangements that stipulate the investor’s money is protected in some way – through using other investment money first, being able to withdraw as soon as possible, or receiving some kind of priority over other investors – will invalidate the investment’s EIS status. Certainly an investor can still buy shares, but the EIS application will be rejected by HMRC, which means none of the benefits listed out above will come to fruition.
Type of Work and Length of Compliance
The type of work performed by the company must meet the “qualifying trades” test, which is relatively easy to meet, but there are some common industries that do not qualify. And finally, the company must follow the restrictions for three years from the date of the investment to maintain its qualification. If it fails, HMRC is able (and definitely willing) to retract the benefits received, even retroactively. Thus investors must remain vigilant of changes in the company and pursue management to stay the course lest they risk their benefits.
Advanced Assurance
EIS relief is only available post-facto through an application by the company. That means the offering company cannot guarantee its investors that the tax office will accept their application. However, HMRC offers Advanced Assurance, documentation stating HMRC is likely to approve the application. They are issued to companies that apply for them (and are deemed qualified), so investors who are not offered one by the company seeking financing should request one. A company that cannot produce one is not necessarily a scam or unlikely to pass the tests to meet the EIS requirements, but it can definitely be a reason for the investor to dig deeper. HMRC lists several reasons advanced assurance may be withheld here.
Where to find these companies
So, you’ve read the benefits conferred by EIS investments and are all ready to find some companies? Where can you go to find them? Many crowdfunding sites like Seedrs, CrowdCube, and SyndicateRoom all welcome companies that seek EIS investors. In fact, each one of those links is to the respective platform’s page or guide on EIS if you’re up for some more reading (though it mostly reiterates what has been written here).
If you’re interested in reading more about EIS, these are a few government and organization sites and publications that provide for some official, albeit sometimes heavy, reading:
Guide directed at investors
Some statistics on the program since its inception, as of May 2018
12/02/2019 at 9:54 pm
Thanks for the great blog article about EIS. I was already aware of many of the tax benefits of EIS investing but not of the Inheritance Tax Relief.