How To Qualify For EIS Tax Relief
A company can use the Enterprise Investment Scheme (EIS) to attract up to £5 million a year in investment from UK tax resident investors if the company has less than £15 million of assets and is unquoted.
As an investor, EIS provides significant tax reliefs if you subscribe for new shares issued by an EIS qualifying company, principally whereby an investor can reduce their income tax by an amount equal to 30% of their investment and any gain on the sale of the shares is tax free. Other tax reliefs include capital gains tax deferral relief, exemption from inheritance tax and loss relief.
However, in order to qualify for EIS relief there are many rules and conditions with which an investor and the investee company will have to comply with, both before and after the investment is made.
What companies can be invested in?
In order to claim the relief, the company invested in must comply with the EIS rules and continue to do so for 3 years after an EIS investment. It must also be carrying out a qualifying trade. If it’s part of a group, the substantial majority of the group’s activities must be qualifying.
Most trades count as “qualifying trade”, although the following are normally excluded: coal or steel production, farming or market gardening, leasing activities, legal or financial services, property development, running a hotel, running a nursing home or generation of electricity, heat, gas or fuel.
The company invested in must also:
- be based in the UK (normally it needs to have an office in the UK through which business is conducted and not just an office of another company in the group);
- unquoted (with no plans to trade on a recognised stock exchange);
- not control any other company (other than qualifying subsidiaries);
- not be controlled (or be 50% owned) by another company;
- not have gross assets worth more than £15 million before any shares are issued and not more than £16 million immediately afterwards;
- have fewer than 250 full-time equivalent employees at the time the shares are issued (these last two conditions also apply to any qualifying subsidiaries);
- not be in financial difficulty when the investment is made; and
- be carrying out the trade for which the money was raised for at least four months before an investor is eligible for EIS relief (albeit this doesn’t stop the company from raising money from EIS investors before this, just that a EIS 1 compliance statement can’t be sent to HMRC before this time period has elapsed).
The 7 year limit and ‘condition B’
An EIS investment must be within 7 years of the company’s first commercial sale and if there are subsidiaries, then from the first commercial sale in the group. However, it may still be possible to qualify for EIS after this 7 year threshold if the company raises EIS money amounting to at least 50% of its 5-year average turnover, and spends that money on entering a new product or geographic market. This is known as the ‘condition B’ requirement and relates to section 175 of the Finance (no 2) Act 2015.
A “product market” for the purposes of this condition B requirement is all those products and/or services which are regarded as interchangeable or substitutable by the customer, by reason of the product’s characteristics, their prices and intended use. HMRC will only want a company to satisfy the condition B requirement if the situation is such that the market does not have sufficient information concerning a company’s ability to make sales in, what for the company will be, a new product or geographical market, as to establish a track record on which ordinary market funding might be available.
HMRC’s guidelines relating to this area are very detailed and a company should take particular care when making an advance assurance application that seeks clearance from HMRC that a company satisfies condition B and can raise EIS monies after it has been trading for seven years.
The company being invested in must not be a subsidiary of another company or controlled by another company (or by another company and persons connected with that other company) at any time before the three year holding period for EIS.
Also, any subsidiary of the issuing company must, until the three-year period ends, be a ‘qualifying subsidiary’ in which the issuing company owns more than 50% of the ordinary share capital, is not controlled by any other company (other than the company being invested in or another qualifying subsidiary) and must not be under any “arrangement” whereby someone else is in control of this subsidiary. If the subsidiary is a ‘property managing subsidiary’ the ownership requirement is 90%
Risk to capital condition
To meet the risk to capital condition means:
- a company must use the money raised for growth and development; and
- the investment should be a risk to the investors capital.
The company must not operate on a ‘project basis’. The growth and development of a company should be permanent and not rely on the investor’s continued support, while the investment should be used to grow a company’s revenue, customer base and number of employees on a long term basis (after the initial three-year period). In this respect, companies should pay particular attention to HMRC’s guidance relating to the new ‘risk to capital’ condition that came into force in March 2018.
There should be a significant risk that the investor will lose more capital than they are likely to gain as a net return.
The net return includes:
- income from dividends, interest payments and other fees;
- capital growth; and
- upfront tax relief.
In assessing whether the risk to capital condition is met, HMRC will look at things like a company’s:
- sources of income;
- use of subcontractors;
- marketing of the investment opportunity; and
- relationship with other companies
A company will not meet the risk to capital condition if there are risk reducing arrangements in place that result in an investor:
- getting priority over other investors;
- being able to withdraw their money as soon as possible; and
- protecting their money so that other investors money is used first.
There are slightly different rules for “knowledge-intensive” companies that carry out a significant amount of research, development and innovation, and either:
- want to raise more than £12 million in the company’s lifetime; or
- didn’t receive investment under a venture capital scheme within 7 years of the first commercial sale.
Knowledge intensive companies also benefit from an employee limit of 499 and can raise up to £20m in total but the rules surrounding them can be complex. We have written in more detail about this area of the Enterprise Investment Scheme here.
Issue of shares
The shares issued must be paid up in full, in cash, when they’re issued. The shares must also be full risk ordinary shares which:
- aren’t redeemable
- carry no special rights to the company’s assets
The shares can have limited preferential rights to dividends. However, the rights to receive dividends can’t be allowed to accumulate or allow the dividend to be varied. An investor must retain the shares for a minimum of three years.
On issue, there must be no arrangement:
- to guarantee the investment or protect the investor from risk;
- to sell the shares at the end of, or during the investment period;
- to structure activities so that the investor can benefit in a way that’s not intended by the scheme;
- whereby the company invested in, invests back in the investor’s own company to gain tax relief; and
- to raise money for the purpose of tax avoidance – the investment must be for a genuine commercial reason.
If an investor sells their shares, a call option is granted, or an investor or an associate receives value from the company or someone connected with the company, in the three years following the share issue, EIS tax relief will be lost.
How and when money raised by your investment must be used
The money raised by the new share issue must be used so as to promote business growth and development of a qualifying business activity, namely:
- a qualifying trade;
- preparing to carry out a qualifying trade (which must start within 2 years of the investment); and
- research and development that’s expected to lead to a qualifying trade.
The money raised by the new share issue must also:
- be spent within two years of the investment, or if later, two years from the date trading started;
- be used to grow or develop a business for the long terms; and
- not be used to buy all or part of another business.
It is not possible to convert a loan into shares, and if an investor advances funds before the shares are issued the parties will need an advance subscription agreement, or the subsequent share issue may be construed as not raising any new money.
Share issues used to repay existing loan financing are unlikely to qualify for EIS relief.
Limits on individual investment
You can invest up to £1,000,000 a year in total for Income Tax relief and Capital Gains Tax exemption, but there is no limit on the amount you can invest if you only claim Capital Gains Tax deferral and Inheritance Tax exemption.
The rules relating to EIS are particularly complex and there are no guarantees that all the qualifying criteria may be met. We see many mistakes being made and recommend that companies and investors seek professional advice from the outset if they are intending to benefit from the Enterprise Investment Scheme.
This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited 2023.