The lowdown on EIS Blick Rothenberg partner Nimesh Shah explains how companies and investors can benefit from the Enterprise Investment Scheme. The Enterprise Investment Scheme ( EIS ), and now the Seed Enterprise Investment Scheme ( SEIS ), are a critical source of funding for small private companies. They are considered by many sophisticated investors to be the real success story in the evolution of funding for UK smaller companies due to the reasonable tax reliefs for investors. One great success story is the brand Innocent Drinks, which, with the assistance of some initial EIS funding, sold out a stake in the business to Coca-Cola for a reported 60m in 2010. Introduced in 1981, the EIS evolved from the Business Expansion Scheme into today s form of investment. The industry sectors qualifying for relief have become more restricted over time, but the qualifying annual investment has increased to 1m per individual. The SEIS was introduced in 2012 for the smallest companies offering higher tax breaks. Both the EIS and SEIS rules allow high-risk investments in small private trading companies to qualify for substantial tax reliefs. These reliefs reduce the net cost to investors and directly encourage investment in some of our riskiest start-up companies. They offer a tangible platform for sophisticated investors who are not often able to otherwise participate in and gain access to private equity investment. Tax-free returns are available, but investors should never underestimate that any investment might be totally lost. A diverse spread of EIS (or SEIS) investments should limit the risk and increase the potential returns for serial investors. What is an EIS? A minority investment in new ordinary share capital of small private trading companies. These investments are characterised by their high risk of failure, lack of control and illiquidity. Successful companies however can produce some of the highest investment returns taxfree. The Enterprise Investment Scheme ( EIS ) is not a separate category of investment. It is a term applied to shares in unquoted limited companies that satisfy certain conditions and qualify for generous tax reliefs approved upfront by HM Revenue & Customs. Other types of business structure such as co-operatives and limited liability partnerships do not qualify under the scheme. Size of market: Gross investment in 14/15: EIS 1.8bn, SEIS 175m. Growth in market: Average growth of 24% per year between 2010 and 2015. Taxation: Reliefs available on investment or income tax, capital gains tax ( CGT ) and inheritance tax. Gains made on exit are free of CGT after three years. Suitable for: Sophisticated investors who understand trading company shares, who are prepared to take a high degree of risk and who wish to benefit from the tax reliefs given under the scheme.
Angel investors who have had previous experience of running businesses, and understand the trading sector they are invested in and who may also attend board meetings or act as a non-executive director, may be best placed to manage their investments and exposure to risk. Qualifying sectors Companies who want to raise money under the scheme must conduct trading activities. While the majority of EIS and SEIS investment today is in shares in the high-tech sector, companies in industries as diversified as food production, component manufacturing and general retailing can qualify. A company operating in sectors that are characterised by grants and subsidies, such as the steel, coal and agricultural sectors do not usually qualify under the schemes, which with their substantial personal tax breaks provide a subsidy at the investor level. Since 2015, companies no longer qualify where the investment is for renewable energy production under subsidies such as the feed-in-tariff schemes for electricity production. There is often a fine line between those activities that qualify and those that do not. For example, the primary production of raw timber does not qualify, eg investing in a commercial forest, but purchasing raw timber and producing furniture for retail would qualify, subject to conditions such as company size (see below). Another example is in the construction industry, where property development is a non-qualifying activity but the provision of construction services to the general public or other businesses can be a qualifying activity. The purpose of the scheme is to encourage investment in small trading companies that find it harder to raise capital from traditional banks than big businesses. These smaller private companies will often have ideas for products and services with great potential, but with limited asset security and proven profitability to attract the traditional bank funding they need. They are potentially high-growth businesses, but come with both uncertainty and high risk. The sectors that successive governments have deemed to be safe, such as property development, property investment and other sectors backed by real estate, including hotels and residential care homes, are also prohibited from the relief, as are many finance companies operating in the leasing and insurance sectors. SEIS versus EIS Typically a company wishing to raise shares under the SEIS scheme will be a microbusiness and likely to have untried and untested products and services. It will typically be in the start-up phase and money raised in the scheme will be its first major investment to get the business off the ground. A company in this position will often be the type seen on the Dragons Den programme or one funded through crowdfunding with a range of small investors. A company under the EIS scheme can be a start-up, but may typically be an established company funded through the initial seed stage by private means, including friends, family and business angels. The money raised under EIS will often be used to expand a company that already has a proven market for its goods and services, but needs additional working capital to expand to a critical and sustainable level. Money can be raised under both the SEIS and EIS schemes, but only via SEIS first. There is also a requirement that the company must have spent 70 per cent of the money raised under SEIS before it can apply for EIS funding. Company size The investee company is required to fulfil strict criteria, ofwhich some of the important ones are: It must have a permanent establishment in the UK. It must have fewer than 250 employees (SEIS companies: 25). For EIS companies involved in knowledge intensive businesses, the employee level must not exceed 499. Knowledge intensive businesses have to show they spend at least 10 per cent a year on research and development, rising to at least 15 per cent in one of the three years before investment, or they must satisfy rules on the viability of intellectual property or the recognised qualifications of 20 per cent of the workforce directly applied on research and development. Gross assets must be less than 15m before the EIS share subscription and 16m after it (SEIS: 200,000). Maximum annual company raise under EIS is 5m and over its lifetime 12m (SEIS: is limited to 150,000).
Shares can only be subscribed for under EIS within seven years of the company making its first commercial sales. For SEIS share subscriptions the trading operations must be under two years old and that company must have no other trade. There are strict conditions that prevent both SEIS and EIS companies from being part of wider trading groups that would otherwise breach their qualifying status. Shareholder conditions Shareholders must not be connected with the company, which means they must not own or have the right to acquire more than 30 per cent of the ordinary voting shares. The rules extend to count any shares owned by close family members such as spouses and children (but does not include siblings). An investor can, however, be a director and sit on the board, so long as any pay is reasonable and they do not benefit personally from free or below-market-price goods and services from the company. The rules for shareholders are very detailed and very strict. Not sticking to them is one of the main reasons why the investor may lose their tax reliefs. Attractive tax reliefs include: Income tax relief 30 per cent for EIS and 50 per cent for SEIS. The maximum investor limit is 1m per annum for EIS and 100,000 for SEIS. Capital gains tax relief up to 28 per cent for EIS investors on a deferred basis and 28 per cent for SEIS investors on a potentially permanent basis. Note that the headline rate of CGT is now 20 per cent for most assets. It remains 28 per cent for gains on residential property, so the amount of relief may vary. Capital gains tax exemption on qualifying investment if the company is successfully sold, for example in a flotation, management buyout or a trade sale, the gains made are taxfree. Inheritance tax the value of the shares will usually be exempt from inheritance tax within the business property relief rules. However, the existence of a buyout clause in the company Articles or the shareholder s agreement can prejudice the inheritance tax relief. Such clauses may be commerciall necessary however. The annual limit per investor is currently 1m in the case of EIS subscriptions and 100k in the case of SEIS. There is a carry back facility of one year for income tax purposes, subject to not breaching the investment limit for that earlier year. In both cases the subscriber must not breach the requirement to hold no more than 30 per cent of the voting shares, including shares acquired by persons connected with them under formal tax rules. For capital gains tax purposes gains on old assets can be deferred so long as they are made three years before or one year after the exact date the EIS shares are subscribed. The deferral will apply even though an investor may breach the 30 per cent voting interest in the company. Under SEIS, the time limits are different. The capital gain on the old asset can be potentially exempted from future capital gains tax if the SEIS shares are subscribed for in the same tax year, or the subsequent tax year if the investment is elected to be carried back. See the worked example on page 39 for how these reliefs may be applied. If a company is successful and has high retained earnings, it is likely to distribute most of these as dividends. It is unusual to distribute dividends in the early years as earnings are often retained in the business to fund its expansion. Dividends received from the SEIS or EIS shares will remain taxable under normal income tax rules depending on an investor s personal position. Routes to investment Finding appropriate companies to invest in can be timeconsuming. How those companies are found will often depend on their size. Most small investments under either EIS or SEIS, say up to 200,000, are often via friends, family or small private investment clubs. Investments at levels greater than this can be sourced via business angel associations, accountancy firms or trade bodies such as the British Private Equity and Venture Capital Association or the EIS Association.
For investors who seek the tax reliefs but wish to have little interaction with the company, some investment managers offer an EIS portfolio service where regular annual amounts can be subscribed to shelter income and capital gains tax. These services do not tend to accommodate the smaller SEIS company due to their relative small size. Once an investee company has been found and an investor has done their relevant due diligence the process to go through is in four stages: Company: The company seeks advance assurance from HMRC that the trade and share investment should qualify for relief. It will send in details of the shares to be issued, the investors names and tax references, a business plan setting out what the money is to be used for and the timeline for expenditure and investments. HMRC will normally respond within 30 days, but it is currently trying to bring that timescale down. Company: Once advance assurance is given, the company will issue shares to investors in return for their cash investment. After four months, the company will submit EIS1 to HMRC s Small Company Enterprise Centre to formally validate the scheme within the EIS/SEIS rules. HMRC: An officer at HMRC s Small Company Enterprise Centre may ask for any additional information they may need from the company to confirm that the shares are qualifying shares under the EIS or SEIS schemes. Providing the company satisfies HMRC that it still qualifies as a trading company and has not breached any investment limits, HMRC will authorise on form EIS2 that the company may issue form EIS3 to investors. This confirms the number of shares issued, the date of subscription and the amount of investment on which income tax relief can be claimed. Investor: The investor submits form EIS3 to HMRC to claim income tax relief in their PAYE code or alternatively makes a claim in their Self Assessment Tax Return. The EIS form is important and no claim to relief should be made until the original form has been received by the investor. There are penalties of up to 3,000 for claims made too early. Example investment Assumes the investment does not become disqualified within first three years and taxpayer has income and capital gains to shelter on the disposal of old assets at the highest rates. This assumes the old asset is otherwise liable to capital gains tax at 28 per cent, eg a sale of residential property. Initial tax relief proceeding to a disposal after three years Example: 100,000 in new qualifying shares EIS SEIS Gross share investment 100,000 100,000 Income tax relief: 100,000 @ 30% (30,000) 100,000 @ 50% (50,000) Capital gains tax deferral on old assets : 100,000 @ 28% (28,000) Capital gains tax reinvestment on old assets : 50,000 @ 28% (14,000) Net cost 42,000 36,000 On a successful disposal of the shares (eg on a flotation or trade sale) after three years, the returns are free of capital gains tax. Returns must be measured against the adjusted net cost, which differs in the case of SEIS and EIS. For SEIS shares the adjusted net cost is after the capital gains tax relief of 14,000. The disposal proceeds less costs of the deal must be measured against the adjusted net cost of 36,000 to ascertain the true return over the life of the investment. With EIS shares the capital gains tax of 28,000 on the old assets was only deferred allowing the full gain on the old asset to be reinvested into the shares. When the EIS shares are disposed of however, the capital gains tax of 28,000 is recovered by HMRC, generally under Self-Assessment. For EIS investors, the returns on the qualifying EIS shares must be measured against the higher adjusted net cost of 70,000 (ie 42,000 plus the 28,000 capital gains tax to be paid on the old assets ). If the investor in both cases received net proceeds of 150,000 after four years, the returns would be: EIS investor - 150,000 / 70,000 = 214% (or compound 21% per annum) SEIS investor - 150,000 / 36,000 = 416% (or compound 43% per annum)
Initial tax relief but the company eventually fails Where an investment fails, the maximum further tax relief that can be claimed is as follows: EIS SEIS Example: 100,000 in new qualifying shares Gross share investment 100,000 100,000 Income tax relief: 100,000 @ 30% (30,000) 100,000 @ 50% (50,000) Net cost after income tax relief 70,000 50,000 Write-off of remaining net costs against income at 45% (31,500) (22,500) Capital gains tax reinvestment relief - (14,000) Net exposure on a failed investment 38,500 13,500 Percentage of gross investment 38.5% 13.5% On a failed investment, the tax reliefs claimed will cushion the net loss to as little as 38.5% in the case of EIS investors and as low as 13.5% in the case of SEIS investors. The capital gains tax reinvestment relief is not clawed back for SEIS investors, so long as the company has not breached the qualifying conditions as to trading etc within the first three years of the share subscription. Loss relief can be claimed against capital gains and/or income of the investor of the year the shares become worthless of the previous year. An investor should always seek professional tax advice on both managing the tax reliefs on initial investment and those on a failed investment. HMRC will apply both flat and tax geared penalties if incorrect claims are made. First written for Investors Chronicle. Partner Nimesh Shah +44 (0)20 7544 8746 nimesh.shah@blickrothenberg.com Blick Rothenberg 16 Great Queen Street Covent Garden London WC2B 5AH +44 (0)20 7486 0111 email@blickrothenberg.com July 2017. Blick Rothenberg Limited. All rights reserved. While we have taken every care to ensure that the information in this publication is correct, it has been prepared for general information purposes only for clients and contacts of Blick Rothenberg and is not intended to amount to advice on which you should rely. Blick Rothenberg Audit LLP is authorised and regulated by the Financial Conduct Authority to carry on investment business and consumer credit related activity. www.blickrothenberg.com