Out-Law Legal Update
Individuals advised to check whether they can still claim entrepreneurs' relief
Out-Law Guide | 29 Mar 2012 | 3:28 pm | 13 min. read
This guide was last updated in August 2018.
This Guide briefly outlines the main features of EIS and the major pitfalls which need to be avoided by both the company and the individual claiming the relief. However, the conditions for relief are very complex and specific tax advice should be taken before making any investment or disposing of EIS shares.
EIS relief is available where a qualifying company issues new shares. The purpose of issuing these shares, and any others issued at the same time, must be to raise money for a qualifying business activity. The issue must also be to promote business growth and development. The EIS shares must be subscribed wholly in cash (which includes payment by cheque and other means) and the cash must be paid in full by the time the shares are issued. In order to benefit from the relief, the relevant shares must be held for at least three years after issue or, if later, three years after the company begins to trade.
The relief consists of an initial 30% income tax saving and exemption from capital gains tax when the EIS shares are disposed of. The annual investment limit for individuals is £1 million (or £2 million in the case of knowledge intensive companies).
It may be possible for EIS shareholders to defer an existing capital gains tax liability by rolling it into the EIS shares – this is known as EIS reinvestment relief, and is further explained below. Shareholders may also be able to obtain further income tax relief if the shares are later sold at a loss.
The maximum amount that the EIS company can raise in any 12 month period from a combination of EIS and other schemes qualifying as state aid is £5 million (or £10 million in the case of knowledge intensive companies where the shares are issued on or after 6 April 2018). These schemes include the Seed Enterprise Investment Scheme (SEIS), Venture Capital Scheme (VCT), and the Social Investment Tax Relief (SITR).
There is a cap on the total investment a company may receive under EIS, SEIS, SITR and the VCT scheme. The cap is £20 million for knowledge intensive companies and £12 million for other qualifying companies.
Knowledge intensive companies have to satisfy detailed conditions which include that they must be involved in intellectual property creation and in at least one of the three preceding years at least 15% of their operating costs must have constituted expenditure on R&D or innovation.
In addition to the investment limits, the gross assets of the EIS company must not exceed either £15 million before the relevant share issue takes place or £16 million afterwards.
To be eligible for the relief, the EIS company must have a permanent establishment in the UK for a period of 3 years from the issue of the shares and all the money raised by the share issue must be used within two years in a 'qualifying trade' – see below - carried on by the parent company or subsidiary which is a 90% subsidiary for a period of 3 years from the issue of the shares.
At the time of the issue, the company and its subsidiaries must have fewer than 250 full-time employees (or part-time equivalent). This limit is 500 for knowledge intensive companies.
Income tax: The individual's income tax liability for the year of the share issue will be reduced by 30% of the amount used to subscribe for shares. In effect, this means that up to 30% of the cost of the individual's share investment will be paid for by HM Revenue & Customs (HMRC).
There is no minimum investment which an individual must make to take advantage of the relief. The maximum amount of EIS relief which a person can claim in any one tax year is £1 million. The limit is increased to £2 million provided at least £1 million is invested in one or more knowledge intensive companies. Unused EIS relief cannot be carried forward to be used in later years, and there is only a limited carry-back facility.
An individual who claims EIS relief cannot claim tax relief for interest on a loan taken out to buy the shares, even if that interest would normally have qualified for tax relief.
Capital gains tax: Provided that the EIS relief has not been withdrawn, no capital gains tax will be payable when the EIS shares are disposed of other than on any gain rolled over into those shares under the reinvestment relief provisions. To take advantage of this relief, the EIS investor must not dispose of the shares for at least three years after the date of issue or, if later, three years after the company begins to carry on a qualifying trade.
If the investor makes a loss when disposing of the shares that person can elect for the amount of that loss, less any income tax relief given, to be set against income made in the year in which the shares were disposed of, or any income from the previous year, instead of being set off against any capital gains.
EIS relief is available where 'eligible shares' are issued before 6 April 2025 to raise money for the purposes of a qualifying trade. The shares must also be to promote the business growth and development of the issuing company. All of the money raised is used in a qualifying trade carried on by the parent company or 90% subsidiary within two years. The money raised cannot be used to acquire a controlling interest in a company, trade or goodwill and intangible assets employed for the purposed of a trade.
The shares must be new, ordinary shares with no special rights attached to them. Shares issued which carry a preferential right to dividends will be permitted provided that their amount and the date that they are payable is not dependent on a decision of the company, the holder or anyone else, and provided that the dividends are not cumulative.
The EIS shares must be fully paid up in cash throughout the company's 'relevant period'. This period starts on the date the EIS shares are issued and ends either three years after that or, if later, three years after the company starts to trade.
A company can become listed on a stock exchange within that three-year period without losing EIS eligibility. The company only needs to be unquoted on a stock exchange at the time the shares are issued, providing that there are no arrangements at that time for the company to become quoted. A company admitted to the alternative investment market (AIM) will not be regarded as quoted for these purposes.
Relief will not be available if the shares are issued, or any money raised by the issue employed, inconsequence or anticipation or otherwise in connection with 'disqualifying arrangements'. Arrangements are 'disqualifying arrangements' if the main, or one of the main purposes, of the arrangements is to secure that the investee company carries on a qualifying activity and that shares issued by it qualify for EIS relief; and either
For shares issued on or after 15 March 2018 the 'risk to capital' condition must be met in order for EIS relief to be available. This condition is intended to exclude investments designed to preserve capital for investors.
The condition is met if, having regard to all the circumstances, it would be reasonable to conclude that the issuing company has objectives to grow and develop its trade in the long term, and there is a significant risk that the investor will have a loss of capital of an amount greater than their net investment return.
EIS relief applies only to individuals and not, for example, companies or trusts. The individual does not need to be resident and ordinarily resident in the UK for tax purposes when the shares are issued but will need to be liable for UK income tax.
There are certain restrictions affecting the investor, the main one being that the EIS investor cannot be 'connected' with the company. An investor will be connected with a company:
An investor's associates for these purposes include: spouses, civil partners, children, grandchildren, parents, grandparents or partners in any business partnership of which the investor is a member or companies which the investor controls. Brothers, sisters, nephews, nieces, uncles and aunt are not considered to be associates for this purpose. Associate also includes trustees of a trust of which the individual or any relative of the individual is a settlor.
EIS is only available to an investor who holds no other shares in the company when the EIS investment is made other than subscriber shares or other EIS/SEIS/social investment relief shares.
In order to qualify for EIS relief, the company must:
Any activities apart from the qualifying trading activities must not be significant.
Most trades are qualifying trades provided that they are conducted on a commercial basis with a view to making profits, however certain activities are excluded and the trade of the company must not include these activities to any substantial extent during the three-year qualifying period. What constitutes 'substantial' is not defined but HMRC generally interprets this as 20%.
Excluded activities include: dealing in commodities, shares and land; financial activities including banking and insurance; leasing or receiving royalties or licence fees, providing legal or accountancy services; property development, operating or managing hotels, nursing homes or residential care homes and energy generation . For the full list, see the HMRC VCM manual.
Once the three-year period is over, there are no restrictions on the company's activities.
Companies which HMRC consider are "in difficulty" are not eligible for investment under the EIS scheme. HMRC has, however, published some guidance as to when it will not consider a company to be in difficulty – such as within the first three years of operations.
A maximum age limit condition must be met by the company. Broadly, shares must be issued within the 'initial investing period'. This will be seven years from the date of first commercial sale or, for knowledge intensive companies, ten years from the date of first commercial sale. First commercial sale is the first sale by the issuing company of a product or service, excluding limited sales to test the market.
Where shares are not issued within the initial investing period, relief may be available in some specific circumstances which include where the company is entering a new product or geographical market and some circumstances where previous EIS investments have been made. These are all subject to detailed conditions.
Subsidiaries: There are complex restrictions preventing the EIS company from owning shares in other companies. In broad terms, an EIS company cannot have any subsidiaries other than qualifying trading subsidiaries and these must be more than 50% owned by the EIS company.
There are various anti-avoidance measures, which are beyond the scope of this Guide, designed to prevent abuse of the EIS. The rules are very complex and it is essential that advice is taken at the outset and also before any transactions or arrangements are entered into during the relevant period.
However, one main one to look out for is that during the company's three-year relevant period there must not be any arrangements where the company will, or even could, come under the control of another company even if these arrangements will not take effect until after the relevant period has passed.
An individual cannot claim EIS relief until the company sends him or her a form EIS3. The relief is claimed on the self assessment tax return, usually for the tax year in which the investment is made. However, claims to relief can be made up to 5 years after the first 31 January following the tax year in which the investment was made.
EIS reinvestment relief allows an investor to defer capital gains tax liability to the extent that the gain is reinvested into suitable qualifying shares. EIS reinvestment relief can be claimed independently of any EIS relief claim.
The investment must be in a company which is a qualifying company for EIS purposes as outlined above, but reinvestment relief will be available regardless of whether the investor qualifies for income tax relief under the scheme.
An individual or trustee can defer the capital gains tax due on the disposal of any asset by making a qualifying investment in shares and claiming EIS reinvestment relief. The chargeable gain is deferred for as long as the investor retains those new shares providing none of the qualifying conditions below is breached first.
The investment in the new shares must take place within the period from one year before to three years after the gain arose.
There are particular rules for reinvestments of gains from business assets potentially qualifying for entrepreneurs' relief.
Qualifying conditions: The investor must subscribe in cash for fully paid-up, eligible shares in a qualifying company. The company must be a trading company or the holding company of the trading group, and all of the money raised must be used for the purposes of a qualifying trade within two years. Each of these conditions mirror the conditions of the main EIS.
Reinvestment relief will not be available where the reinvestment is in the same company, or a company in the same group, as that in which the gain arose.
The reinvestment relief claim is not subject to the annual investment limit, although the gross assets test (£15 million before the investment and £16 million afterwards) does apply. The £5 / £10 million limit for investments made in the company in the previous 12 months which qualify for EIS relief, VCT relief or corporate venturing scheme relief also applies.
However, unlike the main EIS relief, there is no prohibition on the investor being connected with the company either through being a paid director or employee or holding over 30% of the shares. This means it is perfectly possible for an investor to obtain EIS reinvestment relief by subscribing for additional shares in a company which that person already owns.
In certain circumstances, the gain which has been deferred will crystallise and the resulting capital gains tax will become payable. The most obvious situation is where the new shares are disposed of; however the gain will also crystallise if:
If the gain does crystallise for any of the reasons mentioned above, it is possible to defer that gain once more by making a further claim for EIS reinvestment relief into another company.
Individuals who qualify for EIS may also be interested in the Seed Enterprise Investment Scheme (SEIS) which has applied since 6 April 2012. The qualifying conditions for SEIS are based very closely on EIS.
Although the amount of investment qualifying for SEIS relief is quite low - only £100,000 for an individual, compared to £1 million for EIS, qualifying investors will be able to claim income tax relief worth 50% of the cost of buying shares in the company under certain circumstances (compared with 30% under EIS).
Qualifying SEIS investors will also be exempt from paying capital gains tax on gains on shares within the scope of the SEIS. A reinvestment relief was available for the year 2012-13 on gains realised from disposals of assets in that period where the gains were reinvested through the new SEIS in the same year. From 2013-14 half of the amount reinvested can be exempted from CGT.
For further detail of the SEIS proposals see our guide to Seed Enterprise Investment Scheme.
Out-Law Legal Update
Individuals advised to check whether they can still claim entrepreneurs' relief