Enterprise tax reliefs

This article was written by tax specialist, director Zoe Fatchen, and was first published by The Tax Journal on 28 May 2015.

Enterprise tax reliefs continue to provide valuable incentives to investors in new and growing trading companies. The rules are complex and ever changing but the tax reliefs are generous. The injection of much needed enterprise capital may, in the right hands, transform a great idea into a flourishing business. This practice guide sets out the key features of two of those reliefs, Enterprise investment scheme (EIS) and Seed Enterprise investment scheme (SEIS), which are available to individuals seeking to take advantage of qualifying commercial investment opportunities, and provides some practical tips for advisers.

Enterprise investment scheme

Investors that are UK tax resident and subscribe cash for new ordinary shares in a qualifying company may be eligible for a range of EIS reliefs. The core legislation is found at Part 5 of ITA 2007, while HMRC's Venture Capital Schemes Manual contains a wealth of useful guidance.

CGT deferral relief: CGT deferral is available on the disposal of any asset up to the amount subscribed for EIS shares in the period beginning one year before and ending three years after the date that the gain arose, whether or not the conditions for income tax relief are met (TCGA 1992 Sch 5B).

The key conditions relating to the company in which the reinvestment is made (the EIS company), the shares for which the investor subscribes and the use of the money raised are described below.

The deferred CGT becomes payable in a variety of circumstances, including when:

• the investor disposes of the EIS shares that were the subject of the reinvestment (unless the proceeds of those shares are further reinvested);
• the investor becomes non-UK resident within three years of making the investment; or
• the EIS shares cease to be eligible shares within three years after their issue.

Income tax relief: 30% income tax relief (based on the amount subscribed for EIS shares) is available in the year of investment (or the previous year if an election is made). The maximum amount of relief is currently £1m per investor per year (ITA 2007 s 158).

Prospective EIS companies should apply to the HMRC Small Company Enterprise Centre (SCEC) for advance clearance to confirm that, on the basis of the information provided, the relevant conditions for income tax relief will be satisfied. As with any tax clearance, it is important to include all relevant information and to present it in a clear, accessible format.The time taken to process clearances depends upon the complexity of the investment. Where possible, however, the company should allow at least four to six weeks for an initial response and to address any additional queries that may be raised by HMRC.

Once the investment has taken place, the EIS company must complete form EIS1 and return it to HMRC, setting out details of the investment and the investors. HMRC then issues form EIS2 to the EIS company; and authorises the company to issue form EIS3 to the investors. EIS3 is the certificate that investors require in order to claim income tax relief. It is important to complete form EIS1 as soon as possible following the investment, so that investors may make their claims for relief in good time. However, investors should be made aware that form EIS1 cannot be completed until the trade (or R&D) has been carried on for at least four months.

Additional income tax loss relief: An EIS investor may be eligible for additional marginal rate income tax relief, if a loss is incurred which is greater than the amount of income tax relief originally obtained (see box 2). The effective loss for a top rate (45%) taxpayer may be limited to 38.5%. The investor's ability to use this relief will depend upon the individual circumstances.

CGT exemption: A full exemption from CGT is available on a disposal of the EIS shares, if made more than three years after their acquisition; or if made after the trade commences (if later), provided that income tax relief was and remained available in relation to the disposal (TCGA 1992 s 150A). The CGT exemption will be restricted to a proportion of the gain, where the income tax relief is also restricted.

Conditions for EIS relief: EIS CGT deferral relief, income tax relief and the CGT exemption are all available subject to the following conditions. All section references are to ITA 2007, unless otherwise specified.

The individual investor must subscribe wholly in cash for new, full risk ordinary shares, carrying no present or future preferential right to dividends or to the company's assets on its winding up, and no present or future right to redemption. This definition is wider than it may at first appear (s 173). For shares issued on or after 6 April 2012, preferential dividend rights are permitted where they are not cumulative and where the amount and timing of the dividend is not subject to the discretion of the company, the shareholder or any other person.

The shares must be fully paid up at the time of issue (s 172(3)). Where possible, subscription monies should be collected by direct transfer into the company's bank account before the shares are issued. Problems can arise if the investor pays for the shares by cheque and there is a significant delay before the cheque clears into the company's bank account; this may occur if, for example, the EIS company is a new start up and does not have an open account when the investment takes place. If the funds are received by cheque, the company should issue the investor with a written receipt, evidencing the date on which the funds were received. The cheque should be presented without delay, ideally in time for the funds to clear before the shares are issued. No consideration other than cash is permitted.

The shares must be issued by a qualifying company (ITA 2007 Part 5 Chapter 4).This means an unquoted company (which can include an AIM company), existing wholly for the purpose of carrying on one or more qualifying trades; or a parent of a trading group, where the group's business does not consist to a substantial extent of anything other than qualifying trade activities.

The company must not be a subsidiary of another company, or under the control of another company, and there must be no arrangements in place for another company to gain control (s 185). It is important to beware of any options and/or loan conversion rights available to any corporate shareholder that could result in that shareholder (together with any connected person) obtaining control of the EIS company.

The gross asset value of the company or group must not exceed £15m immediately before the issue of the EIS shares; and must not exceed £16m immediately afterwards (s 186). The company or group must not have 250 or more full time or full time equivalent employees. When the changes set out in FA 2015 come into effect, this limit will increase to 499 employees for a knowledge intensive company (s 186A). European Community guidelines on state aid require that the company issuing the shares must not be in financial difficulties.

The EIS shares must be issued to fund a qualifying business activity carried on by that company or one of its qualifying 90% subsidiaries (as defined at s 190). A qualifying business activity may be either a qualifying trade, or research and development from which the company intends to derive a qualifying trade.

A trade will be a qualifying trade if it does not consist to a substantial extent of one or more excluded activities (see box 3).

The company issuing the shares must have a permanent establishment in the UK (s 180). In practice, that means that the company must have a base in the UK with sufficient substance to satisfy HMRC that it is significantly more than merely a registered office or post office box. If the EIS company is the holding company of a non-UK 90% subsidiary that carries out the qualifying trade, the EIS company should actively manage its subsidiaries. A passive holding company is not likely to be sufficient. The precise level of substance may depend upon the nature of the business, but should at least comprise a properly functioning and staffed office, which is able to carry out some of the functions of the company or group.

The funds must be employed wholly for the purpose of the qualifying business activity within two years of the share issue; or, if later, within two years of commencement of the qualifying business activity (s 175). EIS relief is not available if the funds are used to acquire shares in another company that will carry on the qualifying business activity.

It is important to keep a record of the uses to which the funds are put, including the dates on which they are spent. It may be useful to open a separate bank account specifically for the EIS monies in order to track the way in which they are spent, but this is not strictly necessary. For some smaller investments, it may be prudent where possible to identify one or more large costs that meet the definition of EIS qualifying expenditure and employ the EIS funds for these purposes. This will simplify the administrative requirements for EIS implementation and avoid unnecessary diversion of management time.

Additional conditions for EIS income tax relief: The investor must not be 'connected' with the EIS company in the period beginning two years before the shares are issued and ending three years afterwards; or, if later, three years after the trade commences (ss 166-171). The investor is deemed to be connected with the company if he or she:

• (alone or together with associates) has, or is entitled to acquire, more than 30% of the issued ordinary share capital or the voting power of the EIS company or any of its subsidiaries;
• is employed by, or is a director of, the company or any of its subsidiaries; or
• is a partner of the company or a subsidiary.

A director may qualify for relief if they are only appointed after the first funding round in which that director acquires EIS shares, provided that they have never before been connected with the company or its trade. That individual may receive reasonable remuneration for carrying out the duties of a director. There is a further relaxation of this rule for business angels that make their expertise available to the business.

The investor must continue to hold the shares (and the conditions must continue to be met) throughout the period ending three years after the issue of the shares; or, if later, after the trade commences. Relief will also be withdrawn to the extent that the investor receives value from the company in the period beginning 12 months before the issue of shares and ending three years later; or, if later, after the trade commences.

Withdrawal of income tax relief: A range of anti-avoidance provisions restrict the availability of relief, for example where:

• the investor takes out a loan linked to the investment (s 164);
• the arrangements for the issue of shares include arrangements for the disposal of those shares (to prevent pre-arranged exits as defined at s 177);
• the funds were raised as part of a tax avoidance arrangement (s 178);
• the conditions for relief are not satisfied throughout the three year qualifying period from issue of the shares/commencement of trade; or
• value is received by investors during the qualifying period (ss 213-222).

Seed enterprise investment scheme

Seed EIS (SEIS) relief was introduced on 6 April 2012 and is the entry level enterprise relief for investment in many start up companies. The tax reliefs are considerably more generous than the mainstream EIS reliefs, but the scope of SEIS is much more limited and it is equally complex. When first announced, it was expected to last only until April 2017, but it is now open ended. An SEIS investor may receive:

• 50% income tax relief on an investment up to £100,000 in the tax year, regardless of the investor's effective rate of income tax (s 257AB);
• CGT exemption on disposals of SEIS shares which attract and retain SEIS income tax relief; and
• CGT exemption for 50% of the gain on the sale of any asset in the tax year up to the amount of the SEIS investment (s 257AE).

SEIS requirements: Most of the EIS conditions also apply to SEIS. The key differences are:

• The company must be a seed stage company; i.e.:
  • the shares must be issued within two years of commencement of the business;
  • the company's gross assets must not exceed £200,000 when the shares are to be issued and the company must have fewer than 25 employees;
  • the maximum the company can raise under SEIS is £150,000 and it must not previously have had any EIS or VCT investments; and the company's main purpose must be to carry on a new qualifying trade and there must be a genuine new venture.
• Executive directors cannot usually claim EIS, but SEIS is available to employees that are also directors (s 257BA). The 30% substantial interest test applies (s 257BB).
• The money raised under SEIS must be spent on qualifying business activities within three years of the date on which the shares are issued (s 257CC). Qualifying business activities for SEIS purposes are wider for SEIS than for EIS. They include carrying on or preparing to carry on a new qualifying trade, or carrying on R&D from which such a trade will be developed.
• Income tax relief can only be claimed when 70% of the money raised has been spent on qualifying activities and the company has provided appropriate certification to investors. The certification process required for SEIS is broadly similar to EIS, with equivalent forms SEIS1, SEIS2 and SEIS3 to be completed and issued by the company and HMRC.

Changes announced in March 2015

The changes set out below were heralded by George Osborne in the 2015 pre-election Budget. They are not yet in force. Their introduction depends on the grant of state aid clearance, which is expected following the completion of the ongoing state aid review. The results are expected this summer, although at the time of writing no announcement date has been fixed. Meanwhile, investments taking place before the implementation date should not be affected by these changes.

Aggregate funding cap: The maximum amount that any company can receive from EIS and VCT investments as an aggregate of all its funding rounds will be capped at £15m. This limit increases to £20m for knowledge intensive companies.

Companies are already prevented from qualifying for VCT or EIS relief where their gross assets exceed £15m immediately before the investment and £16m thereafter. This reduces the potential impact of the aggregate cap. It may be significant where additional funds are needed and the proceeds of early rounds have already been spent, for example on R&D. That expenditure may not yet be reflected on the balance sheet through the development of a recognisable intangible asset, such as a registered patent.

Employee limit: The number of employees that an investee company may have immediately before a qualifying investment is currently capped at 250. For knowledge intensive companies, this limit will be raised to 499 employees.

Long established companies: The tax advantages provided by the EIS and VCT regimes will no longer be generally available for investments in companies that are more than 12 years old.

There are two key exceptions:

• Qualifying investments can still be made in older companies, where the total amount raised exceeds 50% of the average annual turnover of the company over the last five years.
• The age limit is disapplied where the investment will result in a substantial change to the activity of the company, such as the development of a significant innovation.

Most EIS and VCT investments are made in relatively young companies. Indeed, in the majority of first funding rounds the investee company is a start up. Individuals operating a well established business that intends to seek EIS or VCT funding for a new qualifying activity may need to do so using a newly incorporated company. The anti-avoidance provision ITA 2007 s 178A denies relief where, broadly, arrangements are made to secure relief for an investment and 'it... [is] reasonable to expect that the whole or greater part of … the relevant qualifying business activity would have been carried on as part of another business'. This risk should be carefully considered when setting up a new company whose activities are connected with an existing business. Care must be taken to minimise the risk that this provision could prevent such an investment from qualifying.

SEIS: Under current SEIS rules, 70% of the funds raised must be spent before any EIS or VCT investment can be made. This requirement is due to fall away when and if state aid clearance is granted. e necessary legislation is awaited and is not yet in force.

Points to watch

Enterprise tax reliefs are valuable but include many potential pitfalls for the unwary. The anticipated additional restrictions will add to their number if implemented, but will also provide useful new opportunities. Key points to consider are as follows:

• It has always been simpler and more efficient to channel EIS investments into a newly incorporated company. This will be further reinforced when and if the 12 year age limit is introduced. Investors will approach established companies with even greater caution.
• Consider whether it is possible to take advantage of the more generous employee limit and aggregate investment cap for knowledge intensive companies.
• Founder directors will be able to take advantage of the tax benefits associated with SEIS without incurring a significant delay before a more substantial EIS or VCT funding round occurs.