The perils - and rewards - of the UK's enterprise investment scheme are explored by Ian Harlock-Smith, tax manager, Deloitte.
The Enterprise Investment Scheme (EIS) was introduced in 1994 by the UK.
Government to encourage entrepreneurial activity in small unquoted trading companies, through the provision of equity finance. Given that these investments are by their very nature high risk, tax breaks were introduced to make them more attractive.
The intention behind the legislation was straight-forward. The tax incentives should improve the post-tax returns for investors, while providing funds to enable the companies covered by the scheme to improve their performance.
The long-term benefit would be the increased competitiveness of the UK small companies sector and the UK economy as a whole. In brief, the EIS seeks to provide relief to 'qualifying individuals' who subscribe for 'eligible shares' in 'qualifying companies' that are undertaking 'a qualifying business activity'.
The legislation governing the EIS is incredibly complex and has been compounded further by significant changes made since its introduction. As a result, there are many pitfalls, which can prevent the unwary investor from taking full advantage of the various tax reliefs. Together with the investment risk, the complexities of the legislation have made the EIS seem less attractive than it might have been.
Nevertheless, claims made up to August 2005 show a cumulative total in excess of £4.7bn has been invested through the EIS. While figures for recent years are incomplete, it appears that both the annual cumulative investment and the numbers of investors have fallen since the peak in 2000/01. Those investors taking advantage of the ability to defer capital gains, i.e. defer an otherwise immediate tax liability, invested significantly more of this total than 'mainstream' EIS investors*.
The purpose of this article is to highlight some of the more common pitfalls that can arise, in order to help those 'mainstream' investors make sure that they qualify for the EIS relief(s). (This article is not intended to cover the pitfalls that can arise in respect of the company status and its business activity, which is a separate topic in itself.)
A QUALIFYING INVESTOR
The first question an investor seeking both the income tax relief and the capital gains exemption must ask is whether he or she is eligible, and this is determined by the connection with the company in which the investment is being made. An investor would be connected if his or her shareholding exceeds 30 per cent of the issued share capital before or after the investment under consideration, and for this purpose the investor's shareholding includes the shares owned by associates, including spouse and children, parents and grandparents, business partners and trusts but excludes siblings or fellow directors.
Breaching this test in respect of the two subscriber shares of a newly formed company would not deny the relief, provided the investor reduces his or her holding to 30 per cent or less before the company does anything other than issue the shares.
Assuming the investor will also be a director of the company or of any subsidiary, he or she would also be connected if entitled to receive any excluded payments from the company, or has been so entitled in the two years prior to making the investment.
Once again, the recipient is not limited to the investor alone, and broadly an excluded payment means any payment other than a reimbursement of business expenses, arm's length payment for certain goods and services provided to the company or any payment other than one which represents a normal commercial return (dividends or rents, etc). Therefore, a director will not become connected with the company merely by being a director but will become connected if paid.
BECOMING A PAID DIRECTOR
As soon as the investor starts to receive a salary or benefits in-kind, he or she will become connected with the company. This connection will not affect the claims for EIS relief made on previous investments. However, becoming connected in this way would deny relief on any future investments in the same company, unless they were made within three years of an earlier issue of eligible shares. This limitation applies equally where the investor is not a director but an associate is, with husband and wife, settlor or trustees being the most common cases.
To summarise, the major issue for investors who will also be paid directors is to ensure that their investment is made before they have any entitlement to be paid anything other than basic expenses. There should be a period, however brief, when the investor is an unpaid director or not a director at all, and any future investments should be made within three years of the original subscription. In addition, the overall remuneration package, including benefits, must be reasonable in relation to the services provided.
Already, there are subjective tests and judgements to be made about what is reasonable or commercial and there is already the potential for a simple slip to deny relief from the outset. With care and a little planning, however, the investor's position can usually be managed and qualification for the relief secured.
QUALIFYING NEW SHARES
The subscription by the investor must be for new ordinary shares, paid for in cash, and no other type of share or security can qualify for the relief. Thus, it is not possible to purchase second-hand shares and qualify for EIS relief. The shares should not carry any preferential rights to dividends or to the company's assets on a winding-up, although in practice it may be possible to structure preferential rights with careful drafting.
If the investor has borrowed to fund the purchase of an EIS share subscription, that borrowing should be secured on assets other than the shares themselves. The investor will also not be entitled to claim relief for any interest paid on that borrowing, despite the company being unquoted.
REPLACEMENT CAPITAL AND RETURNS OF VALUE
An unpaid director may have made loans to the company and may now be considering a subscription for new ordinary shares, which at face value could qualify for relief. EIS relief will be denied if any of the cash subscribed for the new shares is used to repay the loan. Previous loans made by an unpaid director will similarly not qualify for EIS relief where they are converted to ordinary share capital. Whilst the shares might be new ordinary shares, the subscription will not have been made in cash.
With thought and careful planning, however, it is often possible to have the company repay its loans to unpaid directors either before or after the subscription for EIS shares, provided the two things are not linked. There are similar provisions to prevent an investor who has previously traded in partnership or on his own behalf from incorporating a new EIS company to carry on that same trade and claim relief. Employees of the old business can become investors in the new EIS company, but only if they are unpaid.
Where the EIS investors subscribe for their shares alongside venture capital firms and institutional investors, there must be no related arrangements in place under which those other investors will ultimately exit. EIS relief will be denied if the venture capital firm has such related arrangements in place to redeem its preference shares or, even if there are no such arrangements, it actually redeems its preference shares within the three-year qualifying period. Once again, the capital structure of the company, the previous history of its business and the requirements of the EIS investors need to be carefully considered if pitfalls are to be avoided. It is usually possible to meet the aims of all parties with thought and, occasionally, a little compromise.
NO ROOM FOR THE PASSIVE
The maximum value of EIS income tax relief is limited to £40,000 (20 per cent x £200,000) in 2005/06. The capital gains tax relief may be significantly more valuable in the future, but that will be determined by the success of the company's trade and the ability to secure a sale. Coupled with the high likelihood that any investment in a small unquoted company will fail, the EIS relief generally attracts few passive investors.
Passive investors tend to find the capital gains tax deferral relief more attractive, as this has no limit and no connected tests (investors can own more than 30 per cent of share capital, for example) and the immediate relief can equate to a deferral of up to 40 per cent of the total amount invested. However, it must be appreciated that the tax deferred will come back into charge eventually, even if the investment itself becomes worthless (albeit in these circumstances, there would also be an allowable loss, which could be claimed against the deferred gain or other gains, even income).
The EIS does, however, provide a good medium through which unquoted trading companies can attract new funding from investors who want to play a role in the running of the business, paid or unpaid, and through which new business startups and management buy-ins (not buy-outs) can be structured.
The legislation is complex and subjective and occasionally counterintuitive, with the result not truly certain until the three years have ended. All that is needed to jeopardise the relief after the investment has been made is for the company to begin letting out the old trading premises, so that the qualifying activity test is breached and relief is clawed-back. However, with proper advice, the EIS can provide significant benefits to investors who have already made their decision to invest.
An alternative to EIS is to use venture capital trusts to spread the investment risk for passive investors among several small companies, especially as the level of income tax relief is twice that for EIS in the current tax year.
*Source: Independent report commissioned by HM Revenue & Customs
Readers are advised that this article is only intended to give an overview of the EIS relief and some of the pitfalls that investors can encounter. The legislation is complex and professional advice should be sought when considering investing into an EIS company.