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Tax Considerations

Overview

Tax has the potential to impact on all aspects of both setting-up and running your business.  Considering tax issues from the outset can ensure that your business is established in the most tax efficient way for both you and your investors.  It is also important to consider tax issues going forward to ensure that you are complying with all of the relevant tax law requirements and making the most of any available reliefs and other opportunities to maximise the tax efficiency of your business.

The notes provide a general introduction to some of the tax issues that may be relevant to your business and some of the changes in law that have been proposed recently, but there are many more!  You should always take specific advice as tax law and tax rates change regularly.

The Enterprise Investment Scheme

The Enterprise Investment Scheme ("EIS") offers tax incentives to individuals investing in small and medium-sized trading companies. The purpose of the scheme is to help those companies which might otherwise struggle to raise finance.

This covers the basics of how the scheme works, what tax relief is available and who can qualify for the scheme. It reflects the law and practice as applicable at June 2016.

How does the scheme work?

The scheme provides income tax and capital gains tax reliefs for individual investors who subscribe in cash for ordinary shares in qualifying companies.

Income tax

opening the safeFor shares issued on or after 6 April 2011, an investor who qualifies for the relief can claim an income tax reduction equal to 30% of the money subscribed. The relief is subject to an annual subscription limit, currently £1,000,000, giving a maximum tax reduction per tax year of £300,000.

For example, if an investor subscribes £50,000 for shares and claims EIS relief, he or she can deduct £15,000 from their income tax liability for the tax year (although EIS relief can only be used to the extent that they have an income tax liability, it cannot create a loss or a repayment of tax). Relief can be ‘carried back’ in whole or part to the previous tax year, subject to the same investment limit for that year, to ‘accelerate’ relief for the taxpayer.

Capital gains tax

Provided the shares have been held for the requisite period of time (which is discussed later in this note), any gain made by the investor on a disposal of EIS qualifying shares is exempt from capital gains tax.

There are also special rules which allow losses incurred on the disposal of EIS qualifying shares to be set against an investor’s income tax liability (net of income tax relief at investment).

How long do the shares have to be held for?

calendarTo benefit from full income tax relief, EIS shares must be (broadly) held for at least three years after the date of their issue. If an investor disposes of EIS shares within three years of their issue, then the EIS income tax relief is withdrawn by reference to the proceeds that the investor receives.

The effect of this is that, if an investor sells his EIS qualifying shares within three years of their issue for an amount equal to or greater than the money he subscribed for them, his EIS relief would be fully withdrawn.

In addition, if an investor sells their EIS qualifying shares within three years of issue, then any gain ceases to be exempt from capital gains tax.

Are there restrictions on who can be a qualifying investor?

As the purpose of the scheme is to incentivise external investment in high risk trading companies, the scheme is not generally available to directors and employees of those companies. However, in recognition of the fact that companies qualifying for EIS can often benefit from the business experience of their investors, there are some exceptions for existing directors who do not receive salary from the company and new directors (e.g. angel directors) who have not prior to their investment been involved in the company’s trade. Complex rules apply to these exceptions.

There are also limits on the size of shareholding that an investor can take. EIS relief is not available to investors that hold (directly or indirectly) more than 30% of the company’s ordinary share capital or voting rights.

Which companies qualify for EIS?

The scheme is only available to companies which meet certain qualifying conditions, the purpose of these conditions being to restrict the scope of the scheme to those companies which may otherwise struggle to secure financing. The conditions include:

  • the company must have a UK permanent establishment (i.e. it need not be a UK company issuing the shares);
  • the company must carry on a qualifying trade on a commercial basis. Companies carrying on certain excluded activities, including (amongst others) dealing in land, property development and banking are not eligible for the scheme;
  • the company must not be listed on a recognised stock exchange (although a company quoted on the Alternative Investment Market can continue to qualify for the scheme);
  • the company must not be controlled by another company;
  • the company must have gross assets of no more than £15 million before the investment and £16 million immediately after the investment; and
  • the company must have fewer than 250 full time employees.

rising chartUnder changes introduced to the regime in late 2015, the above employee threshold is increased for ‘knowledge intensive companies’ to 500. Knowledge intensive companies are, broadly, companies for which R&D spend constitutes a specified proportion or greater of their total operating costs and for which either (i) the majority of their business will involve exploiting IP generated within the business or (ii) 20% or more of their workforce has a higher education qualification and is involved in R&D.

In addition, companies can only raise a maximum of £5 million in aggregate under the EIS, the Seed Enterprise Investment Scheme (“SEIS”), the Venture Capital Trust Scheme (a separate scheme which provides tax benefits for indirect investment in small trading companies through a form of fund known as a Venture Capital Trust) and certain other State aid investments on a rolling 12 month basis. Under new changes introduced in late 2015, when testing this £5 million threshold it may also be necessary to take into account investments within these categories into certain other companies, including companies acquired by the company now issuing EIS shares and companies, that have sold business assets to the company now issuing EIS shares.

Although EIS is generally available only in relation to issues of ordinary shares, shares carrying certain limited preferential rights (not including preferential rights to assets on a winding up, cumulative dividends or dividends where the amount or timing of the dividend depends on a decision of the company or another person) may qualify for EIS.

A 'no disqualifying arrangements' anti-avoidance rule applies to issues of EIS shares. The rule excludes any arrangement from qualifying for relief if it is entered into with the purpose of ensuring that the relevant tax relief is available AND either, (a) all or most of the monies raised are to be paid for the benefit of a party to that arrangement, or, (b) it would be reasonable to expect that, absent the arrangement, the business would be carried on as part of another business. In the latter case, this means that a structure to separate part of an existing business (that would not qualify) so that investment into that part, taken alone, can qualify for relief is no longer effective.

New rules

In addition to the revisions to existing conditions mentioned above that were introduced last year, some entirely new conditions have also been introduced. These rules:

  • require that companies must be less than 7 years old (10 years old for ‘knowledge intensive companies’) when receiving their first EIS investment (unless the investment will lead to a substantial change in the company’s activity);
  • introduce a £12 million cap on total investment received under the tax-advantaged venture capital schemes (increased to £20 million for ‘knowledge intensive companies’);
  • require that all investments are made with the intention to grow and develop a business;
  • require that all investors are ‘independent’ from the company at the time of their first EIS, SEIS or share issue (excluding founder shares) – this effectively means that any external investor seeking EIS relief must either have no existing shareholding or have obtained SEIS or EIS relief in relation to any existing holding; and
  • prevent the use of EIS funding to fund a business acquisition.

moneyIn addition, it has been announced that (to comply with EU State aid requirements) EIS relief will only be available for investments made before 6 April 2025. However, it is possible that this long-stop date for EIS will be extended by future agreement with the EU. In addition, given that many of the additional restrictions introduced into the EIS rules in recent years have been driven by the need to secure EU approval of compliance with State aid rules, the operation of the rules could also change in the event of a BREXIT.

Lastly, in late 2015 the previous requirement that 70% of any funds raised under SEIS had to be spent by the company before it could issue shares under EIS was repealed. Accordingly, joint SEIS / EIS funding rounds are now possible (although care must still be taken to ensure separation of the SEIS and EIS share issues and receipt of monies by the company).

Tax considerations

"To benefit from full income tax relief, EIS shares must be (broadly) held for at least three years after the date of their issue. If an investor disposes of EIS shares within three years of their issue, then the EIS income tax relief is withdrawn by reference to the proceeds that the investor receives."