What is EIS/SEIS?
The Enterprise Investment Scheme (EIS) provides valuable tax relief to individual investors and is an extremely useful tool for small and growing trading companies looking to attract equity investment.
Similar to EIS, Seed Enterprise Investment Scheme (SEIS) is aimed at start-up companies and individual investors who are looking to make equity investments in new businesses.
EIS and SEIS are both approved tax incentives but with highly regulated regimes requiring great care, both from the point of view of the individual investor and of the company, in order to claim the relief successfully.
To give an idea of how widely the EIS is used, in the 2020/21 tax year 3,755 companies raised a total of £1.7bn of funds under the EIS and in the 2019/20 tax year 4,165 companies raised £1.9bn.
What are the tax benefits of EIS?
The following tax reliefs are available:
- provided investors hold their shares for at least three years they may deduct an amount equal to 30 per cent of the money invested from their total UK income tax liability for the tax year, up to an annual limit of £1m (or £2m in the case of knowledge intensive companies, such as those whose trade mainly involves the development of intellectual property / software),
- if income tax relief is secured, any capital gain made on disposal of the shares is exempt from capital gains tax,
- if the shares are sold at a loss, relief is given for any losses (unless any income tax relief is already given) which can be used against either income profits or chargeable gains, and
- capital gains tax otherwise due on the disposal of other assets may be deferred by investing the proceeds in an EIS qualifying company.
Conditions to be met to qualify under the EIS regime
Given the value of EIS tax reliefs a series of strict conditions must be met (usually for a period of three years from each issue of EIS shares) to secure EIS treatment. A breach of the conditions can lead to any tax relief being clawed back. Bespoke legal advice should always be sought by each investor or company looking to secure EIS relief.
For the company broadly the following main conditions must all be met:
- the investment must be made into a “new” business (generally less than seven years old),
- the company must have no more than £15m of gross assets before any investment is made (and no more than £16m of gross assets afterwards),
- there must be fewer than 250 full time employees (or 500 for knowledge intensive businesses),
- the shares issued must be new fully paid-up ordinary shares subscribed for in cash and which must not carry any preferential rights on a winding up or redemption,
- the shares must be issued for genuine commercial purposes and must not be listed on certain stock exchanges (though shares traded on AIM are acceptable),
- the company must use the cash raised by the investment for the purposes of its trade,
- the company must not be a subsidiary or under the control of another company,
- if the company is the parent of a corporate group, it must own at least 50 per cent of any subsidiary and the group must be a trading group (if the trade is carried on by a subsidiary then the minimum ownership threshold increases to 90 per cent),
- the company’s trade must not include a substantial amount of financial services, property development or trading, operating or managing hotels or nursing homes or certain other defined “low risk” activities or anything which involves bought-in intellectual property,
- the company must carry on a trade which is taxable in the UK (though it can also trade outside the UK,
- the investor must be exposed to a genuine risk of losing their capital and the business must grow organically, rather than by acquiring other businesses,
- the company cannot raise more than £5m under EIS (or any other corporate venturing scheme such as SEIS (see below) or Venture Capital Trusts) over a 12 month period, unless the business is "knowledge intensive" in which case the annual limit is £10m, and
- there is a lifetime limit of £12m (or £20m if knowledge intensive) per group.
For the individual broadly the following conditions must all be met:
- the investor and their associates must not be connected with the company (for example they cannot have previously been an employee or director although a non-executive director position is generally allowed),
- the maximum stake that can be held in the company is 30 per cent,
- the investor cannot invest more than £1m in EIS companies annually (£2m for knowledge intensive companies).
As its name suggests, SEIS is a form of EIS which is targeted at even smaller (and riskier) start-up businesses than EIS, but which offers even greater tax reliefs. A successful SEIS investment provides the following tax reliefs:
- provided the investment is held for at least three years investors may deduct an amount equal to 50 per cent of the sum invested from their total UK income tax liability (up to an annual investment limit of £100,000),
- if income tax relief is secured, any subsequent capital gain on the disposal of the business is exempt from capital gains tax,
- if the business is sold at a loss, relief is given for any allowable losses (less any income tax relief secured) against either income or chargeable gains tax, and
- 50 per cent of the capital gains tax otherwise due on the disposal of any asset may be exempt from tax if the gains are reinvested in SEIS shares.
SEIS has similar features to EIS, and so many of the requirements are the same or similar. The key conditions for SEIS that differ from the EIS regime are as follows:
- immediately before the investment the total value of the company's assets must not exceed £200,000,
- at the time of the investment the business must have fewer than 25 full time equivalent employees,
- the business cannot have raised more than £150,000 under the SEIS in the three years before the investment, and
- the business must not have previously raised money under the EIS (or certain other tax-advantaged investment schemes).
SEIS needs to be addressed at the very start of a business, creating an early opportunity to structure the business for success. However, a business can follow a SEIS share issue with further issues of shares under EIS and investors can benefit from both schemes. So if investors are too late for a SEIS investment (for example because the business has grown too big), EIS may still be available.
Timing and process
Given the strict and technical nature of the above EIS and SEIS conditions, they should be considered at the earliest possible stage of a business's life. By getting EIS (and where relevant SEIS) right at the outset, a business can be made significantly more attractive to potential UK investors, who will be able to secure some extremely valuable personal tax reliefs.
It is possible for a company to seek advance assurance from HMRC that qualification with the conditions is met which provides comfort to companies and investors alike. This can be particularly useful if for example there is some doubt about whether the company’s business is a qualifying trade.
Pitfalls to watch
One of the EIS/SEIS conditions is that the shares issued to the investor must not have any preferential right to a company’s assets on a winding up and to certain dividends. The requirement is included so that an investor cannot obtain the tax advantages of relief while being shielded from the economic risk of the investment.
A number of companies have had their EIS status revoked by inadvertently breaching this condition, by for instance creating a class of deferred shares ranking behind the EIS ordinary shares on a winding up. The courts have held that it is not possible to ignore small or insignificant preferential rights. Great care must thus be taken when the company has more than one share class to ensure that the EIS shares class do not carry any disqualifying preference and careful drafting can in some cases avoid an issue.
Company must remain independent
The issuing company must not be a 51 per cent subsidiary of another company or under the control of another company. This condition can cause an issue when say a venture capital fund is an investor and the test must be reviewed on the initial subscription and on each subsequent funding round. It may be possible to avoid issues if part of this funding takes the form of non-voting preference shares and also by ensuring that the institutional or corporate investor cannot for instance appoint a majority of board directors.
Timing of the investment and use of ASAs
EIS and SEIS investments must be made by way of a subscription for new ordinary shares and it is not possible for investors to make loans and then convert them into shares. This can be an issue when a company is raising money outside a funding round and so the value of the shares is not easily ascertained. HMRC do however accept that funding by way of advance subscription agreements (ASAs) can work for EIS and SEIS purposes if certain conditions are met. Broadly under an ASA investors pay the subscription funds to the company but the issue of shares occurs at a later date. The company must demonstrate that the timing and terms of ASA fits into its business plan and planned expenditure, and the funds provided must not be refundable or assignable, must not bear interest and must have a longstop date of no more than six months.
The generous tax reliefs provided by EIS and SEIS come with the catch that the rules are extremely complex and impose requirements on the company receiving the investment as well as on the investors. Businesses must be well prepared before seeking funding supported by these regimes and should take appropriate professional advice.
If you require further information about anything covered in this briefing, please contact David Gubbay or your usual contact at the firm on +44 (0)20 3375 7000.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, August 2022