EIS: BASIC PREMISE

When EIS relief is mentioned in conversation, it’s usually the income tax relief that is being referenced, owing to the opportunity to claim a substantial tax reduction which makes it a powerful planning tool. However, this sells the EIS short. The scheme is actually a collection of four tax reliefs badged as one.

What are the four tax breaks?

• income tax relief
• capital gains tax (CGT) deferral
• CGT exemption disposal relief
• loss relief.

The income tax relief carries the most stringent conditions, so we will look at these in this Focus. Note that we will not look at the general conditions relating to the investment or the risk to capital condition here. These will be considered in a future Focus. 

 

How does the income tax relief work?

The blue riband of the EIS, income tax relief, is given as a tax reduction against the overall tax liability for the year the investor subscribes for qualifying shares. Alternatively, the investor can make an election to utilise some or all of the relief in the preceding year.

The current rate of relief is 30% on up to £1 million of qualifying investments per tax year. This maximum is doubled to £2 million if the issuing company is a “knowledge-intensive company”. Whilst the relief can lead to a refund, e.g. where tax has already been paid via PAYE, it cannot create a repayment (or further repayment) by reducing the overall tax liability below £nil.

This is where the election to carry back the relief comes in useful - if the relief available exceeds the tax liability for the year of the investment, look to see if the carry back claim might help.

Example

Arthur makes a qualifying investment of £100,000 in 2022/23. His overall tax liability for the year is £20,000, of which £18,000 has been deducted via PAYE. Arthur qualifies for £30,000 of EIS income tax relief, but this will be restricted to £20,000 because he does not have a sufficient tax liability to offset. He will receive a refund of £18,000 and will have no further tax to pay via self-assessment, but £10,000 of the EIS relief is lost unless it can be carried back to 2021/22.

THE QUALIFYING INVESTOR

It is important to note that the EIS legislation is written in terms of certain specific periods - namely periods A, B and C. This means that some requirements are not just measured at the date of the investment but for a prerequisite amount of time after, and in some cases preceding the investment date. It is therefore imperative that you understand what these periods are and when they are relevant to particular conditions.

What are periods A, B and C?

Each of the periods, as referenced by the share issue date, are defined by the legislation as follows:

1. Period A - beginning with either the incorporation date, or two years before the share issue date (whichever is later) and ending immediately before the “termination date” of the relevant shares.
2. Period B - beginning with the share issue date and ending immediately before the termination date.
3. Period C - beginning twelve months before the share issue and ending immediately before the termination date.

The legislation can be confusing as it refers to the “relevant period” in a number of places. The relevant period can be period A, B or C - this will be defined in the particular section.

 

What is the termination date?

The termination date is the date that the income tax relief becomes final. In most cases this will be three years after the share issue date. However, it is important to be aware that it can be later.

If the company issuing the EIS shares has not commenced trading at the share issue date but is undertaking preparatory work in order to do so, income tax relief can still be claimed. However, the termination date is deferred until the third anniversary of the qualifying trade commencing. In practice, this means the termination date can actually be up to five years from the share issue date. It is crucial that the termination date of the shares is established from the outset. If the shares are sold or otherwise disposed of before the termination date, relief may be withdrawn in full.

 

When is the share issue date?

The shares are treated as issued when the investor is entitled to exercise their voting rights, receive dividends, etc. Broadly speaking this will be the date that the investor is legally entitled to the shares. In practice this means the dates that the relevant entries are written into the register of members of the company. This will often be the same day the shares are paid for, and the share certificate is printed. However, this is not necessarily the case and it is important to realise that any delay can move the goalposts when looking at the termination date.

 

What is a qualifying investor?

For the purposes of EIS income tax relief, a qualifying investor is one who has:

• no connection to the issuing company at any time during period A
• not been issued with a linked loan during period A; and
• not made the investment otherwise than for a genuine commercial purpose, and not as part of a tax avoidance scheme.

There is also a relatively new test for existing shareholders which we will consider.

 

How is a connection to the issuing company established?

As the name implies, a connection means that the investor has a relationship with the company that goes above and beyond being a mere shareholder. A person is considered to be connected with the issuing company in three circumstances, namely:

• where they are an employee, director or partner
• where their interest in the company’s capital exceeds the permitted amount and is considered “substantial”; or
• where shares are subscribed for under certain arrangements.

They will also be considered to be connected if any associates of theirs meet the above criteria.

 

What is an associate?

An associate for these purposes includes a spouse or civil partner, a parent or another linear ancestor, e.g. a grandparent, or a natural child and other linear descendants, e.g. grandchildren. Associates will also include a business partner (someone the individual carries on business with in a formal partnership) and any trustee of a settlement the individual has made.

The need to consider associates is a simple thing to forget, but a crucial element of securing relief. As we will see shortly, failure to do so can see relief denied in very innocent situations involving no tax avoidance motive.

 

Working for the company - is it an automatic bar?

If, during period A, you are an employee, director or partner of:

• the issuing company or any subsidiary
• a partner of the issuing company; or
• a subsidiary of a partner of the issuing company

then you will be connected and precluded from making a claim for EIS income tax relief. Don’t forget this also applies if any of your associates fit the bill. This can mean no relief even where the connection is seemingly tenuous.

Example

Albert wants to make an investment in Acom Ltd in March 2023. Acom is a corporate partner of AB LLP, along with Bcom Ltd. Bcom has a wholly owned subsidiary, Zcom Ltd. During the summer of 2022, Albert’s granddaughter worked as a temporary receptionist at Zcom for eight weeks during her break from university. As this falls within period A, Albert can’t make a claim for relief as he will be connected to Acom.

 

Can directors make investments via the EIS?

The position for directors is often misunderstood in practice. The fact is that there are two provisions that allow a director to qualify for relief in circumstances that they are unpaid, or where they are “business angel” type investors. However, these are not automatic, and a number of conditions apply to both of them.

 

How does the unpaid director concession work?

The provision in s.168 Income Tax Act (ITA) 2007 says that a director won’t have a connection merely due to the directorship unless they (or an associate) receive a payment during period A. This prevents the director being paid a salary, but there are a number of payments which can be ignored for these purposes. Payments of the following will not cause a connection:

• any business expenses that would qualify for a deduction under the income tax rules, i.e. expenses incurred wholly, exclusively and necessarily in the performance of the employment duties
• dividends paid at a commercial rate
• interest on any loans which is paid at a commercial rate
• reasonable rent paid for any property owned by the individual and used by the issuing company - provided this is equivalent to an arm’s length rate
• payment for the supply of goods or services not exceeding their market value; and
• certain remuneration.

The final point here refers to payment for services that the investor provides to the company (or any related person, e.g. a person who is connected to the company) during the course of a trade or profession, as long as this is at least partly carried out in the UK. Furthermore, the type of services rendered cannot include managerial or secretarial, or those similar to ones the company (or related person) provides itself.

A final condition in respect of the remuneration is that it must form part of the profit and loss calculation for tax purposes.

Example

Charles is a health and safety specialist. During a consultancy visit where he undertakes a comprehensive review of procedures, he strikes up a conversation with the owner of Acom Ltd, a manufacturing company. Charles subsequently makes an investment in Acom and becomes a director. Payment of his invoice for the earlier consultancy services will not cause a connection and s.168 may apply (depending on any other payments) as long as it’s included in his tax return calculation for his self-employment.

 

What about the business angel concession?

S.169 ITA 2007 is even more generous and permits a director who is paid a salary to be a qualifying investor by ignoring the connection. This is aimed at attracting investors with significant specialist knowledge who are likely to want to become directors in order to help the company grow and prosper. Such investors are more likely to make an investment if they are able to be paid a fair salary for their services.

Is there a cap on the pay a director can receive?

There is no outright cap, but there are three conditions that must be met before s.169 can apply and the first of these is concerned with the level of remuneration. The conditions are:

• Condition A. The remuneration the director (or their associate) receives or becomes entitled to is reasonable when considering what services have been rendered in the capacity of a director.
• Condition B. When the qualifying shares are issued, the investor must never have had a connection to the issuing company or have been involved in carrying on any part of the trade or business of the company or one of its subsidiaries. If the current share issue is not the first share issue, the requirement to have had no connection etc. is measured at the earlier share date. This permits an investor who becomes a director to make a follow up investment at a later date.
• Condition C. If the shares being issued do not meet Condition B, they must be issued before the termination date of the most recent issue of shares that did meet the condition.

 

What does “involved in carrying on the trade” mean?

In the context of a director, any attendance at board meetings or having any gainful say in the trade of the company is likely to cause issues. Obviously, this can’t be an issue if the trade hasn’t started at the time the investment is made.

To remove any risk, the company should wait until after the share issue to make the appointment of the new director.

There can never have been a connection, it’s not just period A that is considered here. Working for the company 20 years ago is enough to stop any relief being claimed. However, you could potentially rely on the unpaid director concession if you are happy to take no salary.

 

How can the interest in the company cause a connection?

The interest here essentially means the capital interest or control by means of the capital interest. You will be connected if during period A you (alone or together with your associates) directly or indirectly own, or become entitled to acquire, more than 30% of the:

• ordinary share capital
• voting rights; or
• rights to assets upon a winding up

in respect of the issuing company.

The inclusion of the word “indirectly” means you can’t own 29% of, say, the shares yourself and then form a company or set up a trust that you can benefit from to acquire more shares that would effectively take you above the 30% cap.

 

What about the connection due to “certain arrangements”?

It might be possible to arrange things artificially so that there is no connection. The legislation stops this from being effective by inserting a deemed connection. An example of where this would apply is if you and a friend both own companies that need a similar amount of capital injection and you both agree to make the investment into each other’s company instead of your own, purely with the aim of securing 30% relief.

 

What is a linked loan and how can it prevent relief?

A linked loan is any loan made to the investor (or an associate of theirs) during period A that would not have been made, or would have been made on different terms, if the investment for the EIS shares didn’t take place.

So, if you put £100,000 into a company but the owner then personally lends you £100,000 in return, this is an obvious example of a linked loan. However, the link does not have to be as blatant as that.

Example

You are looking to fund an investment into a start-up company that manufactures alternative products to plastic containers. You convince a specialist financier to lend you the required amount, but it insists on taking a charge over the shares as part of its security. This loan will be considered “linked” and will preclude relief.

A “loan” for this purpose will also cover arrangements that include, e.g. a line of credit being issued to the investor or the issuing company agreeing to take over responsibility for debts of theirs.

 

What about the requirement to make a genuine commercial investment that doesn’t involve tax avoidance?

This would probably rule out an investment that is made as part of an aggressive tax avoidance scheme. However, the requirement for the investment to be commercial means that the investor should have some hope of a return on the capital. It’s therefore unlikely that an investment made for purely benevolent purposes meets this condition. For instance, if a former football player makes an investment into their old club which is obviously failing financially it is unlikely that this would be genuinely commercial.

Similarly, making an investment on your deathbed in the hope of saving income tax in the year of death is unlikely to work.

 

What about restrictions for existing shareholders?

Since 18 November 2015, a restriction restricts relief for existing shareholders. Where shares are issued to an investor that already holds shares in either the issuing company or any qualifying subsidiary, relief is only available if those shares:

• were issued as a risk finance investment (namely one for which the EIS, seed enterprise investment scheme (SEIS), or social investment tax relief (SITR) was given); or
• are subscriber shares, i.e. shares in existence when the company was originally formed, which the individual:
  • has held since throughout; and
  • subscribed for at a time when the company had only issued subscriber shares, and had not begun to carry on a trade or preparatory work intended to lead to a trade.

This can cause problems if you hold a mix of shares that qualified for relief under one of the schemes. If the qualifying and non-qualifying shares are of different classes there is a relatively simple solution.

The existing shareholding is measured by reference to shares held by the investor only, i.e. holdings of associates are ignored. Additionally, the test is only applied at the investment date and not at any other time.

This means that non-qualifying shares could be gifted to a spouse shortly before the investment date so that there are no pre-existing shares.

Things are more complicated if the EIS and non-EIS shares are all of the same class because there are special ordering rules to identify which shares are disposed of first.

These rules apply to disposals by spouses/civil partners, so shares are treated as disposed on a first in first out basis. The planning point is fine if you acquired non-EIS shares first, but not if EIS shares were acquired first or on the same day. If a mix of shares was acquired on the same day, EIS shares are treated as disposed of first.

In this situation you could consider having your spouse make the investment instead. Alternatively, give them all of the pre-existing shares ahead of the investment date.

is the company a "qualifying company?"

Now that we’ve covered who is a qualifying investor, we turn to look at the conditions from the point of the view of the company looking for the investment. Again, there are a number of conditions that must be met in order for your company to be a “qualifying” company for EIS purposes.

 

What conditions apply to the company?

A qualifying company is one that meets all of the conditions set out in the legislation. These relate to the company’s:

• UK permanent establishment
• financial health
• trading and qualifying trade
• unquoted status
• control and independence
• gross assets
• number of employees
• qualifying subsidiaries; and
• property management subsidiaries.

 

Does the company have to be registered in the UK?

No, although prior to April 2011 a company had to carry on its business wholly or mainly in the UK to be a qualifying company, this has been relaxed. Now, a company need only have a permanent UK establishment throughout period B.

This condition will be met if either:

• it has a fixed place of business in the UK through which the company’s business is wholly or partly carried on; or
• an agent acting on behalf of the company has habitually exercised its authority to enter into contracts on behalf of the company.

A fixed place of business means a physical location where at least some of the business is carried on. Examples given by HMRC include offices, factories, workshops and building sites.

Your company can rely on the second test, the agent condition, if the person acting as the agent is able to stand in the shoes of the company itself, i.e. they have the authority to enter into contracts. If they need hierarchical approval to do so, they will be unlikely to be an agent for these purposes.

 

What is meant by financial health?

Basically, your company can’t qualify under the EIS legislation if it’s in financial difficulty. Whilst this might seem obvious, the test is applied according to the definition contained in the lengthy EU “Guidelines on State Aid for rescuing and restructuring non-financial undertakings in difficulty (EU 2014/C 249/01)”. However, HMRC sums it up nicely in the venture capital schemes manual:

“Broadly, a company is in difficulty where, without receiving the tax-advantaged investment, it will almost certainly go out of business in the short or medium term.

HMRC will regard any company as being ‘in difficulty’ when it meets the criteria for insolvency under the Insolvency Act 1986, such as:

• the company is unable to pay its debts as they fall due
• the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities (the “balance sheet test”).

Additionally, where more than seven years have passed since the company’s first commercial sale, it will be regarded as being in difficulty if more than half of its subscribed share capital, including the share premium account, has disappeared as a result of accumulated losses.”

This test prevails following Brexit - at least for the time being. Common sense should be applied here. If the company is heavily leveraged, i.e. it has more debt than equity, or has a low or negative balance sheet and is generally unable to continue in the short term using its own resources then it’s likely that HMRC will resist a claim to EIS relief.

 

What is the trading requirement?

To qualify for EIS relief, your company must exist for the purposes of carrying on at least one qualifying trade or be the parent company of a group whose business does not have substantial non-qualifying activities (when looked at as a single business). This applies during period B.

If your company is not part of a group, a small proportion of non-qualifying activities (like rental income) won’t necessarily disqualify it from qualifying under the EIS legislation. However, such activities must be no more than incidental.

In contrast, if the company is the parent of a trading group it will only fail the trading requirement if non-qualifying activities are substantial. Substantial is taken to mean more than 20% (as it is in other areas of tax). This is more generous.

If you have a single company whose non-qualifying activities are more than incidental but not substantial, consider restructuring as a two-company group ahead of the investment date - the condition only needs to be met during period B.

 

What is a qualifying trade?

A qualifying trade is one that is carried out on a commercial basis with a view to realise a profit. Non-trading activities, such as property letting and other investment activity, are not trades by definition, and are therefore non-qualifying activities that need to be considered when looking at the company’s activities as a whole.

Other than that, most trades will qualify. However, there are a number of trades that are specifically excluded from being qualifying trades by the legislation:

• dealing in goods otherwise than in the course of an ordinary trade of wholesale or retail distribution
• banking, insurance, money-lending, debt-factoring, hire-purchase financing or other financial activities
• leasing (including letting ships on charter or other assets on hire)
• receiving royalties or licence fees
• providing legal or accountancy services
• property development
• farming or market gardening
• holding, managing or occupying woodlands, any other forestry activities or timber production
• shipbuilding
• producing coal
• producing steel
• operating or managing hotels or comparable establishments
• operating or managing nursing homes or residential care homes
• generating or exporting electricity or making electricity generating capacity available
• generating heat
• generating any form of energy not within the above two points
• producing gas or fuel; and
• provision of services or facilities for another business.

If your company is trading and not doing one of the above activities, and any non-qualifying activities are minimal, you should meet the trading requirement.

Note. If your company is undertaking a genuine trade, but this fails and the company enters administration or receivership, etc. before the end of period B, relief may not necessarily be lost as long as the cessation of the trade is because of the impending liquidation.

 

Is achieving the unquoted status as simple as it sounds?

Yes, this one is easy to measure - though as with most seemingly simple things in the tax world there are some ifs and buts to worry about. The requirement will be met long as the issuing company is unquoted at the time of the investment, and there are no existing arrangements for it to become quoted, or to become the subsidiary of another company that is/will shortly become quoted.

“Quoted” means that the company has a listing on a recognised stock exchange. HMRC maintains an up-to-date list of stock exchanges that are considered to be recognised for the purposes of the income taxes Acts. Broadly, being listed on major exchanges like the London Stock Exchange is a no-no. However, a listing on an alternative exchange like the Alternative Investment Market (AIM) is permitted.

As a bonus, if your company is successful beyond your wildest dreams and becomes listed before the end of period B your investors won’t lose relief. After all, the whole point of the EIS is to encourage investment in small companies to help them be successful.

 

What about control and independence?

These requirements are all to do with who owns the company, and what other corporate entities the company holds an interest in.

During period B, the issuing company, either on its own or with other connected persons, can’t control any subsidiaries unless it directly or indirectly holds more than 50% of the ordinary share capital.

The company must also be independent during period B. This means that if you are looking at a group structure, only the top parent company can issue shares under the EIS.

Don’t forget that the condition needs to be met until the end of period B. So if the company is independent at the investment date, but is later taken over by another company, any EIS investors will lose the relief.

 

What is the gross assets test?

This test measures the capital value of the company before and after the share issue. For these purposes, gross assets mean the property that the company owns that would appear in the balance sheet if one were drawn up on the investment date. In order to arrive at a value, you must apply the valuation method used to prepare the most recent published balance sheet in your accounts.

To pass the test, the value of the gross assets of either the company, or the group companies in aggregate, must not exceed:

• £15 million immediately before the relevant investment; or
• £16 million immediately after the relevant investment.

The £16 million limit that applies immediately after the investment is sometimes overlooked. Let’s say your company has gross assets of £14 million immediately before an investment, the maximum you can issue via the EIS would be £2 million or the gross assets test would be failed, and no EIS relief could be claimed by any investors.

 

How many employees can I have?

On the day the investment is made, your company must have fewer than 250 full-time equivalent employees, including the directors.

Full time means 35 hours per week. Part-time employees need to be measured based on the hours they usually work and added up together to obtain a number for full-time equivalent employees. As a basic example, two employees who work 17.5 hours per week each will be one full-time equivalent employee for the purposes of this test.

 

Do I need to count seasonal staff?

No, unless they are still working for the company at the investment date. Consider delaying taking on any such staff if the numbers would likely tip over the 250 full-time equivalent cap.

 

What if one of my group companies is a property management company?

There is a specific requirement that if a subsidiary company carries on a business which is mainly that of holding land or property, or deriving value from land, it has to be a 90% subsidiary, i.e. the issuing company must directly or indirectly hold at least 90% of the ordinary share capital. Just because the subsidiary is a 90% subsidiary, it doesn’t mean the end of the story is far as the EIS is concerned. Don’t forget that property management is not a qualifying trade, and so you still need to consider whether that non-qualifying activity is substantial when looking at the group as a whole.