UK: Investing In Companies - Tax Incentives - October 2014

Introduction

Investing in smaller businesses can often be viewed as risky. But there can be significant tax incentives for investing in some companies, which help to mitigate economic risk.

For those companies looking for alternatives to bank funding, the Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCTs) are options well worth exploring. In relation to the EIS, tax relief is potentially available to owner-managers of businesses, as well as outside investors.

In this guide we examine the three main types of investment available, EIS and funding from VCTs, which can be an important source of financial support for smaller businesses. We also examine the Seed Enterprise Investment Scheme (SEIS). SEIS was introduced with effect from 6 April 2012 and is aimed at stimulating investment in new businesses.

Under the EIS and SEIS, individuals invest directly in unquoted trading companies, whereas under the VCT scheme they invest in a quoted vehicle whose managers invest funds in such companies ('investee' companies).

These three schemes have some characteristics in common but a number of important differences. The appendix provides a comparison between them.

The reliefs that investors are likely to be most interested in are:

  • Income tax relief on investment/dividends
  • Capital gains tax (CGT) relief on sale of EIS/SEIS/VCT shares
  • CGT exemption on other gains by re-investing in a SEIS company
  • CGT deferral under EIS
  • Inheritance tax (IHT) relief under EIS and SEIS.

This guide is based on legislation and information available as at September 2014.

Qualifying individuals

EIS

Investors must be individuals to qualify for income tax relief. In addition, they must be resident in the UK if they are to qualify for CGT deferral relief.

Trustees of certain trusts can get CGT deferral relief, but not income tax or CGT-free sales.

Broadly, the individual must not be connected (in a period beginning two years before the share issue and ending three years after the later of the issue of the shares or commencement of trade) with the company in which they invest, which means:

  • The investor and their associates must not own more than 30% of: the ordinary shares, or the voting rights, or the total issued share capital, or assets on a winding up. (Associates include business partners and relations i.e. spouse/civil partner, grandparents, parents, children and grandchildren – but not brothers or sisters – in addition to trustees of certain trusts).
  • They must not be a paid director of the company except in limited circumstances.
  • They must not receive value from the company e.g. repayment of certain loans, receipt of excessive dividends, assets transferred at an under/over value, repayment of share capital.
  • They must not be an employee of the company or any of its 51% subsidiaries.

The rules are complex and have not been covered here in detail. This guide provides an overview of the rules only and professional advice should be sought.

Not all the above conditions apply if only CGT deferral is being claimed.

VCT

To receive VCT income tax relief an investor needs to be aged 18 or over. Trustees cannot qualify for this relief. There are complex provisions that can deny income tax relief where the investment is financed by loans.

Qualifying companies

EIS

For shares issued on or after 6 April 2012, the value of the gross assets of the company (or group if appropriate) must not exceed £15m immediately before the investment takes place and £16m immediately thereafter. For shares issued before 6 April 2012, these limits were £7m and £8m respectively.

The company must not be, "in difficulty" to qualify for the scheme (under the EU guidelines on State Aid for rescuing and restructuring firms in difficulty).

Investment must be into new ordinary shares that have no preferential rights. For shares issued after 5 April 2012, this rule has been relaxed to align the definition of qualifying shares with those for VCTs i.e. broadly, to allow certain preferential rights in relation to dividends. For shares issued after 5 April 2012, where the company has previously issued shares qualifying for SEIS relief (see below), it will only be possible to issue shares qualifying for EIS relief if at least 70% of the SEIS funds have been spent on the qualifying business activity for which they were raised.

The company must be unquoted (AIM qualifies) although it could become quoted in the relevant period (three years from the later of the share issue or commencement of trade) without loss of relief, if no prior arrangements for a quotation were in place.

The company issuing the eligible shares must have a "permanent establishment" (essentially a fixed place of business) in the UK. The funds raised must be used in qualifying activities within 24 months of the later of the share issue and the commencement of trade.

Certain trades are specifically excluded, including:

  • dealing in property, shares, commodities and other financial instruments
  • property investment and development
  • insurance and banking (though not insurance broking)
  • leasing
  • legal and accounting services
  • farming, market gardening and forestry activities
  • hotels and nursing homes
  • exploitation of intellectual property rights (not created by the company)
  • ship building
  • coal and steel production
  • for shares issued on or after 6 April 2012 (see page 9) subsidised generation or export of electricity attracting FIT subsidies, except in certain limited circumstances.
  • for shares issued on or after 17 July 2014 (see page 9) in companies benefiting from a Renewable Obligation Certificate (ROC) and/or under the Renewable Heat Incentive (RHI) scheme, except in limited circumstances.

In addition the company must not be under the control of another company and is restricted as to how it holds shares in subsidiaries.

VCT

A VCT cannot be a close company and must have received HMRC's approval to operate as a VCT. Broadly similar rules to the above apply to define the types of companies in which a VCT can invest. However, a VCT may have up to 30% of its investments in other assets such as fixed interest stocks i.e. at least 70% by value of its investments must be represented by shares or securities in qualifying companies. Of the 70% of investments that must be in qualifying companies, at least 70% of this must be in "qualifying ordinary shares", for example ordinary, non-redeemable shares (though please note recent changes to allow certain preferential rights in relation to dividends).

There is a three year grace period for satisfying these conditions for new VCTs. The VCT's shares must be admitted to trading on an EU regulated market. Any money held by a VCT, or held on its behalf, is treated as an investment for the purpose of these tests even if the funds are held on non-interest bearing accounts. No more than 15% of the value of a VCT's investments can be represented by shares in any one company.

From 6 April 2012 the aggregate annual funding limit under the venture capital schemes was increased from £2m to £5m. From 17 July 2012 (the date of Royal Assent of Finance Act 2012) an additional condition was introduced which requires VCTs not to invest in companies which breach the aggregate annual funding limit (from SEIS, EIS and VCT sources).

Overview of changes in recent years

Following various announcements in 2011, the Government confirmed in the March 2012 Budget that the changes below apply to shares issued on or after 6 April 2012 (subject to State Aid approval).

  • The employee limit for investee companies increased to fewer than 250 full-time employees (previously fewer than 50 full-time employees)
  • The size threshold for the gross assets test for investee companies increased to no more than £15m immediately before investment, and £16m immediately thereafter (previously £7m and £8m respectively)
  • The maximum annual amount that can be invested in a company through the EIS and from VCTs in aggregate in any 12-month period increased to £5m (previously £2m)
  • In relation to VCTs only, in order to retain qualifying status it must not invest in a company that breaches the annual funding limit of £5m, in aggregate from VCTs, under EIS and any other form of EU State Aid.

The amount that an individual can invest per tax year in EIS shares has increased to £1m (from £500,000) from 6 April 2012. This increase has already received State Aid approval.

Other changes that were confirmed in the 2012 Budget, which apply to shares issued on or after 6 April 2012, included the following.

  • Clarification that investors are disqualified from claiming EIS income tax relief if, together with associates, their shareholding or voting power exceeds 30% (previously there was in addition a 30% test for the aggregate of issued share capital and loans made to a company).
  • Replicating the definition of eligible shares for EIS purposes to that used for VCTs with respect to certain preferential rights in relation to dividends (previously shares with certain preferential rights were excluded).
  • Shares issued in connection with "disqualifying arrangements" will not attract EIS or VCT relief. This has been designed to catch the following two scenarios:

(i) where the whole or majority of the amounts raised are paid to or for the benefit of another party

(ii) in the absence of arrangements it would have been reasonable to expect that the qualifying activities would have been carried on as part of another business.

For some time, HMRC has wanted to target companies specifically set up for EIS/VCT purposes which fulfil a financing role but have no real commercial substance, typically with no employees or premises. These proposals are designed to stop the scenario where all or most of the trading activities are sub-contracted to another party or parties.

  • Tax relief will also not be available under EIS or from VCTs where the funds raised by a share issue are to be used to acquire shares in another company. For VCTs this applies to funds raised after 5 April 2012. This particularly impacts on typical management buy-out and buy-in structures.
  • Removal of the £1m per annum limit on investment by a VCT in a single company (except for companies in a partnership or a joint venture).
  • Removal of the £500 minimum investment limit for EIS investments.

Seed EIS

The Government introduced in the Finance Act 2012 the new SEIS effective from 6 April 2012. The rules are summarised as follows.

  • In order to qualify for the SEIS, a company must be under taking, or planning to undertake, a new business which has fewer than 25 full-time employees and gross assets of less than £200,000 at the time of the SEIS investment.
  • Qualifying companies will be able to raise up to £150,000 under the scheme, and funds raised must be used within three years. Once 70% of funds have been utilised, the company may raise funds under the EIS or from VCTs.
  • The scheme offers up-front income tax relief of 50% for subscriptions of shares by investors of up to £100,000 each (an investor can include a director). It should be noted that a claim for relief under SEIS may not be made until at least 70% of the money raised by the issue has been spent by the issuing company for the purposes of the qualifying business activity for which it was raised.
  • The investor must not own more than 30% of the ordinary share capital, the issued share capital, or the voting power.
  • The individual investor limit for SEIS will be £100,000 per tax year across all investments.
  • There is also no CGT payable on the disposal of SEIS shares held for three or more years.

Furthermore, the rules provide for an exemption from CGT on gains realised from disposals of other assets in 2012/13 where the gains are reinvested through the new SEIS in 2012/13 or 2013/14 (under the one year carry-back facility) and held for a full three years, although transfers to spouses or civil partners do not prejudice this holding period requirement.

Finance Act 2013 extended this exemption to gains realised in 2013/14, but capping the exemption at 50% of the SEIS investment. Finance Act 2014 made this change permanent.

In addition to the above rules, and following recent consultation, the SEIS also incorporates the following.

  • Companies can qualify even if they have subsidiaries.
  • Eligibility is determined by reference to the age of the trade, rather than the company (any trade being carried on by the company at the date of the relevant share issue must be less than two years old at that date, whether the trade was carried on by the company or another person). For example, an individual carrying on a restaurant business established for more than two years in one location could not use SEIS to set up a company to buy that business. However, they could set up an SEIS company to start a new restaurant business at another location.
  • The reference to holdings of other entities in calculating asset and employee tests has been removed.
  • The rules allow past (but not current) employees to qualify for relief.
  • The rules allow directors who qualify under SEIS to continue to qualify under EIS (provided the EIS shares are issued before the third anniversary of the date of issue of SEIS shares).

Renewable energy sector

In respect of shares issued before 6 April 2012, legislation was included in the 2012 Finance Act to prevent companies whose trade consists wholly

or substantially in the receipt of feed-in tariffs (FITs) or similar subsidies from qualifying for EIS or VCT investment in cases where they did not start generating electricity before 6 April 2012. However, companies who issued EIS/VCT shares prior to 23 March 2011 will not be affected by this change. No EIS, SEIS or VCT relief will be available for shares issued in such companies after 5 April 2012 except in certain circumstances.

Similar rules have been introduced for shares issued on or after 17 July 2014, to exclude companies benefiting from ROCs and from the RHI scheme from being a qualifying company for the purpose of investment under the venture capital schemes. Anaerobic digestion and hydroelectric power businesses will, however, not be excluded from qualifying under the venture capital schemes.

Income tax relief on investment/dividends

EIS

Individuals can currently get a tax credit of 30% (prior to 6 April 2011 the rate of relief was 20%) on a maximum investment of £1m in cash for newly issued shares in a single tax year (this was £500,000 for investments prior to 6 April 2012). The maximum income tax relief is, therefore, £300,000 (£150,000 prior to 6 April 2012). The credit is set off against the individual's tax liability but he/she must have an income tax liability sufficient to cover the credit in order to obtain the relief in full. The relief can only reduce the income tax liability to nil.

For investments made in the 2009/2010 income tax year and subsequent years, an individual may carry back any EIS income tax relief arising at any time in an income tax year, to the previous income tax year. This is subject to the overall cap per income tax year, and subject to the individual having sufficient income to offset the relief.

Income tax relief will be withdrawn if shares are disposed of within three years of acquisition or within three years of the company starting to trade if later, or if the investor or company ceases to qualify.

Income tax relief will not be withdrawn if the company becomes quoted within three years of the qualifying investment, so long as this was not part of a pre-arranged scheme.

Dividends from EIS companies are taxable in the normal way.

VCT

The rate of income tax relief is 30%.

The maximum annual investment is £200,000 per tax year. No carry back facility is available.

Income tax relief is given as a credit against the individual's income tax liability for the year of subscription.

Income tax relief will be withdrawn if the VCT ceases to qualify within five years of the issue of shares or if the shares are disposed of within five years of issue.

Dividends in respect of up to £200,000 of VCT investment per annum are free of income tax. This, unlike the income tax relief on subscriptions, is also available on 'second hand' shares as well as newly issued ones.

SEIS

The rate of income tax relief is 50%.

The maximum annual investment is £100,000 per tax year. No carry back facility is available.

Income tax relief is given as a credit against the individual's income tax liability for the year of subscription.

Income tax relief will be withdrawn if the SEIS shares are disposed of within three years of the date of issue, the investor receives value before that date, or the relief is subsequently found not to have been due.

Dividends are taxable in the normal way.

To view full article click here.

By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

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