Investing in smaller businesses is often 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), Seed Enterprise Investment Scheme (SEIS) and Venture Capital Trusts (VCTs) are options well worth exploring. In relation to the EIS and SEIS, 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, SEIS and funding from VCTs, which can be an important source of financial support for smaller businesses. Social Investment Tax Relief (SITR) is not covered in this brochure.
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 on pages 18 to 19 provides a comparison between them.
The reliefs that investors are likely to be most interested in are:
- Income tax relief on investment
- 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
- Tax-free dividends on VCT shares
- Inheritance tax (IHT) relief under EIS and SEIS.
This guide is based on legislation and information available as of June 2016.
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 obtain 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 direct 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.
- In addition, with effect from 18 November 2015, a requirement has been introduced whereby all investors seeking relief under EIS have to be independent from the qualifying company at the time of the relevant share issue. If the individual holds shares at the time of the EIS investment, they must have acquired those shares as either subscriber shares or from a previous issue qualifying for EIS, SEIS or Social Investment Tax Relief.
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 always be sought.
In addition, not all the above conditions apply if only CGT deferral is being claimed.
The rules governing qualifying individuals for SEIS are summarised as follows:
- The investor must not own more than 30% of the ordinary share capital, the issued share capital, the voting power, or rights to assets on a winding up.
- 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 last date of issue of SEIS shares).
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.
Currently the aggregate annual funding limit under the venture capital schemes is £5m. This is on a rolling twelve-month period, with no reference to tax years or financial years. The venture capital schemes comprise EIS, SEIS, SITR (Social Investment Tax Relief) and investment by VCTs. With effect for investments made on or after 18 November 2015 there is a £12m lifetime cap on total venture capital investment a company can receive (£20m for knowledge intensive companies).
Under current rules, 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.
To qualify for the scheme, the company must not be 'in difficulty' (under the EU guidelines on State Aid for rescuing and restructuring firms in difficulty), and with effect for investments made on or after 18 November 2015 investments have to be made for the purpose of growing and developing the business.
Investment must be into new ordinary shares that, in general, have no preferential rights.
For shares issued before 5 April 2015, 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. This rule has been removed for qualifying investments made on or after 6 April 2015.
The company must be unquoted (AIM qualifies for this purpose) 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.
Additional requirements were introduced with effect for investments made on or after 18 November 2015:
- The first commercial sale of a qualifying company or the relevant trade must be less than seven years ago when receiving their EIS (or VCT) investment (ten years for 'knowledge intensive' companies). This rule will not apply where the investment represents more than 50% of turnover averaged over the preceding five years and the money is wholly used for entering a new product or geographic market.
- In this respect an investment will qualify for EIS/VCT relief (if all other conditions are satisfied) if a previous SEIS/EIS/VCT investment was made in the relevant seven/ten year period.
- There will also be a £12m cap on total venture capital investment a company can receive (£20m for knowledge intensive companies).
- Knowledge intensive companies are broadly ones that are innovative, with significant R&D expenditure, and they must meet criteria relating to employee skills and the future commercial exploitation of intellectual property. There are various tests to be met, which are not detailed here.
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)
- 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
- subsidised generation or export of electricity attracting FIT subsidies
- for shares issued on or after 17 July 2014 in companies benefiting from a Renewable Obligation Certificate (ROC) and/or under the Renewable Heat Incentive (RHI) scheme
- for shares issued on or after 30 November 2015 in companies benefiting from reserve electricity generation
In addition the company must not be under the control of another company and is restricted as to how it holds shares in subsidiaries.
The rules governing qualifying companies for SEIS are summarised as follows:
- In order to qualify for the SEIS, a company must be undertaking, or planning to undertake, a new business which has fewer than 25 full-time employees and gross assets of not more 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 the funds raised must be used within three years.
- Companies can qualify in certain circumstances 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.
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.
In addition, a VCT is not allowed to invest in companies which breach the aggregate annual funding limit (from SEIS, EIS and VCT sources).
We have taken great care to ensure the accuracy of this publication. However, the publication is written in general terms and you are strongly recommended to seek specific advice before taking any action based on the information it contains. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. © Smith & Williamson Holdings Ltd 2016. code: NTD285 expiry date: 31/03/2017