Make sure your tax relief is not clawed back

The Enterprise Investment Scheme and its Seed counterpart offer exceptional tax breaks for qualifying UK investors. Some of these benefits include income tax relief and loss relief as well as tax-free gains. However, these schemes come with caveats. Prospective investors need to make sure that the company’s directors follow the rules. If they don’t your tax relief could be clawed back. In this brief article we take a look at the important things the company directors’ must and must no do to ensure that your tax relief is not clawed back.

What is SEIS and EIS?

The Seed Enterprise Investment Scheme (SEIS) and the Enterprise Investment Scheme (EIS) are venture capital schemes that offer considerable tax breaks to UK investors. The government introduced EIS in 1994 and SEIS more recently. Collectively these schemes have helped start-ups and young businesses secure early-stage funding to flourish.

Under SEIS, qualifying investors can protect up to 72.5p in the pound whilst EIS can safeguard up to 61.5p in the pound. If an investor put money into these schemes instead of paying off a Capital Gains Tax bill, the savings could be higher still.

Qualifying conditions under EIS

However, the government does not give money away for nothing. Both schemes are designed to help companies that use the funds to grow their business, which will benefit the wider economy. Because of this there are several conditions which companies and investors must meet in order to be eligible for receiving investment under the scheme.

Conditions for companies

There are various conditions imposed on the recipient company in terms of its size and its business activities.

Size and age

• The investment must be made into a “new” business that is less than 7 years old.
• There must be fewer than 250 full time employees (or 500 for knowledge intensive businesses).
• 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).

Risk to capital

• 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.

Must be a qualifying trade

• The company must undertake a qualifying trade. This excludes 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.
• Cash raised by the investment must be used for the purposes of its trade.
• 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)

Company structure

• 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),

Restrictions to money raised under the scheme

• The company cannot raise more than £5m under EIS (or any other corporate venturing scheme such as Venture Capital Trusts over a 12 month period, unless the business is “knowledge intensive” in which case the annual limit is £10m.
• There is a lifetime limit of £12m, though this rises to £20m if its a knowledge intensive industry.

Conditions for individuals

• 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).

SEIS Benefits

SEIS is a form of EIS which offers more generous tax breaks, but is more restrictive compared to EIS. 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 £200,000).
• 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.
• 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 qualifying conditions

SEIS has very similar features to EIS, and so are many of the requirements. 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.
• The business cannot have raised more than £150,000 under the SEIS in the three years before the investment.
• The business must not have previously raised money under the EIS (or certain other tax-advantaged investment schemes).
• At the time of the investment the business must have fewer than 25 full time equivalent employees,
  

SEIS needs to be implemented at the very start of a business, creating an early opportunity to structure the business for success. HMRC offers businesses a two year window from when the company starts trading and not from when the company was incorporated. So for example, if a business was dormant for the first 12 months, the company could continue to raise funds under SEIS for a further two years.

From April 2023, companies can raise up to £250,000 under SEIS. Once these funds have been fully used up future investment will go into EIS.

Key differences between SEIS and EIS venture capital investment schemes	SEIS	EIS
Company location	UK	UK
Max trading age of business (date of trading not of incorporation)	2 years	7 years or 10 years for KIC
Maximum number of employees	25	250 or 500 for KIC
Maximum gross assets	£200,000	£15m
Maximum investment allowed	£250,000	£12m or £20m for KIC
Corporate investors allowed	No	Yes, but no tax relief
Funds must be spent within	3 years	2 years
Initial tax relief rate	50%	50%
Capital Gains Tax relief	Yes	Yes
Loss relief	Yes	Yes

Understanding timescales

Given the strict and technical nature of the EIS and SEIS conditions, they should be considered at the earliest possible stage of a business’s life. By using these schemes correctly at the outset, a business can be made much 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.

Things the companies and investors should watch out for

Preference shares

• 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.
• Several companies have had their EIS status revoked by inadvertently breaching this condition. For example, by 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.

Independence

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.

Advanced Subscription Agreements

• 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. There must be a longstop date of no more than six months.

ASAs in action

One of the few tax concessions retained from the infamous mini-budget was to increase the amount that could be raised under SEIS. The chancellor increased the Seed round to £250,000. This was up from £150,000 previously. However, this scheme would not take effect until the 2023 tax year. As a result, several venture capital funds have advised their clients to use a longstop where funds can be received immediately, but the money will not be formally but into SEIS until April 2023.

Summary

It is important that companies wishing to raise funds using the EIS and SEIS venture capital schemes are fully aware of the rules. Otherwise they risk inadvertently violating these rules and losing their investors’ preferential tax status.