The lowdown on EIS

Introduced in 1981, the EIS evolved from the Business Expansion Scheme into today's form of investment. The industry sectors qualifying for relief have become more restricted over time, but the qualifying annual investment has increased to £1m per individual. The SEIS was introduced in 2012 for the smallest companies offering higher tax breaks.

Both the EIS and SEIS rules allow high-risk investments in small private trading companies to qualify for substantial tax reliefs. These reliefs reduce the net cost to investors and directly encourage investment in some of our riskiest 'start-up' companies.

They offer a tangible platform for sophisticated investors who are not often able to otherwise participate in and gain access to private equity investment. Tax-free returns are available, but investors should never underestimate that any investment might be totally lost. The tax reliefs in the example below show how the downside is often limited.

A diverse spread of EIS (or SEIS) investments should limit the risk and increase the potential returns for serial investors.

Angel investors who have had previous experience of running businesses, and understand the trading sector they are invested in and who may also attend board meetings or act as a non-executive director, may be best placed to manage their investments and exposure to risk.

Qualifying sectors

Companies who want to raise money under the scheme must conduct trading activities. While the majority of EIS and SEIS investment is in shares in the high-tech and business services sectors, companies in industries as diversified as food production, component manufacturing and general retailing can qualify. A company operating in sectors that are characterised by grants and subsidies, such as the steel, coal and agricultural sectors do not usually qualify under the schemes, which with their substantial personal tax breaks provide a subsidy at the investor level. Since 2015, companies no longer qualify where the investment is for renewable energy production under subsidies such as the 'feed-in-tariff' schemes for electricity production.

There is often a fine line between those activities that qualify and those that do not. For example, the primary production of raw timber does not qualify, eg investing in a commercial forest, but purchasing raw timber and producing furniture for retail would qualify, subject to conditions such as company size (see below). Another example is in the construction industry, where property development is a non-qualifying activity but the provision of construction services to the general public or other businesses can be a qualifying activity.

The purpose of the scheme is to encourage investment in small trading companies that find it harder to raise capital from traditional banks than big businesses. These smaller private companies will often have ideas for products and services with great potential, but with limited asset security and proven profitability to attract the traditional bank funding they need. They are potentially high-growth businesses, but come with both uncertainty and high risk.

The sectors that successive governments have deemed to be 'safe', such as property development, property investment and other sectors backed by real estate, including hotels and residential care homes, are also prohibited from the relief, as are many finance companies operating in the leasing and insurance sectors.

It is possible for a company that is considering raising funds under the scheme to formally approach one of HMRC's Small Company Enterprise Centres for 'advance assurance' that the share issue should qualify for the relief. This is essential for any company wishing to attract investors.

Company size

The investee company is required to fulfil strict criteria, of which some of the important ones are:

■ It must have a permanent establishment in the UK.

■ It must have fewer than 250 employees (SEIS companies: 25). For EIS companies involved in 'knowledge intensive' businesses, the employee level must not exceed 499. Knowledge intensive businesses have to show they spend at least 10 per cent a year on research and development, rising to at least 15 per cent in one of the three years before investment, or they must satisfy rules on the viability of intellectual property or the recognised qualifications of 20 per cent of the workforce directly applied on research and development.

■ Gross assets must be less than £15m before the EIS share subscription and £16m after it (SEIS companies: £200,000).

■ Maximum annual company raise under EIS is £5m and over its lifetime £12m (SEIS: is limited to £150,000).

■ Shares can only be subscribed for under EIS within seven years of the company making its first commercial sales. For SEIS share subscriptions the trading operations must be under two years old and that company must have no other trade.

■ There are strict conditions that prevent both SEIS and EIS companies from being part of wider trading groups that would otherwise breach their qualifying status.

Shareholder conditions

Shareholders must not be connected with the company, which means they must not own or have the right to acquire more than 30 per cent of the ordinary voting shares. The rules extend to count any shares owned by close family members such as spouses and children.

An investor can, however, be a director and sit on the board, so long as any pay is reasonable and they do not benefit personally from free or below-market-price goods and services from the company.

The rules for shareholders are very detailed and very strict. Not sticking to them is one of the main reasons why an EIS or SEIS company may lose its qualifying status. The consequence of this is a removal of all past and future tax benefits.

Investor tax reliefs

Attractive tax reliefs include the following;

■ Income tax relief - 30 per cent for EIS and 50 per cent for SEIS. The maximum investor limit is £1m per annum for EIS and £100,000 per annum for SEIS

■ Capital gains tax relief - up to 28 per cent for EIS investors on a deferred basis (see below for when the tax becomes payable to HMRC) and 28 per cent for SEIS investors on a potentially permanent basis. Note that the headline rate of CGT is now 20 per cent for most assets. It remains 28 per cent for gains on residential property, so the amount of relief may vary

■ Capital gains tax exemption on qualifying investment - if the company is successfully sold, for example in a flotation, management buyout or a trade sale, the gains made are tax-free.

■ Inheritance tax - the value of the shares will usually be exempt from inheritance tax within the 'business property relief' rules. However, the existence of a buyout clause in the company Articles or the shareholder's agreement will often prejudice the inheritance relief. Such clauses will be commercially necessary however.

The annual limit per investor is currently £1m in the case of EIS subscriptions and £100k in the case of SEIS. There is a carry back facility of one year for income tax purposes, subject to not breaching the investment limit for that earlier year. In both cases the subscriber must not breach the requirement to hold no more than 30 per cent of the voting shares, including shares acquired by persons ‘connected’ with them under formal tax rules.

For capital gains tax purposes gains on ‘old assets’ can be deferred so long as they are made three years before or one year after the exact date the EIS shares are subscribed. The deferral will apply even though an investor may breach the 30 per cent voting interest in the company.

Under SEIS, the time limits are different. The capital gain on the ‘old asset’ can be potentially exempted from future capital gains tax if the SEIS shares are subscribed for in the same tax year, or the subsequent tax year if the investment is elected to be carried back. See the worked example below for how these reliefs may be applied.

If a company is successful and has high retained earnings, it is likely to distribute most of these as dividends just before it is sold. It is unusual to distribute dividends in the early years as earnings are often retained in the business to fund its expansion. Dividends received from the SEIS or EIS shares will remain taxable under normal income tax rules depending on an investor's personal position.

Routes to investment

Finding appropriate companies to invest in is often time-consuming. How those companies are found will often depend on their size. Most small investments under either EIS or SEIS, say up to £200,000, is often via friends, family or small private investment clubs. Investments at levels greater than this can often be sourced via business angel associations, accountancy firms or trade promotion bodies such as the British Private Equity and Venture Capital Association or the EIS Association.

For investors who seek the tax reliefs but wish to have little interaction with the company, some investment managers will offer an EIS portfolio service where regular annual amounts can be subscribed to shelter income and capital gains tax. These services do not tend to accommodate the smaller SEIS company due to their relative small size.

Once an investee company has been found and an investor has done their relevant due diligence the process to go through is in four stages:

Company: The company seeks 'advance assurance' from HMRC that the trade and share investment should qualify for relief. It will send in details of the shares to be issued, the investors' names and tax references, a business plan setting out what the money is to be used for and the timeline for expenditure and investments. HMRC will normally respond within 30 days, but it is currently trying to bring that timescale down.

Company: Once advance assurance is given, the company will issue shares to investors in return for their cash investment. After four months, the company will then submit EIS1 to HMRC's Small Company Enterprise Centre to formally validate the scheme within the EIS or SEIS rules.

HMRC: An officer at HMRC's Small Company Enterprise Centre may ask for any additional information they may need from the company to confirm that the shares are qualifying shares under the EIS or SEIS schemes. Providing the company satisfies HMRC that it still qualifies as a trading company and has not breached any investment limits, HMRC will authorise on form EIS2 that the company may issue form EIS3 to investors. This confirms the number of shares issued, the date of subscription and the amount of investment on which income tax relief can be claimed.

Investor: The investor submits form EIS3 to HMRC to claim income tax relief in their PAYE code or alternatively makes a claim in their Self Assessment Tax Return. The EIS form is important and no claim to relief should be made until the original form has been received by the investor. There are penalties of up to £3,000 for claims made too early.

Nimesh Shah is a partner at accountancy, tax and advisory firm Blick Rothenberg