Enterprise Investment Schemes
In order to encourage investment into small businesses, the legislation offers a number of tax reliefs to investors. These are reliefs from income tax and capital gains tax, relief from inheritance tax, and loss reliefs. These reliefs reflect the risky nature of investing into unquoted companies, that may include certain AIM stocks.
Types of EIS Scheme Available
- Seed EIS (SEIS) – introduced in the March 2012 Budget, the SEIS is designed to reward high risk investors in start-up companies requiring small amounts of investment. The investment limit is £150,000 per company, and investors may invest a maximum in the tax year of £100,000 for income tax relief of 50% (even if their tax rate is lower). CGT deferral relief is also available as an exemption for gains invested, but only for this tax year. Total tax reliefs could be as high as 78%.
- EIS – the usual EIS reliefs allows an individual to invest up to £1 million in this tax year and claim tax relief at 30% of the investment. Unlimited capital gains may be deferred.
Income tax relief
Investing into a qualifying EIS company will be tax deductible at 30% of your investment. Up to £1 million may be invested per person and 30% of the investment reduces your actual tax bill (you must have a tax bill to be reduced). EIS shares must be held for 3 years to qualify for tax reliefs.
EIS can only be made by individuals for tax reliefs (Trusts can make EIS investments to defer CGT though, but not get income tax reliefs). You do not need to be resident in the UK, you merely need a UK income tax liability to claim the relief.
Losses on EIS shares – you may claim loss relief of the amount invested less any tax relief previously given. This relief is available against income or capital gains.
Note that tax relief cannot be set against dividend income (as the tax credit attached to the dividend is not recoverable).
Dividends are taxable.
Capital gains tax deferral relief
You can defer a capital gain indefi nitely and it dies with you through investing into an EIS investment. The investment to defer the gain is unlimited (not limited to £1 million) and can be made one year before and up to 3 years after the date of disposal leading to the gain.
However, if in the last 3 years you have paid CGT at 40%, then investing into an EIS to defer CGT will also return the tax paid at 40%. Once the event is crystallised, the investment can be sold (e.g. AIM Shares) and tax paid at 18% or 28%.
Capital gains on disposal are tax-free.
CGT deferral is unlimited (although only £1 million will qualify for income tax relief).
Individuals and trusts can invest into an EIS qualifying investment to defer a capital gain. Capital gains tax is at 18%-28% for individuals and 28% for trusts, and an EIS investment can be used to defer a capital gain. This means that you do not pay the capital gains tax until you recrystallise the gain. You could do this each year to use your personal CGT allowance, until you have extinguished the gain.
In 2012/13 only an SEIS will offer a CGT exemption for gains realised on the disposal of assets that are invested in the scheme. Normally, the shares would need to have been held for three years to qualify for CGT exemption, but for the fi rst year of the scheme, the government will offer a CGT holiday on any gains realised on the disposal of assets in 2012/13, provided the gains are re-invested in the SEIS programme in the same year.
EIS shares reduce your estate after two years for IHT purposes.
If the EIS shares are held for 2 years, then the value and growth on those shares falls out of your estate for IHT. The asset backed or capital protected EIS offerings are used more for IHT reduction, as they offer a perceived more secure route for your money. The two year period is from the time the EIS investment was fi rst made. If subsequently that investment is replaced with another, then the EIS clock continues to run – you do not have to start the EIS period again.
Transfers of EIS shares can be made between husband and wife/civil partners, and the recipient stands in the shoes of the transferor.
There are no age limits to be an EIS investor. However, for contractual reasons, most EIS offerings will be to someone age 18 and older.
This investment is classed as high risk, as it invests into unquoted companies.
Individuals can invest into an EIS qualifying company and also work in the company and receive remuneration as paid directors.
EIS companies – getting paid as an investor
Must have a qualifying trade, for at least 4 months, which can include research and development. There is a list of trades that do not qualify, such as nursing homes, dealing in land or commodities, banking, leasing, property development, farming etc.
The company must issue an EIS 3 certifi cate for the investor’s tax relief to be claimed.
Some investors wish to ‘follow’ their investments and to be involved in some way with the company invested into and are investors who have a particular expertise to offer a business, and wish to be paid for their involvement. A little known fact is that an investor can retain tax reliefs and receive an income from the company. This is usually in the form of director’s fees. This is ideal for someone, for example, who invests redundancy money into the company who also needs a job; or a serial investor seeking paid directorships. Your expertise could be in fi nance, marketing or whatever, for say 2 days a week.
The general rule is that if an investor is connected with a company, then EIS tax reliefs could be lost or not available. You are connected with the company if you control the company; have more than 30% of the votes; your shares plus loan capital exceed 30% of the share capital plus loan capital; you trade in partnership with the company; you are an employee of the company; you are a director (unless exempted); you subscribe for shares as part of an arrangement where another buys shares where you are connected. See ICTA/S219A (4) & (5) and ITA/S169 and VCM25080.
You are not treated as connected, if you are an unpaid director; your expenses as a director are reimbursed for performance as a director; you may have interest on funds loaned to the company; reasonable dividends; a reasonable rent for property let to the company; reasonable charges or remuneration for services (not secretarial or managerial) provided to the company. See ICTA/S291A (3); ITA/S 168(2) & (3) or VCM25070.
Betsy invests £50,000 for 25% of the shares into Salop Marketing, a qualifying EIS company. She receives 30% income tax relief at £15,000. She provides financial expertise for 3 days a month for £1,500 per month to the company. Including her tax relief, she would have her initial investment returned in just over 2 years. Betsy would not lose her tax reliefs, and stays close to the business, and assists it to be profi table. The director’s fees she earns will be taxable in her hands. As an EIS qualifying company, no CGT is payable when she sells her shares.
A number of companies will do this kind of deal. They not only get expertise, but they get investment cash to use for company purposes. This type of deal would not be available if investing through an EIS portfolio or EIS fund.
There are two main routes into making ISA investments – direct EIS investment into a qualifying company or an investment into an EIS Fund or Portfolio. Managers tend to group EIS companies into portfolios to spread risk. EIS remains a very high risk investment as you are investing into unquoted companies and AIM shares.
Some product providers, such as Octopus and Downing have had asset backed or capital protected EIS investments where the capital is under less risk. However, expect next to no return from these types of investments. Your return is the tax relief of 30% (held for 3 years, equates to around 10% p.a. for the 3 years).
A number of companies – such as Octopus with its Eureka EIS Portfolio Service (this has achieved an internal rate of return of over 15% p.a. even including the recent fi nancial crisis), Rathbones, Oxford Capital Partners and others group together EIS companies into a portfolio to reduce risk through spreading the investments. Some EIS portfolio managers have not done well at all – one large stockbroker with some portfolios lost over 80% of value in recent years, as AIM stocks were particularly hard hit in the recent fi nancial downturn. Previously they had averaged around 16% p.a. It pays to shop around and see how various EIS managers have done in the past (even though past performance is no guide to future returns, it is used as a benchmark by many investors.)
For general legislation and guidance on EIS, see http://www.hmrc.gov.uk/eis/guidance.pdf for further information. There are also finance houses that provide details on companies seeking investment from ‘business angels’, who will invest their money for equity in the company, and possibly for paid expertise.
However, not all investors are business angels. Some are merely looking to diversify their investment portfolios, or seeking inheritance tax mitigation, or who wish to defer a capital gain.
What type of investor is an EIS suitable for?
EIS’s are not suitable for all investors. They might be right for your investment portfolio if you:
- Are looking to reduce you income tax liability.
- Seek a long-term investment opportunity. You must be prepared to invest for at least 3 years to keep the EIS tax reliefs.
- Are in a position to take on a higher risk for potentially higher gains.
- Want a highly tax-effi cient alternative to other funds that invest in UK smaller companies.
- Are seeking to potentially reduce the overall risk to your investment portfolio with an investment that typically follows a different cycle to stock markets (private equity).
- Require an additional source of retirement income, or non-executive director (you are not locked in as you are with a pension.) However, the periods of investment at 3 years minimum to retain income tax reliefs, may not be long enough, or even too short for you. The investment would most certainly also be illiquid, and you do not have a ready market for your shares, when you may need liquidity or cash.
- Are looking for an alternative tax-effi cient investment to an ISA. However note that an ISA investment has instant access and can be liquidated if you need cash. An EIS investment is largely illiquid and your capital is tied up for a number of years. EIS investments will become more popular for higher earners as pension contribution relief becomes more restricted.