Enterprise Investment Scheme (EIS) relief offers an extremely valuable package of tax benefits to individuals who make equity investments in qualifying SME trading companies.
Investors who subscribe for new ordinary shares can expect to receive 30 per cent upfront income tax relief on the cost of their investment, further income tax relief on failed investments and complete exemption from capital gains tax on realised gains. Companies that cannot offer EIS relief to prospective investors are therefore at a significant disadvantage to those that can.
Which companies qualify
The EIS rules are complex, but a number of trends emerge.
Size: First, the company or group must be an SME, which in this case means having fewer than 250 employees and gross assets of no more than 15m at the date of investment.
Even that comparatively simple test can prove deceptive. For example, a company might acquire another company at a cost of 10m, even though the acquired company’s gross assets are only 3m the difference being represented by intangible assets not recognised on the balance sheet. In that case, only the 3m balance sheet assets would be taken into account, so a group that sees itself as quite large may meet the EIS criteria.
Permanent establishment in the UK: Another requirement is that the company that issues the shares must have a permanent establishment in the UK.
It may be possible, for instance, to form a UK parent company with an office in the UK that meets the permanent establishment requirement, but for all trading activities to be carried on by overseas subsidiaries. We have had recent examples of an EIS company which carried on oil exploration activities in Texas, and another that was looking to open a private school in Colombia.
Qualifying trades: Perhaps the most important EIS requirement is that the company or group must exist for the purpose of carrying on one or more qualifying trades.
Some non-qualifying activity, generally no more than 20 per cent of overall activity is permissible, but EIS qualification will be denied if a substantial part of overall business relates to investment business or carrying on “excluded activities”.
A list of these can be found here, but they fall into a number of broad categories.
Property-backed businesses such as farming, property development, forestry, hotels and care homes do not qualify. But the meaning of these is not always clear.
Take hotels for example, which do not qualify, whereas running a pub will. But what about an inn or a pub with rooms If in doubt, it is possible to ask HMRC to provide advance assurances as to qualifying status, and it might be possible to limit the accommodation offered at an inn, or to consider splitting activities between two companies, one that is EIS qualifying and one that is not.
That said, there is recent legislation on “disqualifying arrangements” that may limit the ability to operate through separate companies, unless it can be justified for commercial reasons.
Another excluded activity is banking, insurance or “other financial activities”. It might be thought that other financial activities extend to provision of independent financial advice. However, in practice, HMRC will generally accept that IFAs are EIS qualifying because, unlike banks and insurance companies, they do not hold client money.
Leasing, and receiving royalties or license fees, are excluded activities, unless the royalties or licence fees are derived from self generated intellectual property. However, a company may not be excluded if its “royalties” are in fact substantially a payment for such services as maintenance or marketing support. Critical analysis of income streams may be key to establishing EIS status.
As HMRC increasingly clamp down on tax avoidance, the opportunities for tax saving become fewer.
EIS (and its junior partner Seed EIS, which offers significantly greater tax relief for investments into very small early stage businesses) is becoming ever more important in tax planning for wealthy individuals, and so offers a key source of financial support for qualifying companies.
The range of EIS qualifying companies is much greater than is commonly supposed, and any SME trading company that is seeking equity investment should consider the possibility of EIS relief.
Chris Lee is a partner Business Tax team at accountants James Cowper. Chris was recently shortlisted as EIS Tax Adviser of the year by the EIS Association, alongside a number of global accountancy practices. He can be contacted at firstname.lastname@example.org.