By Tom Daltry, Tax Solicitor, Keystone Law
Part of the Government’s efforts to encourage growth in the economy involve increases to the limits on investments which can obtain enterprise investment scheme (EIS) tax reliefs and the introduction of a new form of EIS, to be known as seed enterprise investment scheme (SEIS), designed to encourage new business ventures.
In this article we highlight some noteworthy features of these changes which are expected to apply from 6 April 2012 and comment on some of the implications. For additional information about EIS and SEIS please see further newsletters or contact us directly.
Changes to Enterprise Investment Scheme (EIS)
Eligible investors who subscribe for shares in qualifying companies can secure 30% income tax relief in respect of their investment, a capital gains tax (CGT) exemption when selling the shares and also the opportunity to defer CGT on the disposal of other assets by reinvesting in the EIS shares.
Limits apply and the changes to take effect from 6 April 2012 are as follows:
- increasing the annual EIS investment limit for individuals to £1 million (from £500,000);
- increasing the limits on the size of qualifying company to companies with fewer than 250 employees (up from 50) and with gross assets of up to £15m before investment and £16m after (up from £7m and £8m);
- increasing the total amount of venture capital investments a qualifying company can secure to £10 million (from £2m).
EIS relief is not available to someone who is “connected” to the company. This rule excludes employees and (in broad terms) executive/paid directors of the company. An angel investor can, however, usually become a director and be paid reasonable fees for the role preformed without being connected solely by virtue of that directorship. Investors who have more than 30% of the share and loan capital are also treated as being connected. However, this rule is to be changed so that loan capital will not count towards the 30% limit.
A proposal floated in a July 2011 Consultation Paper to change existing EIS rules to make it possible to include certain types of anti-dilution provisions in a shareholder agreement has not been adopted. Presumably HMRC is not satisfied that it could formulate a test which allows greater flexibility in this area than is possible under current rules without offending the principle that EIS capital should be genuine risk capital.
The increases referred to above are meaningful and should increase EIS investment activity in 2012/13. In particular the increases in the limits on the size of companies which can secure EIS relief mean that companies which are further down the growth path and have a more proven business can attract EIS relief. This is good news for investors and growing companies looking for additional funding.
The ability to have a mixture of loan and share capital, without the loans counting towards the 30% limit, also provides greater flexibility in structuring a fund raising. Whilst investors may welcome the ability to extract some of their investment before an exit and the priority loan capital has over share capital in a liquidation, they will not secure income tax relief on any amount paid by way of loan. Care will also have to be taken to avoid the loan having any equity features (e.g. convertible loans would count towards the 30% limit) and to avoid loan repayments prejudicing the EIS relief.
Seed Enterprise Investment Scheme (SEIS)
SEIS will be available for shares issued between 6 April 2012 and 5 April 2017. The proposals contain the following key features:
Tax reliefs under SEIS
- 50% income tax relief on the amount invested, with an annual limit of £100,000 per investor.
- Exemption from CGT on disposals of shares which attracted SEIS relief.
- CGT tax holiday for gains realised in 2012/13, when reinvested in SEIS eligible share in that same year.
Definition of seed stage company
- The company must be unquoted and have gross assets of no more than £200,000 when the shares are issued and less than 25 employees;
- The share must be issued within two years of the incorporation of the company;
- the maximum amount the company can raise under SEIS is £150,000 and the company must not previously have had EIS or venture capital trust investments;
- the company’s main purpose must be to carry on a new qualifying trade and there must be a genuine new venture;
- the company must not control any other companies (it cannot have subsidiaries) and must not be under the control of any other company.
Definition of qualifying investor
- cannot be an employee of the company unless also a director;
- the idea floated in the July 2011 Consultation Paper of limiting eligibility to “professional angel investors” (people who will provide their business experience to the company) has been abandoned;
- cannot have an interest greater than 30% in the equity of the company and must not “control” the company (loans do not generally count towards the 30% test).
Method of investing
- must invest in new qualifying shares by way of a cash subscription;
- the original proposal to allow for investment partially in debt to be eligible for relief has been dropped. This means that the commercially attractive idea of allowing tax advantaged convertible debt to be used in early stage investment is not to be a feature of SEIS.
- the shares must be held for three years;
- the money must be raised for qualifying business activities and must be spent on those activities within three years;
- if money is raised under SEIS 75%, of this must be utilised before any investment can be made under EIS or by a venture capital trust.
This new form of enterprise investment relief is targeted at start-up (seed) companies. This is said to be in recognition of the fact that EIS is typically used for established but growing businesses (rather than start-ups). In practice this is due to the fact that investors will usually be much more attracted to a company which has got beyond the initial start-up stage and which can demonstrate a proven concept and some traction.
However, it must be questionable whether SEIS, with its low limits and suffering from much the same degree of complexity and technical detail as EIS, will encourage business angels to invest in companies which have yet to start trading, as opposed to continuing to focus their available resources on the growth stage of established businesses via EIS. Something much more straightforward, requiring less in the way of intensive professional advice, would surely be appropriate for start-ups.
The SEIS proposals also offer no solution to the perennial thorny valuation issue, namely that almost all seed capital stage companies have a negligible value and investors, irrespective of any reliefs, will be expecting significant equity stakes for their cash; but cannot have an interest of more than 30%. However, the greater flexibility (under EIS and SEIS) for money to be invested in loan capital without counting towards the 30% limit, does mean that an investor whose priority is a capital gains tax exemption on exit rather than income tax relief could channel their money into loan capital and pay a low amount for the shares.
If SEIS is contemplated then it will have to be appreciated that the company will not be able to seek subsequent funding under EIS until at least 75% of the SEIS money has been utilized.
Some reasons why SEIS might be considered in practice are:
- The 50% tax relief is attractive (compared to 30% for EIS).
- Executive directors/owner managers usually cannot use EIS but could use SEIS, if the investor can keep within the 30% shareholding restriction (this may prove to be the most common reason for considering SEIS).
- It appears from the draft legislation that an entrepreneur setting up a new business could secure SEIS backing from close family without the entrepreneur’s shares counting towards the 30% restriction on the investor’s shareholding — e.g. Dad could support son without son’s shares counting towards the 30%. This does not seem to be consistent with Treasury comments on responses to the consultation process, so it remains to be seen whether this will be a feature of SEIS when the legislation is finalised.
- If there is a risk that the start-up might not actually get to trade, SEIS could be preferable.
- The SEIS CGT holiday for reinvested gains in 12/13 is expected to be an exemption rather than deferral (as is the case with EIS).
The changes to the EIS limits (on investment and size of company) should be attractive to angel investors and it seems likely that EIS, rather than SEIS, will continue to attract the attention of that category of investor. SEIS take up may prove to be focused on management of an early stage company who do not qualify for EIS and who can keep within the 30% equity restriction; and possibly also on the friends and family of entrepreneurs — i.e. people who are prepared to back an individual without too much regard to valuations and without costs being incurred on the type of investor protection (through shareholder or investment agreements) that third party investors would typically require.