When investing in small, unquoted companies, there is a significant risk that you may lose your investment, or at least not see any substantial return. This in turn makes in difficult for companies to raise equity financing. To assist both sides, the Enterprise Investment Scheme was devised by the UK government to allow a range of tax relief to investors in shares of qualifying companies, thereby aiming to increase investments in this area.

In this article we aim to give a general outline of the major points surrounding the issue of qualifying shares, on or after 6 April 2000, concentrating primarily on the scheme's impact in relation to Business Angels. It does not cover all aspects of the scheme and persons interested in using EIS should seek professional advice.

The Tax Relief

An individual subscribing for qualifying shares may receive an income tax reduction based on the amount invested. The maximum investment that qualifies for relief is £400,000 in any tax year (i.e. the maximum tax relief available is £80,000…20% x £400,000). The maximum investment in any tax year before 2006/07 was £200,000. Naturally this tax relief can only be taken if there is an income tax liability that it can be offset against. Before EIS income relief is deducted, relief must first be deducted for any subscription for shares in Venture Capital Trusts (VCTs) and taxable gains on life assurance policies.

Secondly, individuals who subscribe for shares in qualifying companies may be able to postpone a capital gains tax charge arising on the disposal of another asset within the period of one year before and three years after the shares were subscribed.

In addition, an investor may also be eligible for one of the following relief when disposing of the qualifying shares. If the disposal takes place after three years (for shares issued on or after 6 April 2000) or 5 years (for shares issued prior to 6 April 2000) and this disposal realizes a gain on the investment, then capital gains tax on this profit may be avoided. Conversely, if the disposal gives rise to a loss (irrespective of when the disposal takes place) the investor may be entitled to deduct the loss, less income tax relief attributable to the shares, from the current year income for tax purposes. Alternatively an investor can offset the loss against chargeable gains in the normal way.

Qualifying Shares

In order to qualify for EIS, there are a number of regulations around the type of shares that may be issued:

• They must be new, ordinary (i.e. not preference) shares of the company
• They may not carry any preferential dividend rights
• They may not carry any right to be redeemed through the period of the EIS
• They must not have any preferential rights on company liquidations
• The must be issued for bona fine commercial reasons (i.e. not for tax avoidance purposes)
• At least 80% of the money raised must generally be utilized within 12 months after the date on which the shares were issued. The exception to this is when the company is preparing to carry on a qualifying trade (see table 1for non EIS qualifying trades) in which case the deadline is extended to 12 months after the date on which trading commences.

Qualifying Companies

As well as the types of shares that may be issued, the EIS also imposes certain restrictions on the types of companies that are eligible for the scheme:

• The company must be unlisted
• It must have a qualifying trade
• It must not be a subsidiary of another company, except in certain circumstances
• The company's qualifying trade must be carried out wholly or mainly (above 50%) in the UK, although it is not necessary for it to be incorporated or resident in the UK.
• The value of the company's assets must not exceed £7m immediately before the EIS shares are issued or £8m immediately afterward for shares issued on or after 6 April 2006. For shares issued before 6 April 2006, the figures were £15m and £16m respectively.

Table 1: Non EIS Eligible Trades

Joint Investments

Joint investments are treated by HM Revenue & Customs as subscribing equal amounts for the whole of an EIS investment, irrespective of the amounts individually contributed. For example, if you and a relation jointly subscribe £200,000 for 100,000 shares, with one of you subscribing £120,000 and the other £80,000, the Revenue will treat you as each subscribing £100,000 for 100,000 shares.

However, it is worth mentioning that each spouse has his or her own £400,000 upper limit on EIS investments but, at the same time, spouses' subscriptions cannot be aggregated in order to satisfy the £500 lower limit on EIS investment relief.

Limits to Company Associations

Of particular interest to angel investors are the limits that are put on their degree of involvement with the EIS company invested in. Table 2 outlines where you or your "associates" are deemed to be a connected party to the company and therefore ineligible for EIS relief.

Table 2: Parties deemed to be connected to EIS companies

However, in the case of angel investors, if you become a director of the eligible company you can receive payment for the services you provide, without losing tax relief, as long as the EIS related shares were issued before the start of any period where you are eligible to receive payment for services provided.

For further investments in a qualifying company where you have been made a director (and have no other connection) you may again claim relief. This is only the case however if these additional investments are made within the five years beginning with the latest date on which shares were issued to you before you became connected with the company for EIS purposes as a paid director.

Loans and Rentals

As EIS investor can loan money or rent property to a qualifying company in most circumstances as long as it is deemed to be an 'arms length' transaction i.e.

• A loan attracts interest at no more than normal market rate, and
• A rental charge does not exceed current market rates

Share Disposals

For shares subscribed to after 6 April 2000, and sold within three years of subscription, the income tax relief will be lost and sales proceeds will be liable for capital gains tax. This was announced in the March 2000 budget and is a reduction from the 5 years for shares issued before 6 April 2000.

Transfers may be made between spouses without affecting EIS rights. The gain or loss on any subsequent disposal is treated as if he or she had been the original subscriber for the shares.

For part disposals, the first identification rule for calculating relevant tax treatments is the first-in-first-out (FIFO) rule. This treats shares you acquired on different days as being disposed of in the order of acquisition. Other rules apply when shares with differing income tax relief were acquired on the same day.

A working example

On 7th April 2006, two brothers, A&B, together subscribe £360,000 for 200,000 eligible shares in a company in which B is already a director. They contribute £200,000 and £160,000 respectively, but EIS rules treat them as if each brother had subscribed £180,000 for 200,000 shares. Brother A receives max relief of £30,000 (20% x £150,000) but brother B is ineligible for EIS as he is already a director of the company.

The shares are then disposed of at a profit after 3 years and no income tax relief has been withdrawn in the meantime. Brother B again does not qualify for relief, but a proportion of brother A's gain does:

Max relief available/ EIS attributed investment = £150,000/£180,000 = 5/6th of the capital gains is eligible for relief

Conclusion

EIS provides some useful tax breaks for individuals wishing to invest in small, unquoted companies. This investments are, however, generally high in risk compared to the more general share investments, and investors should be aware that there may be no ready market for them to dispose of shares obtained under EIS. One alternative, however, is to use venture capital trusts to spread the investment risk amongst several small companies. Investors are advised, however, that this article has only given an outline summary of the EIS scheme, and professional advice should be sought prior to making any investment decisions.

Readers are advised to refer to the disclaimer notice
with reference to the information contained in this article