A LOOK AT THE RULES AND RESTRICTIONS OF THE EIS SCHEME

This is a basic guide prepared by the Technical Advisory service for members and their clients. It is an introduction only and should not be used as a definitive guide, since individual circumstances may vary. Specific advice should be obtained, where necessary.

Introduction

We are all acutely aware of the difficulties that businesses are currently facing in accessing finance. On the one hand, we have the government proclamations that the UK massively reliant on small businesses and entrepreneurial spirit but, on the other hand, banks are still not lending sufficiently, as their main focus is to build up their capital reserves. Small business and the economy are suffering as a direct consequence of the banks’ unwillingness or inability to lend.

The government is in ongoing dialogue with the banks regarding their lending policies but is also encouraging businesses to explore alternative means of finance, one of which is the ‘Business Angel’. A business angel is defined as a wealthy individual who provides finance to companies in exchange for a share of the companies’ equity.

As far as tax breaks go for this type of investor, the Enterprise Investment Scheme (EIS) is targeted at precisely this kind of financing arrangement. EIS has been with us for a long time now but, due the current reluctance of the banks to lend, is of considerable more relevance now than it was maybe ten years ago.

The Office of Tax Simplification (OTS) has identified EIS as one of the main reliefs requiring urgent simplification.

A Minefield

The tax reliefs available under EIS are actually very generous and these are considered in our separate Guide to Enterprise Investment Scheme – The Tax Reliefs Condensed.

However, many businesses and investors have been reluctant to use it…….which brings us to the main problem with the EIS. The scheme is so complex and full of traps, that it is an immediate turn-off for many would-be investors and businesses alike. In the early days of EIS (and its predecessors, the Business Start-Up Scheme and Business Expansion Scheme) the system was quite open to abuse and so, over the years, more and more anti-avoidance legislation has been thrown into the mix, making for a really complicated set of rules.

It has also historically been an extremely high-risk area for accountants and tax advisers and HMRC have historically been fastidious in applying the rules to the letter which can often result in difficulties.

What the business community is crying out for is a radically simplified set of rules to make EIS a far more attractive proposition for investors and businesses alike.

EIS in Outline

Due to the complex and sprawling nature of the EIS legislation, which runs to 69 pages, it is difficult to condense the rules easily but let us try. These are the rules that apply following the changes as a result of the 2011 and 2012 Budgets.

The EIS scheme allows a company which meets certain conditions (a qualifying company) to raise funds by issuing full-risk ordinary shares to individual investors previously unconnected with the company.

The funds raised must be used to finance a qualifying trade carried on in the UK or for research and development. The funds must be used within 12 months of the commencement of the trade, and this must take place within two years of the share issue.

The trades which qualify are severely restricted so as to exclude trades where the investors’ capital is at little or no risk.

In general, an individual who is or has been connected with the company or its trade will not qualify for relief, but business angels may receive a reasonable remuneration as a director.

Although there is no statutory clearance procedure, HMRC will, on application, give an advance opinion on whether a proposed share issue will qualify for relief.

To qualify for the tax reliefs, an investment needs to be made by a qualifying individual in a qualifying company.

Qualifying Individuals

An individual is eligible for EIS relief if he subscribes for relevant shares in a qualifying company with which he is not connected.

For the purposes of establishing whether an individual is connected with a company, a 30% test applies. If an individual, together his associates, holds more than 30% of the share capital, loan capital, voting rights or rights on winding-up, they will be ‘connected’ and therefore not eligible for relief under the scheme.

‘Associates’ are any partner or relative of the investor and, in certain circumstances, trustees and personal representatives of trusts/estates in which the investor was either settler or had an interest.

Irrespective of the 30 per cent test, an individual is connected with the issuing company if he, or any associate, is an employee or partner of the issuing company or any of its subsidiaries at the time of issue.

An individual is also connected with the issuing company if he is a director (unless unpaid) of that company or of a subsidiary or partner of that company. Business angels, who have had no previous connection with the EIS company, may receive a ‘reasonable remuneration’ for their services as a director. However, new companies are not excluded in the legislation. It would therefore appear to be acceptable for a small group of individuals to set up a new company, be paid reasonable remuneration for the services they provide to the company and claim EIS relief for their investment. However, care must be taken that at the time of the issue of their EIS shares they are not already connected with the company or its trade.

The annual maximum amount that an individual investor may invest under the EIS scheme is £1,000,000 per tax year from 6 April 2012, although if the investor has also made an investment into a Venture Capital Trust (VCT), the amount of investment would need to deducted from the £1,000,000 maximum limit, since it is a combined EIS/VCT limit.

Qualifying companies

The rules start to get really complicated when looking at the requirements for a qualifying company. The main rules are outlined below are an ‘in a nutshell’ version of the rules, which run to many pages of legislation.

For shares to be eligible for EIS relief, the company must

• be unquoted at the time of issue of the shares, with no arrangements in place for the company to become quoted
• not be under the control of another company, nor must there be arrangements in place at the time of the share issue
• meet certain conditions in respect of subsidiaries that it may have
• be a ‘small’ company. The definition of small or these purposes does not follow the Companies Act definition of a small company. To qualify as small for EIS purposes, the company (or group, if there are subsidiaries), the gross asset value of the company must not exceed £15,000,000 before the issue of the EIS shares and £16,000,000 afterwards
• carry on a qualifying trade either itself or through a qualifying subsidiary
• raise no more than £5,000,000 per annum by way of EIS and venture capital trust subscriptions combined
• apply the funds for qualifying trading purposes within two years of the share issue
• have less than 250 employees.

Qualifying Trades

Most trades will qualify as a ‘qualifying trade’. However, certain trades are excluded by legislation. The excluded, non-qualifying trades are as follows:

• dealing in land, in commodities or futures in shares, securities or other financial instruments
• dealing in goods, other than in an ordinary trade of retail or wholesale distribution
• financial activities such as banking, insurance, money-lending, debt-factoring, hire-purchase financing or any other financial activities
• leasing or letting assets on hire, except in the case of certain ship-chartering activities
• receiving royalties or licence fees (though if these arise from the exploitation of an intangible asset which the company itself has created, that is not an excluded activity)
• providing legal or accountancy services
• property development
• farming or market gardening
• holding, managing or occupying woodlands, any other forestry activities or timber production
• shipbuilding
• coal production
• steel production
• operating or managing hotels or comparable establishments or managing property used as an hotel or comparable establishment
• operating or managing nursing homes or residential care homes, or managing property used as a nursing home or residential care home
• providing services to another person where that person’s trade consists, to a substantial extent, of excluded activities, and the person controlling that trade also controls the company providing the services.

A company can carry on some excluded activities, but these must not be ‘substantial’ part of the company’s trade. HMRC take ‘substantial’ to mean more than 20% of the company’s activities.

There is no requirement that the qualifying company is resident in the UK, but for shares issued on or after 6 April 2011, the company must have a ‘permanent establishment’ in the UK.

HMRC Clearance Procedure

The Enterprise Investment Scheme (EIS) is administered in HM Revenue & Customs (HMRC) by the Small Company Enterprise Centre (SCEC).

The SCEC decides if a company and a share issue qualifies. If they do, the SCEC then takes responsibility for checking the accounts etc of the company to ensure that it continues to meet the requirements of the Scheme.

Companies are not required to obtain such an assurance, but companies, particularly those using the EIS for the first time, may consider it prudent to do so. It gives an opportunity to spot any problems before shares are issued, and an assurance from the SCEC is also useful for companies to show to potential investors.

Full guidance on the Advance Assurance application can be found on the HMRC website.

Office of Tax Simplification (OTS)

The OTS, in its Review of Tax Reliefs – Final Report (March 2011), identified EIS as being complex, expensive to set up and administratively burdensome. Due to the requirement for the conditions to be met for a three year qualifying period, the scheme is fraught with traps for would-be investors. The OTS identified several areas of concern. Some of these were addressed by the government in the 2011 and 2012 Budgets but the following still remain areas of concern:

• the legislation governing EIS runs to 69 pages and is found at different parts of tax legislation, making the rules difficult to read and to apply
• the cost of obtaining professional advice to ensure compliance with the rules may make the scheme prohibitive for many
• there is general confusion as to whether the relief is available to directors and employees of the company
• the clearance procedure can provide assurance for investors but can take up to a month to obtain. OTS has suggested that an electronic online clearance procedure would be useful
• one of the requirements is that shares are subscribed for wholly in cash and are fully paid up at the time they are issued. This condition (which was designed at a time when investors generally paid by cheque) causes complexities in the procedures undertaken during funding. Generally investors prefer to pay by electronic transfers, but if they pay prior to the shares being issued, it results in EIS relief being denied; transfers after the shares have been issued results in the shares not being fully paid up (and thus the relief is denied)
• further funds. This condition also means that the proceeds from larger share issues, with some non-EIS funding, must be separately tracked.

OTS Recommendations

The OTS has made the following suggestions for simplifying the scheme:

• the complex and sprawling rules be rewritten into a checklist or flowchart that makes it easy to follow to determine eligibility. Such an approach is likely to be in a Practice Note or HMRC guidance and such guidance should be binding
• in particular, to simplify the administrative side of the relief, consideration could be given to clarifying the position surrounding the eligibility of directors and employees to address some of the confusion that still exists
• a potential grace period for the shares to be fully paid up (of perhaps a few days) to ease the administration of electronic cash transfers
• implementing an electronic certification process to streamline applications.

This document has no regulatory status and provides an overview of the scheme.

If you would like any further information, please do not hesitate to contact Southside Accountants Wimbledon & London.