The Enterprise Investment Scheme (EIS) is a government initiative that allows individual investors some generous tax breaks for providing capital to smaller private companies. It was introduced in 1994 to replace the Business Expansion Scheme.
The EIS allows you to invest up to £500,000 a year and get a 20% tax rebate on your investment. You are also entitled to tax free capital gains when you eventually sell the EIS shares. However, you must hang on to the shares for at least 3 years to qualify for these tax breaks and it should be noted that there is no income tax relief on the dividends. As with VCTs, you can only claim the full income tax relief if you have a tax liability for at least that much in the same year. Otherwise the tax relief will be restricted, although you are allowed to carry some or all of it back to the previous tax year.
In addition to the above tax advantages, you have the opportunity to defer capital gains on any other investment that you sold within the previous 36 months or the following 12 months. This concession applies even if it eventually turns out that you are not entitled to income tax relief on your investment or if you sell the EIS shares during the first 3 years after they issued (or from when the company first started trading if later).
To qualify for EIS tax benefits, you must not own (or be entitled to acquire) more than 30% of the ordinary shares of the company you are investing in. You must also not have had any connection with the company as an employee or paid director within 2 years prior to the date you invested in it or 3 years afterwards, although you are allowed to become a paid director after you are issued with the shares. In addition to this, you must not receive any value from the company such as repayment of debts incurred before the investment was made or payment for giving up your right to repayment of such debts, loans from the company that were not re-paid before the investment, certain benefits or facilities and various other favours, although receipts of insignificant value will not cause the withdrawal of tax relief.
The company itself must also jump through lots of hoops in order to qualify for EIS status. Firstly, it must have a qualifying business activity. Most types of trading activity are permitted although property development, leasing, financial activities, farming and hotels are all excluded. So too are such diverse activities as legal services and ship-building. If a company carries on any such activities in addition to its main trading activity, it will be disqualified if they are substantial, which is generally taken to mean more than 20% of turnover. The other main conditions are as follows:
a) the company or group must have fewer than 50 full-time employees
b) the company must not be under the control of another company
c) the company must be unquoted with no arrangements for this to cease
d) the capital raised in any 2 year period must not exceed £2 million
e) at least 80% of the capital raised must be used within 2 years
f) the remaining 20% must be used within the next 12 months
g) there must be no arrangements to protect the value of the shares
h) there must be no arrangements to enable the realisation of the investment
The company may obtain Advance Assurance for EIS investment by sending Form EIS (AA) to HM Revenue & Customs. This gives investors some indication that the company is likely to qualify for EIS tax relief. Once the company has traded for at least 4 months, it can apply for formal clearance by sending Form EIS1. The Revenue, if satisfied, will send the company Form EIS2 authorising it to issue certificates and a batch of blank EIS3 certificates for it to complete and send to investors. Only then is the investor allowed to claim income tax relief.
Investors can subscribe for EIS shares either directly or through an investment fund. If subscribing through an approved fund you can claim tax relief in the same year that you invest in the fund. If using an unapproved fund you have to wait until the fund has received the EIS shares. This can have implications for the amount of tax relief you are entitled to if the particular tax year you are claiming it for is important.
EIS shares are a very tax efficient way of investing in small companies and are particularly useful if you have some inside knowledge of the company you are investing in without actually being connected with it. This can help you to manage the risk involved in such investments. As with any form of investment, however, you should never allow tax advantages to outweigh normal investment considerations.