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Tax reliefs to encourage investment in fledgling trading companies have been available for many years, and the latest incarnation of these reliefs is the enterprise investment scheme. This scheme does not apply to investment by companies; it is directed primarily at investment by individual taxpayers, although some aspects of the scheme apply to trusts.
The tax reliefs divide into three different categories, these being income tax reliefs, capital gains tax reliefs and an exemption from inheritance tax. Please note that this memorandum sets out a guide to the complex tax rules surrounding these investments, which are almost by definition investments of a risky nature. Accordingly it is very important to take expert financial advice as well as tax advice before proceeding with any investment of this kind.
This memorandum will offer a broad summary of the tax reliefs and also an outline of some of the common pitfalls which can lead to HMRC denying all relief in respect of the shares.
The income tax reliefs
Essentially, the scheme is directed at third party investment in unquoted trading companies. Some types of trade are excluded from the scheme, examples being farming, accountancy services and property development.
It is a requirement that the company raising the funds must carry on a qualifying trade at least partly in the UK and the company must not be in financial difficulty at that time. Any company formed after 23 March 2011 to produce electricity mainly for the receipt of feed-in tariffs must start generating commercial electricity before 6 April 2012.
The scheme is directed at smaller trading companies, these being defined as those with gross assets of no more than £7 million before the share issue, although this limit is set to be increased next year to no more than £15 million. There are also very detailed rules concerning the nature of the company concerned, particularly as regards its subsidiaries (if any), the number of its employees, plus a requirement for the money raised by the investment to be used within the business within two years of the share issue.
The investor must not have been a paid employee or director of the company within the two-year period before the issue of the shares, and must not have a 30 per cent interest in the company in that period or within the three-year period after the issue of the shares. The 30 per cent test is subject to detailed rules and also brings into account the interests of other family members and associates.
It is very important that the investor does not start with making a loan to the company with a view to converting it into an issue of shares at a later time. An investment under the scheme must raise new funds for the company and cannot be made in exchange for an amount of loan previously made.
It is also necessary to follow certain procedures in order to claim the relief. It is not acceptable simply to make the investment in a friend’s company and then claim the relief on your next personal tax return. In relation to any investment, the company must approach a specialist office within HMRC in order to have the EIS claim approved, and once that is given HMRC will issue the necessary claim form to be submitted with the tax return for the year of investment.
The maximum subscriptions in any tax year which can qualify for relief is £500,000. For shares issued before 6 October in any year there is provision for part of the investment to be carried back to the previous tax year to give relief in that year.
Up to 5 April 2011 the rate of relief was 20 per cent on the amount of the investment and on and after 6 April 2011 the rate is to be 30 per cent. Accordingly if an investment is now made in a qualifying unquoted trading company with the amount of the share subscription being £100,000, an amount of £30,000 can be deducted from the tax liability for 2011/12 due on submission of the self assessment tax return. This is not however a repayable credit of any sort, but simply a deduction from the liability due to HMRC and so the most that can be achieved is a reduction in that liability to nil.
After an investment is made, there remains a qualifying period of three years throughout which there must be no return of value to the investor from the company. Return of value is widely defined to include the redemption of shares or securities, loan repayments and certain other types of payment not listed as being acceptable. This does not however prohibit dividends being paid on the shares.
After the three-year period, restrictions no longer apply, and in fact the company can then discontinue its qualifying trade and branch out into other activities which would not have been qualifying under the enterprise investment scheme if carried out when the investment was made.
If the investment should prove to be unsuccessful and ultimately a loss arises on the disposal of the shares, that loss can be claimed for income tax relief. The loss will be the amount of the investment, less the amount of EIS income tax relief which was received. Accordingly, if an investment is now made of £100,000 for which £30,000 of income tax liability is relieved, should the investment prove to be a total loss, an amount of £70,000 can be claimed in the year of loss as a deduction from taxable income. For a 40 per cent taxpayer, this will mean that most of the loss is covered by tax relief, i.e. £30,000 on investment, and £28,000 on the ultimate loss claim, a total of £58,000 in tax relief.
The capital gains tax reliefs
There are principally two capital gains tax reliefs for EIS investments. The first is that for shares which qualified for income tax relief and which are retained for the three-year qualifying period, they then become exempt assets for capital gains tax purposes. Accordingly if they are realised at a profit, that profit will be tax free.
The second capital gains tax relief is that the amount subscribed for the shares qualifies for capital gains tax hold over relief in relation to the gain on any other asset disposed of within three years prior to the EIS investment or within one year after it. Hold over relief is a mechanism by which the gain realised on an asset can be deferred so that tax is not payable for the year in which it was disposed of.
For example, suppose that a holiday home was sold on 1 December 2009 realising a profit of £50,000. If the taxpayer makes an EIS investment of £50,000 at any time up to 30 November 2012, he can ‘hold over’ the gain into the EIS investment so that the figure of £50,000 is no longer taxable, but instead the cost price of the EIS shares for capital gains tax purposes is reduced to nil.
This EIS deferral relief is not subject to the same detailed conditions that apply to the EIS income tax relief. For example, deferral relief applies even if the EIS company is your own wholly owned trading company. You can hold over the gain on any asset into a subscription of shares in a new trading company which you may set up, or alternatively into an issue of further shares in an existing trading company which you already run. At least 80 per cent of the money raised from the subscription must genuinely be used for the purposes of a qualifying trade within 12 months.
The only EIS relief available to trustees is the hold-over relief described as the second relief above. The income tax relief and capital gains tax exemption for EIS shares are not available for trustee investments.
The inheritance tax exemption
Shares issued under the EIS scheme are exempt from inheritance tax once they have been held for a two-year qualifying period. There is no limit on the value of the shares qualifying for this exemption. Furthermore, there is no recapture of any of the other EIS reliefs detailed above on the death of the taxpayer concerned.
The inheritance tax exemption for EIS shares applies to gifts of the shares both on death and in lifetime. In principle therefore EIS shares can be used to shelter gifts of other assets into a family trust made in lifetime. The trust could be formed with an initial gift of the shares and the trustees could then sell those to the settlor in exchange for other assets held by the settlor of equivalent value. This procedure does however require detailed advice.
For the purposes of the EIS scheme, shares quoted on the alternative investment market count as unquoted and therefore if a subscription can be arranged into shares on that market, subject to the other detailed conditions for relief, those shares may qualify for the EIS income tax and capital gains tax reliefs as well as inheritance tax exemption.
The tax reliefs under the enterprise investment scheme are quite generous, although it must be acknowledged that EIS investments tend to be either highly successful or highly unsuccessful. A good principle to keep in mind is that no investment should be made solely for tax reasons, but the overriding consideration should be the soundness of the company concerned from an investment point of view.
FOR GENERAL INFORMATION ONLY
Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so. It is designed to alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.
Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.