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Simon Groom, Head of Tax Training at Tolley Tax Training, outlines the Enterprise Investment Scheme tax regime.

Introduction  

The aim of the Enterprise Investment Scheme (EIS) is to encourage taxpayers to invest in small, private, trading companies. To encourage such investment, the Government offer both income tax relief and capital gain tax deferral. It is these reliefs I will look at in this article.

Income tax reducers

The income tax reducer for 2006/07 is the lower of the annual subscription and £400,000. The tax reducer is given at a flat rate of 20%. Therefore the maximum tax reducer is £80,000 (£400,000 @ 20%). 

The tax reducer reduces the individual’s tax liability. The flat rate of relief ensures that all taxpayers obtain an equal tax-break.

The relief is given before tax suffered at source, and the tax reducer cannot exceed the tax liability. If the reducer would otherwise exceed the tax liability, the liability is reduced to zero and the excess tax reducer is wasted. It is therefore important to plan sensibly to ensure that full relief is secured, either by spreading subscriptions over different tax years or by both spouses making investments.

EIS subscriptions can be carried back to the previous tax year. If a subscription is made before 6 October, the lower of 50% of the subscription or £50,000 can be treated as having been made in the previous tax year.

Qualifying investors

To obtain income tax relief, the investor must not be “connected” with the EIS company.   An investor is connected with an EIS company if he;

• is an employee of the company.  The investor can in certain circumstances be a director of the company (“Business Angel” – see below); or 
• holds more than 30% of the shares, or can exercise more than 30% of the voting rights. In considering whether the 30% limit is breached, shareholdings of associates (parents, siblings and children) must be considered.     

“Business Angels” are paid directors whose role is typically that of providing managerial, financial or entrepreneurial expertise. Business Angels may receive payment for services as long as any remuneration does not exceed what is reasonable for the services performed.

Although tax relief is available for interest payments on loans used to acquire shares in close companies, such relief is denied if EIS income tax relief is available.

Clawback of relief

There are “clawback” provisions preventing an investor obtaining income tax relief on an EIS subscription, then disposing of his shares within 3 years.

The clawback increases the investor’s tax liability in the year of disposal (sale or gift). The clawback will not apply when the gift is to the investor’s spouse, although there will be a clawback if the spouse subsequently disposes of the shares within the 3-year period.

If the investor gives away his shares within the 3-year period, all of the income tax relief originally obtained will be withdrawn.

If the shares are sold within the 3-year period, the relief withdrawn is the sale proceeds multiplied by the rate at which tax relief was originally given (normally 20%).  

The clawback cannot exceed the original tax reducer. Therefore if shares are sold at a profit within the 3-year period, an amount equal to the original tax reducer is added back to the investor’s tax liability in the year of sale.  

“Matching rules”

Special identification rules apply if an investor disposes of part of a holding where income tax relief is attributable to some or all of the shares.

Shares are identified on a first-in-first-out (FIFO) basis. Earlier shares are deemed to have been disposed of before later shares to reduce the likelihood of a clawback. The normal share identification rules for CGT do not apply.

Qualifying EIS company

The company must be an unlisted trading company. A company which is quoted, or derives its income wholly or mainly from making investments, does not qualify. 

Most trades qualify, although there are certain prohibited trades for EIS purposes.

Companies whose activities are primarily financial – dealing in shares, securities, commodities etc. - are excluded, as are companies providing legal and accountancy services.   Farming and market gardening are also excluded activities as is property development, operating or managing hotels, and running nursing homes.

The company’s trade must be wholly or mainly carried on within the UK.   Most EIS companies will be resident in the UK, although non-resident companies are not necessarily excluded.

The EIS rules place a limit on the value of the assets within the company.   The assets of the company must not exceed £7 million before the share issue and must not exceed £8 million afterwards.  These limits were £15m and £16m for shares issued before 6 April 2006.

The company must use the funds raised for a qualifying business activity within a certain time period.   The company must use at least 80% of the cash raised from the issue of shares within 12 months, and the remainder within 24 months. 

Eligible shares

Subscriptions must be for new ordinary shares - no other kind of share can qualify. The shares must not carry any preferential rights to dividends or to assets on its winding up.

Capital Gains Tax

EIS reinvestment relief

If an individual sells an asset, and reinvests the proceeds in qualifying EIS shares, he may claim EIS reinvestment relief.  This relief allows the taxpayer to defer the gain.  There is no ceiling to the amount of the gain that can be deferred – the £400,000 subscription limit only applies for income tax.   

EIS reinvestment relief allows the gain on any asset to be deferred, as long as the proceeds are reinvested in EIS shares.  

The amount of gains that can be deferred is the lower of:

(i) the gain before taper relief;

(ii) the amount reinvested; and

(iii) the specific amount claimed.

The investor may claim less than the maximum permitted, for example to take advantage of taper relief, unused annual exemption or capital losses.

The deferred gain is not rolled over against the base cost of the new EIS shares, but is instead postponed or “frozen”.  This frozen gain will become chargeable in the year of a “chargeable event”.  “Chargeable events” include;

• sale of the EIS shares; 
• gift of the EIS shares (unless to one’s spouse / civil partner).

The frozen gain crystallises in the year of the chargeable event. When the frozen gain becomes chargeable it will qualify for taper relief at the original rate – i.e. the taper relief that would have been given on the original disposal.     

Conditions for CGT  relief

The investor must be UK resident, and must subscribe for shares in a qualifying EIS company within 12 months before or 36 months after the disposal. 

The “connected person” rule does not apply for reinvestment relief.  A CGT deferral claim can be made, even if the investor is an employee of the company, or holds more than 30% of the shares. 

Disposals of EIS shares

No gain arises on the disposal of qualifying EIS shares provided that;

• the shares are disposed of more than 3 years after their issue; and
• income tax relief was obtained on subscription (ie, the investor was not connected with the company and the subscription was within the permitted maximum).
  

If the above conditions are not satisfied, any resulting gain will be chargeable. As EIS shares are shares in an unlisted trading company, business asset taper will apply.

A disposal of shares at a loss will always enable the taxpayer to make a loss relief claim (the ownership period is irrelevant). Any allowable capital loss is reduced by the income tax relief obtained on the investment.

The capital loss on disposal of the shares may either be;

a) set against capital gains in the same or future tax years; or
b) relieved against income under S.574 ICTA 1988.

Section 574 allows capital losses on subscriptions of shares in unlisted trading companies to be set against total income in the income tax computation. A S.574 loss may be taken in either the year of the disposal or the preceding tax year. This is an unusual instance of a capital loss being relieved against income and is usually a more preferable alternative than relieving capital losses against gains as this normally results in a loss of taper relief.

Simon Groom is Head of Tax Training at Tolley Tax Training (part of the LexisNexis group). Simon teaches on ATT & CTA classroom courses in London. He can be contacted via the Tolley Tax Training website at www.tolleytraining.co.uk.

LexisNexis Tolley® Tax Training” provides quality correspondence, classroom and e-training for the ATT, CTA, AIIT and ADIT examinations. In addition their e-learning package “Tolley’s Tax Tutor” is excellent preparation for anyone studying tax for any professional examination (ACCA, ICAEW, ICAS, AAT etc). For further information please click the following link: www.tolleytraining.co.uk or email your query to taxtraining@lexisnexis.co.uk