SEIS and EIS – how to lose tax relief

We find that many businesses obtain advance assurance from HMRC when raising their first investment under the Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS). However, advance assurance does not guarantee tax relief. Changes to the business or its circumstances can cause investors to lose relief and repay tax benefits previously claimed.

Losing tax relief can have significant financial consequences, including:

• Repayment of income tax relief previously claimed.
• Capital gains tax becoming payable on gains that would otherwise qualify for disposal relief.

Risks of EIS/SEIS tax benefits being lost

Companies must satisfy various conditions to secure and retain tax relief. Common issues include:

• Investment funds not being spent within the applicable time limit or on qualifying activities.
• Investors selling shares within three years.
• Changes to share rights or the issue of preference shares.
• Investors becoming connected with the company.
• Changes to the company’s trade.
• Financial difficulties or insolvency.
• Failure to make the necessary income tax relief claim.

Time limits for spending investment funds

Investment funds must be used for the qualifying business activity within the applicable statutory time limit. The rules differ between EIS and SEIS, so the relevant requirements must be checked for each investment.

The funds must be spent on the qualifying activity, rather than simply reserved for future use. For example, if investment is raised to open a new restaurant but development of the site is delayed, ring-fencing the funds for that project does not necessarily mean they have been spent for the purposes of the scheme. Businesses should monitor expenditure carefully to ensure that funds are used within the required period and for the intended qualifying activity.

Investor sells shares within 3 years 

Investors generally need to hold their shares for at least three years to retain the relevant reliefs, subject to the statutory rules. If an investor sells shares within this period, income tax relief may be withdrawn or reduced, and any gain may be subject to capital gains tax.

The consequences depend on the circumstances of the disposal. One investor’s sale does not automatically affect the relief available to other investors.

Preference shares create problems for EIS/SEIS

Shares issued under EIS or SEIS must satisfy specific statutory requirements. They must generally be fully paid in cash when issued, non-redeemable and free from prohibited preferential rights.

Restrictions apply to certain dividend rights, including cumulative dividends and rights that allow dividends to vary at the company’s discretion. Shares must also comply with restrictions on preferential rights to assets on a winding up and satisfy the risk-to-capital condition.

A subsequent issue of preference shares does not automatically invalidate existing relief. However, introducing a new share class or changing existing rights can affect eligibility, so the proposed arrangements should be reviewed before implementation.

Family member becomes a shareholder or employee 

The rules governing connections between investors and companies can restrict eligibility for EIS or SEIS relief. The relevant tests may consider shareholdings, voting rights, nominal value and certain relationships with other shareholders.

Certain family relationships, including spouses, parents and children, may be relevant. Employment by the company can also affect eligibility, depending on the scheme and the circumstances. The rules should therefore be checked against each investor’s position, including any changes occurring after investment.

Trade no longer qualifies for EIS or SEIS

The company must continue to satisfy the relevant qualifying conditions throughout the applicable period. If it ceases to carry on a qualifying trade or breaches another statutory requirement, investors may lose relief.

Certain activities, including some property development and financial services activities, are excluded. Where a business undertakes both qualifying and excluded activities, the statutory rules determine whether relief remains available.

Many start-ups change their focus as their business models develop. Although some changes may be acceptable, others can jeopardise eligibility. Businesses should monitor changes to their activities and review their business plan, particularly where it formed part of the information supplied to HMRC when advance assurance was sought.

Insolvency impact on EIS and SEIS

Financial difficulties can affect whether a company continues to meet the relevant conditions, but insolvency or liquidation does not automatically mean that all tax relief will be withdrawn. The outcome depends on the circumstances and the statutory requirements.

Investors who make a loss on EIS or SEIS shares may be able to set that loss against chargeable gains and, where the conditions are met, against income. The allowable loss must be calculated after deducting income tax relief given and not withdrawn.

Failing to make an income tax relief claim

Failure to obtain income tax relief can affect the availability of capital gains tax disposal relief.

For example, an investor might subscribe for shares in an EIS-qualifying company and later sell them at a substantial gain. If the investor has not made the claim required by the legislation, the gain may not qualify for EIS disposal relief, even if the company itself met the relevant conditions.

Investors should ensure that claims are made correctly and within the applicable time limits, and retain their EIS or SEIS certificates and supporting documentation.

What can you do if you find a problem

Some problems can be resolved, allowing investors to retain relief, while others may result in relief being withdrawn or reduced. The available options depend on the nature of the issue, when it arose and whether corrective action is possible. Early advice can help establish the likely tax consequences and identify any available solutions.

HMRC can investigate whether companies and investors have met the relevant conditions, and smaller companies and their investors are not exempt from scrutiny.

Investors should also consider whether they can rely on an indemnity or contractual undertaking given by the company or its directors concerning EIS or SEIS eligibility. The protection available will depend on the wording and enforceability of the relevant agreement.

Gannons provides tax and legal support to businesses and investors facing EIS or SEIS eligibility issues, helping identify risks, assess available options and protect their financial interests.