Just because the trade qualified for EIS/SEIS on the first round of investment does not mean it continues to do so. We review and confirm if your investors will still benefit from the very generous tax relief EIS/SEIS provides.
SEIS/EIS is incredibly complicated and it is easy to miss a trick. We are happy to talk through ideas.
The Seed Enterprise Investment Scheme and the Enterprise Investment Scheme offer incentives in the form of tax breaks to investors in return for investment in qualifying trades.
We find that many businesses obtain advance assurance from HMRC at the time of the first investment that the trade qualifies for EIS or SEIS. But subsequent changes to the trade can mean that investors find that the trade no longer qualifies for EIS/SEIS and the investors owe HMRC money.
Losing tax reliefs which have been a major part of your business planning has big implications, including:
- If the shares cease to qualify for EIS or SEIS income tax relief already claimed by the investors will be repayable.
- Capital gains tax at 20% will be payable on the profits arising upon sale of the shares.
Risks of EIS/SEIS tax benefits being lost
There are a number of conditions that must be satisfied in order to qualify for SEIS/EIS tax relief. If circumstances change and any of these conditions are no longer satisfied there is a risk that the investment will no longer qualify for SEIS or EIS tax relief. The legislation is incredibly complex with hidden traps which are easy to miss but mean tax relief is missed.
The common problem areas we look at are:
- The time limit for spending the investment funds has expired
- An investor wants to sell shares within three years
- Preference shares have been issued
- A family member has become a shareholder or an investor
- The business has changed
- The business is facing insolvency
- Failing to make an Income Tax Relief claim
Time limits for spending investment funds
The money raised from EIS or SEIS investors must be spent within three years from the issue of shares to the investor and it must be spent on the qualifying business activity it was raised for.
The money should be paid out to independent third parties for commercially supplied goods or services – investing in another company is not sufficient. In practice this means that the money must be spent on the activity for which it was raised. For example, if you have procured investment into the opening of a new restaurant but development of the site is delayed, although the money has been applied or ‘ring-fenced’ for use in the restaurant it has not been ‘spent’ so the investors may risk losing their relief.
Investor sells shares within 3 years
An investor must hold SEIS/EIS shares for 3 years from the date of issue. If they sell SEIS/EIS shares within this period (and the sale is not to their spouse or civil partner), income tax disposal relief for those they sell will be wholly or partly withdrawn. If they make a gain on the disposal, it will be chargeable as capital gains. The other investors’ tax relief is not affected by the disposal.
Preference shares create problems for EIS/SEIS
The shares issued for SEIS/EIS investment must be ordinary, non-redeemable shares, fully paid in cash at the time of subscription. A right carried by a share is a preferential right if that right takes priority over a right carried by another class of shares.
SEIS/EIS shares must not have a present or future right to dividends where either the rights attaching to the share include scope for the amount of the dividend to be varied based on a company decision or where the right to receive dividends is cumulative.
SEIS/EIS shares must also not have a preferential right to assets on a winding up (effectively guaranteeing a return on the investment), as this would fail the ‘risk to capital’ condition that needs to be satisfied in order for the investment to qualify for tax relief.
Where a company has only one class of issued share capital no share carries any preferential right. HMRC guidance on SEI/EIS shares confirms that where a company has two classes of issued share capital, and dividends are declared on one class but not on the other, the right of the former class is not a preferential right.
As long as SEIS/EIS share class has no preferential rights, a subsequent issue of shares in a different class with preference shares should not in itself cause a problem. However, if a new class of shares is being introduced it is always worth checking the effect such a class has on existing share rights.
Family member becomes a shareholder or employee
An investor does not qualify for SEIS/EIS tax relief if they have more than a 30% stake in the company. This percentage takes into account not just number of shares but voting rights and nominal value.
For the purposes of SEIS and EIS in particular, this extends to certain family members too. So if your spouse, parents, children, grandchildren or grandparents have more than a 30% stake or are employed by the company, they are considered to be ‘connected to’ you as the investor and that excludes you from tax relief, even if at the time you invested there was no connection.
Trade no longer qualifies for EIS or SEIS
The company must carry out a qualifying trade for at least 3 years after the investment is made – otherwise EIS or SEIS relief will be withdrawn from the investors. If more than 20% of the company’s trade involves an excluded activity, such as property development, financial services or energy generation, the trade will no longer qualify for SEIS or EIS tax relief.
Many businesses, particularly startups, change their focus significantly in the first few years as their business model develops. Some change is expected and usually accepted but it is important to maintain the business plan as far as possible – in particular if it has been submitted to HMRC as it will be part of the basis on which advance assurance was granted.
Insolvency impact on EIS and SEIS
If a resolution is passed, or an order is made by the court, for the winding up of the company (or its subsidiary), or if the company is dissolved, the company will fail to satisfy the ‘trading company’ condition for tax relief. However, this failure is disregarded where the winding up or dissolution is for genuine commercial reasons (usually, that the company is insolvent).
So if it can be established that the company has gone into liquidation after ceasing to trade because of insolvency, the tax relief should not be withdrawn from the investors.
If an investor makes a loss on the disposal of SEIS/EIS shares this loss can often be set against their chargeable gains – although the cost of shares must be reduced by the amount of any income tax relief given and not withdrawn.
Failing to make an income tax relief claim
If you fail to make an Income Tax Relief Claim you will fail to secure Capital Gains tax relief.
An Enterprise Investment Scheme (EIS) investor failed to secure Capital Gains Tax relief when he failed to make an Income Tax Relief claim at the start;
- Mr A invested £50,000 in Skyventure UK Ltd – an EIS Scheme qualifying company.
- Mr A had no taxable income the year of the investment so did not make a claim for Income Tax Relief once he was issued with his EIS certificate.
- The company was successful and Mr A sold his shares for £333,200.
- Mr A did not disclose his gain on his tax return as he believed it was exempt from CGT under EIS rules. Mr A did however make a disclosure in the additional information section of the return.
- HMRC enquired and investigated the return and amended it to make the gain fully taxable.
The Tax Tribunal held that CGT relief is only available where the claim to EIS tax relief had been made to HMRC within the time limit set down in the legislation.
What can you do if you find a problem
Some problems can be fixed and the shares will continue to qualify for SEIS and EIS tax exemptions. But, some problems are not capable of rectification and tax relief claimed by investors has to be repaid to HMRC. We guide on what choices you have based on the particular facts.
Whilst HMRC currently tend to pursue EIS and SEIS investigations into investors or seed funds in larger companies, smaller companies and their investors are not exempt.
Another area will be to review whether the investors can rely on any indemnity given by the company and/or its directors that the investment will qualify for EIS or SEIS.
If you think your business may be facing SEIS/EIS tax relief problems it is worth speaking with a tax specialist. We offer tax as well as legal advice.
Catherine is an extremely experienced solicitor, having been qualified since 2000, and deals with all types of corporate and commercial matters and advice and also tax law.
Catherine is well known for turning complex problems into solutions, priding herself on always finding a way. In her spare time she runs Gannons!