SEIS and EIS relief – what happens when it goes wrong?
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 startups.
Obtaining advance assurance that investment into a business will qualify for tax relief is a popular method for smaller and medium-sized businesses to attract investors and venture capital seed funds. But what happens if circumstances change?
How can it go wrong?
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 tax relief.
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
- The solutions
The time limit for spending the investment funds has expired
The money raised 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.
An investor wants to sell 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sale is not to their spouse or civil partner), income tax disposal relief for those they sell will be wholly or partly withdrawn.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 have been issued
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.
A family member has become 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.
For example, a father invests in a tech company and holds a 20% EIS-qualifying stake. Two years later his son is employed by that company on their graduate scheme. The father will lose his EIS tax relief because the son is ‘connected to’ the father and SEIS/EIS rules prevent any family member of the investor from being an employee in the company.
The business has changed
The company must carry out a qualifying trade for at least three years after the investment is made – otherwise venture capital tax 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 company will no longer qualify for tax relief.
However, 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.
The business is facing insolvency
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.
Solutions to SEIS and EIS problems
If you believe your business no longer complies with the requirements for SEIS/EIS tax relief it is important to rectify the problem, where possible. One option could be to write to HMRC to explain the change in circumstances – if HMRC confirm that the business still qualifies then there is no problem, although writing to HMRC will put them on notice that you no longer believe the company’s investors qualify for tax relief.
Whilst HMRC currently tend to pursue investigations into investors or seed funds only in larger companies, in the current climate the scope may broaden to smaller businesses that may otherwise slip under the radar.
However, some circumstances, such as ceasing to be a qualifying trade, must be reported to HMRC within specific time limits.
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.