The enterprise investment scheme: current state of play
This article first appeared in the December 2024 issue of PLC Magazine https://uk.practicallaw.thomsonreuters.com/Browse/Home/Resources/PLCMagazine
Investment in business has seldom been more topical. The new government has made clear its intention to restore economic growth, signalled by its inaugural International Investment Summit that took place in October 2024. The Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) tax relief regimes are likely to play a part in helping the government to achieve its stated objective and it is perhaps unsurprising that, at the start of September 2024, the government extended the availability of the EIS by ten years to April 2035; a move that was welcomed across the business community.
Key EIS tax reliefs
The EIS was introduced in 1994 to encourage individuals to invest in smaller, higher risk trading companies in order to help alleviate the problems that they often face in raising equity finance. The EIS achieves this by offering UK-resident individual investors both income tax and capital gains tax (CGT) reliefs. The SEIS is a similar scheme that is specifically targeted at encouraging investment in start-up companies.
Income tax
Income tax relief is generally available at 30% of the amount invested up to a maximum of £1 million per investor per year, or £500,000 for shares that were issued before 6 April 2012. This means that the maximum income tax relief per investor per year is £300,000. Shares that were issued on or after 6 April 2018 in a knowledge intensive company can access an increased maximum limit of £2 million, which represents a maximum income tax relief per investor per year of £600,000.
CGT
An exemption from CGT is generally available on gains that arise on a disposal of shares for which EIS income tax relief has been claimed. Broadly, the disposal must occur at least three years after the issue date of the shares and EIS income tax relief must not have been subsequently withdrawn. The exemption is restricted where income tax relief was not given on the whole amount subscribed for the qualifying shares; for example, because of the investment limits described above.
CGT can generally be deferred on any gains that are realised on a disposal of assets, where those gains are then used to subscribe for shares that qualify for EIS relief. Broadly speaking, that deferred gain will then be payable on the disposal of the relevant EIS shares. The investor must subscribe for the relevant EIS shares between one year before and three years after the accrual time for the capital gain in question. However, if the investor has subscribed for the relevant EIS shares before the accrual of the gain, they must still hold the shares at the time of the accrual.
Recent trends
Given the potential for businesses to attract greater investment as a result of EIS and SEIS tax reliefs, qualifying companies often consider whether either scheme is available to their investors. However, reports have suggested that investment in early-stage companies has fallen in recent times. According to data published by HM Revenue & Customs (HMRC) in May 2024, EIS investments in the 2022/23 tax year decreased to £1,957 million from £2,297 million the previous year (www.gov.uk/government/statistics/enterprise-investmentscheme-seed-enterprise-investment-schemeand-social-investment-tax-relief-may-2024/). Similarly, the number of companies raising EIS investments fell from 4,455 to 4,205.
The decrease in SEIS investments in the 2022/23 tax year was even more pronounced, showing a drop from £207 million to £147 million, with almost 500 fewer companies raising finance through the SEIS. Although the 2023/24 figures are not yet available, HMRC has confirmed that the number of applications for advance assurance has dropped from the previous year, which may suggest a continuation of the trend (see “Scheme requirements” below).
However, the statistics only tell part of the story. 2021/22 was a record-breaking year, with EIS investment enjoying something of a rebound from a pronounced drop during the COVID-19 pandemic in the previous tax year. Sharply rising interest rates across 2022 and 2023 also played a part in discouraging equity investment. Therefore, it would be wise to take the published numbers with a pinch of salt; EIS investment effectively returned to average levels in 2022/23, with the two preceding years representing something of an anomaly.
In any case, the clear message is that usage of the EIS continues to be significant, which suggests that the tax reliefs on offer are having a positive effect on business investment. Although the Autumn Budget 2024 did not include any specific EIS- or SEIS-related measures, the Chancellor of the Exchequer acknowledged the recent extension of the EIS to 2035 and said that the government is committed to working with leading entrepreneurs and venture capital firms to ensure that its policies support a positive environment for entrepreneurship in the UK (see News brief “Autumn Budget 2024: addressing the deficit?“, this issue). This messaging perhaps suggests a continuing commitment to EIS, against a somewhat more muted tax backdrop. Indeed, the increases in CGT announced in the Budget will likely act to encourage take-up of the schemes, given the possible corresponding increase in tax savings.
Scheme requirements
The key point to note for companies seeking to attract investment that falls under the EIS is that there are numerous detailed qualifying criteria that must be met by the company, the relevant shares and the investor before, during and after the shares are issued (see box “Summary of key EIS qualifying criteria”). If any one of these requirements is not met, the schemes will be unavailable and investors will be unable to access the tax reliefs. Similar, but not identical, requirements apply to SEIS investments. The government has published detailed guidance on the wider criteria for both the EIS and SEIS (www.gov.uk/guidance/venture-capital-schemes-applyfor-the-enterprise-investment-scheme; www.gov.uk/guidance/venture-capital-schemesapply-to-use-the-seed-enterprise-investmentscheme).
Summary of key EIS qualifying criteria
| General requirements | • At the time of investment, it would be reasonable to conclude that the company has an objective to grow and develop its trade, and there is a significant risk to loss of capital that is potentially greater than the net return (the risk-to-capital condition). • The shares must not be issued as part of arrangements that include a pre-arranged or guaranteed exit, and must be issued for genuine commercial reasons and not as part of a scheme or arrangement the main purpose of which, or one of the main purposes of which, is the avoidance of tax. • The shares must not be issued, nor any money raised by the issue used, in connection with certain disqualifying arrangements. • The company must meet the permitted maximum age requirements; that is, generally, the investment needs to be made within seven years of the target’s first commercial sale or, for a knowledge intensive company (KIC), within ten years of the target’s first commercial sale or the date the company is treated as reaching an annual turnover of £200,000. |
| Shares | • The shares must be ordinary shares, subscribed for wholly in cash and fully paid up, and must be issued before 6 April 2035 for investors to benefit from income tax relief. • The shares must be issued to raise money for the purpose of a qualifying business activity so as to promote business growth and development, and for genuine commercial reasons; that is, not for tax avoidance purposes. A qualifying business activity can constitute a qualifying trade, preparing to carry on a qualifying trade if the trade begins within two years, or research and development that is intended to give rise to the carrying on of a qualifying trade. • Subject to limited exceptions, for the three years following their issue, the shares must not carry any preferential rights to dividends or assets on a winding up, or any present or future right to be redeemed. |
| Funds raised | • Funds raised must be used for the purpose of a qualifying business activity so as to promote business growth and development, and must be used wholly for the purpose of that qualifying business activity within two years. • Funds raised through the Enterprise Investment Scheme (EIS) and other risk finance investments (broadly, investments that can benefit from tax relief under one of the EIS, the Seed Enterprise Investment Scheme (SEIS) and certain other schemes in the previous 12 months) must not exceed £5 million, or £10 million for a KIC. • Funds raised through the EIS and other risk finance investments must not exceed a total of £12 million, or £20 million for a KIC. |
| Investors | • Investors must subscribe for shares on their own behalf, although nominees are permitted, and the investment must be made for genuine commercial reasons and not for tax avoidance purposes. • Investors must not be connected with the issuing company in the two-year period before the issue of the shares or in the three-year period after issue, subject to limited exceptions including unpaid directorships, and must not have an existing shareholding. • No linked loans can be made to the investor or its associates in the period beginning with the incorporation of the issuing company (or, if incorporated more than two years before the issue date, two years before the issue date) and ending three years after the issue date. • Investors must hold the shares for at least three years. |
| Issuing company | • The company’s shares must be unquoted but shares can be listed on AIM. • The company must have fewer than 250 full-time equivalent employees, or fewer than 500 full-time equivalent employees if a KIC, and it must not have gross assets of more than £15 million immediately before, and gross assets of no more than £16 million immediately after, the shares are issued. • For the three years following the share issue, the company must: – have a permanent establishment in the UK; – exist wholly for the purpose of carrying on one or more qualifying trades, or be a parent company and the business of the group does not consist wholly, or as to a substantial part, in the carrying on of non-qualifying activities; – have only qualifying subsidiaries, or 90% qualifying subsidiaries in the case of property managing subsidiaries; and – meet certain control and independence requirements. |
Failure to meet all of the criteria at the relevant times will disapply the tax reliefs and risks making the investment markedly less attractive. Working through the plethora of qualifying criteria is a time-consuming and often daunting exercise. For this reason, companies intending to attract EIS investment will usually instruct advisers to help with compliance.
Somewhat helpfully, taxpayers can use a two-stage application process that allows the issuing company to seek advance assurance from HMRC before the investment is made, which is similar to an informal clearance application. The application is submitted online, together with supporting documents, with the onus on the company to provide correct information and draw attention to any particular issues that the directors consider could mean that the requirements of the EIS might not be met. However, any advance assurance is not a substitute for formal clearance.
Assuming that the company has been carrying on its qualifying trade for more than four months, it must also apply online for formal clearance through Form EIS 1 within two years from the end of the tax year in which the eligible shares are issued. For example, if the company is intending to issue eligible shares in the 2024/25 tax year, the deadline for submitting a Form EIS 1 would be 5 April 2027.
Recent case law
The numerous qualifying criteria have been the subject of various cases in the English courts, with the EIS regime representing something of a hotbed for legal argument. While many of the decisions focus on EIS compliance, they also have wider tax ramifications.
Putney Power Ltd and Piston Heating Ltd v HMRC concerned the requirement that the company, or a qualifying 90% subsidiary, is carrying on a qualifying trade when the relevant shares are issued or, if not, is preparing to carry on a qualifying trade and that trade actually commences within two years after the shares are issued ([2024] UKFTT 870 (TC); www.practicallaw.com/w-044-8180). The specific question for the First-tier Tribunal to decide was whether the relevant companies had commenced their qualifying trades within the two-year period.
The tribunal noted that the question should be answered as a matter of commercial substance, looking at the whole picture and, most importantly, bearing in mind what is required to start a trade of the kind in question. It considered that the trading infrastructure must be actually, not just contractually, assembled. In reaching this conclusion, the tribunal stated that a trade commences when the putative trader is open for business and this cannot be the case until it is ready to provide the goods or services that form the subject matter of its intended trade. The assembly of trade infrastructure does not need to have been actually completed before trading starts, as long as it is operational.
Putney Power will be relevant to a number of other areas of UK tax law where trading requirements are fundamental to the tax analysis, such as the substantial shareholding exemption on gains made on the sale of shares, business asset disposal relief (previously entrepreneurs’ relief), and the tax treatment of share buybacks.
Other recent cases, including Inferno Films Ltd v HMRC, emphasise the fact that different businesses and industries will have different characteristics that are relevant to ascertaining whether the relevant company meets the qualifying conditions ([2022] UKFTT 141 (TC)). In Inferno, the First-tier Tribunal held that the fact that a company focused on a single film project, the production of which it subcontracted to a third party, did not mean that it failed the risk-to-capital condition. It may well be the case that the court would have reached a different conclusion had the relevant company been active in a different industry.
Other cases have focused on the more administrative requirements of the EIS, highlighting the need for taxpayers to comply with both the letter and the spirit of the requirements. For example, in X-Wind Power Ltd v HMRC, the Upper Tribunal affirmed the First-tier Tribunal’s decision that an incorrectly submitted EIS compliance statement cannot be replaced with a compliance statement for the SEIS ([2017] UKUT 290 (TCC)). This decision confirms the strict importance of submitting the correct paperwork to HMRC.
Looking ahead
If there is one lesson to be learnt from the recent case law, it is that investors and companies should take care not only in ascertaining whether the EIS is available in the first place, but also in ensuring that the formal application is managed correctly. Despite fluctuations in usage following the COVID-19 pandemic, and the myriad complexities described above, the level of EIS investment continues to be significant and, assuming that the new government keeps faith with the regime in its current form, the tax reliefs on offer will continue to provide an attractive incentive for potential investors.
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