Tax Advice | Allen & Atherton

Allen & Atherton's complete guide to the Enterprise Investment Scheme for 2023

The EIS is an exceptional government-sponsored incentive for higher-earning investors with a reasonable risk attitude seeking to reduce their tax bill.

Disclaimer: This article does not constitute financial or investment advice. It is always preferable to consult a professional regarding investments and tax matters, and this is particularly true of EIS investments. Allen & Atherton accepts no responsibility for the accuracy of information contained within this piece. Tax laws are subject to rapid, and occasionally retrospective, change. Investors may not get back what they initially put in.

What is the Enterprise Investment Scheme?

The Enterprise Investment Scheme, often abbreviated to EIS, is a government sponsored early-stage investing incentive launched in 1994.

It’s commonly noted that one of the best ways to rapidly increase wealth is to invest in early-stage high growth companies, such as those found on the FTSE AIM market, with the hopes of benefitting from share price rises. For context, even Apple was a penny stock once upon a time.

However, investing in early-stage companies is speculative and therefore highly risky, even more so in non-listed private businesses. To incentivize private investors to back these types of companies, many qualify for the Enterprise Investment Scheme, where investors can claim tax credits alongside investment returns, including upfront income tax relief, tax-free capital gains, and loss relief on investments that return less than put in.

For context, EIS companies are usually best suited to individuals who have already maxed out both their SIPP and ISA annual contributions. But with speculation swirling that the tax advantages of both could be cut in the next budget, EIS could become even more advantageous than at present.

EIS justification

The government is keen to encourage people to invest in early-stage companies because many will eventually grow large, create jobs, and stimulate the economy. Or from a purely mathematical perspective, your initial tax savings will be recouped by HMRC by the increased number of taxpayers as companies grow.

More than 31,000 businesses have directly benefitted from £22 billion of investment since the scheme began, and investing not only helps to grow individual wealth, but the country’s wealth as well.

EIS qualifying criteria

EIS hugely benefits smaller private companies as it allows them access to investment they might otherwise struggle to acquire. However, there are hard limits on which companies qualify; they must be trading businesses, and cannot be on any stock exchange except for, surprisingly, the AIM market.

Further, those companies in the following sectors are excluded entirely:

i. Dealing in land, property development and leasing

ii. Dealing in goods other than normal retail or wholesale distribution

iii. Dealing in financial instruments, banking, insurance, hire purchase, or money lending

iv. Receipt of royalties or licence fees

v. Legal and accounting services

vi. Farming, forestry, or market gardening

vii. Operating or managing hotels or residential care homes

viii. Coal production, steel production and shipbuilding

ix. All energy generation activities

It’s worth noting that this is not an exhaustive list, and decisions on qualification are ultimately at HMRC’s discretion. However, most companies ‘in the grey area’ can apply for ‘advance assurance’ from the taxman that they will likely qualify.

Knowledge Intensive Companies (KICs): special case

KICs are companies which consider research and development (R&D) as their core business activity. As this is even riskier, these types of companies are eligible for more EIS funding than standard.

However, there are strict rules when investing in KIC EIS:

i. The money invested must be used to buy new shares only

ii. There has to be a risk to capital, i.e., the investment can’t be artificially structured to be low risk

iii. Any funds raised must be used to deliver growth, not maintain pre-existing business expenditure

iv. The company can’t be trading for more than ten years or be controlled by another company.

v. It must be permanently established in the UK.

vi. There must be fewer than 250 employees in a standard EIS company, but this is increased to 500 for a KIC

vii. Gross assets cannot exceed £15 million before investment or £16 million after investment.

In addition:

i. Any funds generated must be used within 24 months.

ii. EIS companies cannot raise more than £5 million per annum (£12 million lifetime), or £10 million (£20 million lifetime) for KCIs

How to invest in EIS

Investors do have the option of researching single EIS-qualifying companies and then placing an investment themselves. However, the vast majority will delegate this work to a specialist manager, who invests pools of funds on behalf of multiple investors into a portfolio of promising companies.

There are numerous benefits to this second approach, including ongoing oversight of companies, the potential to influence decisions, and the expertise to know when best to take profits.

Confusingly, investment through managers can be either through an approved or unapproved fund.

Approved funds require 80% of funds to be invested in KICs within two years, while 50% of funds must be invested within 12 months of the fund closing, followed by an additional 40% within the next 12 months. However, tax reliefs can be claimed earlier, so investors should balance the restrictions with the benefits. Your fund manager will be able to run through this with you.

EIS advantages in brief

There are plenty of advantages to EIS investing, including but not limited to:

i. Investing at the very start of the growth journey

ii. Tax relief, including loss relief not available elsewhere

iii. Investing in future themes; think streaming or EVs before they went mainstream

iv. Portfolio diversification, with a higher risk-reward ratio based on future-based theme investing

v. Complements ISAs and SIPPs, both in terms of tax advantages and risks

vi. Complex tax planning advantages for high-net-worth individuals

vii. Supports the UK economy through innovation, a chance to ‘give back’ and simultaneously see returns

EIS setbacks to consider

However, for balance there are plenty of drawbacks:

i. EIS-qualifying companies are unpredictable and typically high-risk

ii. Investments are volatile, rising and falling in value faster than larger companies

iii. Tax reliefs could change in the future, even mid-investment

iv. EIS companies can lose their EIS-qualifying status, and you may be asked to repay tax reliefs

v. It’s harder to exit; it’s much harder to sell shares and the minimum holding period is three years

Tax advantages summarised: income tax, capital gains, and inheritance

For an overview on these personal taxes, please click here.

UK tax-paying investors benefit from a number of tax reliefs when investing in EIS-qualifying companies.

Income tax relief can be as high as 30%; and the maximum investment that relief can be claimed on annually is £1 million, leaving investors with a potential £300,000 income tax relief per year. For clarity, investors get this relief in the tax year that their money is invested, which can be different to the year the investment is made into an EIS fund because of the time it takes your specialist manager to allocate capital. This is a key point often missed.

Investors in unapproved EIS funds can treat the investment as though it was made in the prior tax year, granting a tax planning advantage. Newcomers can therefore invest up to £2 million in their first year. Again, the company must remain EIS-qualifying for three years after an investment is placed, or HMRC will request some or all qualifying tax relief back. But it is possible to reduce one’s income tax bill to zero with the correct planning.

Tax-free growth

Similar to the better-known ISA, any growth in value from an investment from EIS shares is completely tax-free; a significant benefit as early-stage companies have the propensity to grow quickly. To qualify for this relief, income tax relief must have been claimed and not withdrawn at any stage by HMRC, while investors must hold their shares for at least three years, during which time the company must remain EIS-qualified.

Notably, the maximum amount investable rises to £2 million per tax year as long at least £1 million is invested in KICs.

EIS investors also benefit from capital gains deferral, where a gain made on the sale of other assets can be reinvested into EIS shares and deferred over the life of the investment, with no upper limit to the gains that can be deferred.

Importantly, only the gain can be deferred, not the proceeds of sale. As an example, an asset bought for £20,000 and sold for £100,000 would see a gain of £80,000 that can be reinvested into EIS shares to defer paying CGT.

To defer the gain, the reinvestment into EIS shares must be made no earlier than 12 months prior to, or three years after, the original gain was made. The gain will then be deferred until either the EIS shares are sold, or the EIS company ceases to remain qualified within three years of investment, or the investor ceases to be a UK resident within three years of investment.

When the deferred gain become chargeable, it’s subject to the capital gains rate of the most recent tax year. However, it can in theory be deferred forever, as investors can reinvest into new EIS companies, and continue to do so until death as the gain then becomes non-chargeable.

EIS shares also qualify for Business Property Relief, meaning they are exempt from inheritance tax and do not count towards the threshold when calculating an investor’s estate after death. However, the caveat is that they must have been held for a minimum of two years prior.

Loss relief

As previously noted, EIS companies are early-stage and high risk, so the chance of seeing shares fall in value remains relatively high. Loss relief on individual EIS shares is designed to soften the blow of investor losses, which surprisingly, remains the case even if an investor holds a portfolio which has seen an overall gain.

Therefore, if the value of an individual EIS company’s shares falls to nothing, or if they are sold for less than the original investment amount, the investor can offset this loss against either their capital gains or income tax bill.

Available loss relief is equivalent to the sale of EIS shares proceeds received, minus their ‘effective cost.’ For example, a £100,000 investment into EIS shares would usually benefit from a £30,000

upfront income tax relief, making the ‘effective cost’ and therefore available loss relief to the investor £70,000.

This rule exists to stop investors from benefiting from two tax advantages on the same cash.

Claiming loss relief against income tax is fairly simple; investors deduct the loss from the investor’s income before income tax is calculated, and they can choose to do this in the current or former tax year. The value of the relief is calculated by multiplying the value of the ‘effective loss’ by their marginal tax rate, and is therefore most valuable to additional rate taxpayers.

Alternatively, investors can offset their loss against their capital gains tax, but only for the current tax year. However, if the loss exceeds capital gains in the current tax year, it can be carried forward into future tax year. Similarly, the loss is deducted from capital gains before CGT is calculated, and the value is affected by an investor’s marginal capital gains tax rate.

Special case: If EIS shares fall to zero (or near zero), investors can make a ‘negligible value claim’ by informing HMRC that the shares are essentially worthless. HMRC will treat the shares as having been sold in a process called ‘deemed disposal,’ making it possible to claim loss relief. And if the shares do become profitable again, the proceeds then become subject to CGT.

Married couples and other beneficiaries

The rules surrounding the tax treatment of EIS companies regarding the transfer of shares to your spouse, any other beneficiaries, or indeed inheritors are extremely complex. However, it is worth noting that non-married co-habiting individuals are treated by HMRC as singles (regardless of whether this may be considered fair).

It is highly recommended to seek professional financial advice to consider any and all tax implications of transferring ownership of EIS assets.

Final notes

If you are considering using EIS, consulting your accountant and then a qualified financial adviser should be your first step. Investors should carefully consider their own risk appetite and long-term investment goals, and in particular take care not to let the tax tail wag the investment dog.

EIS companies can — and often do — fall to zero value. Further, companies can cease to be EIS-qualifying within the mandatory three-year period, making all relief payable back to HMRC. And tax rules are subject to change, even retrospectively.

Choosing the right IFA or investment manager can be difficult; check their track record (though past performance provides no guarantee of future success), any fees charged, and check there will be several investment exit opportunities as your EIS companies grow. Some can take over a decade to allow investors to withdraw their profits, occasionally without giving any prior warning.

Remember, these hugely advantageous tax incentives exist because the government wants you to invest in speculative UK-based companies. But EIS is complex, and you are strongly encouraged to seek suitable financial advice before making the decision to invest.