Tax reliefs offered by enterprise investment schemes
13 September 2021
13 September 2021
Niki Patel, Technical Connection
In this article we consider Enterprise Investment Schemes and look over what tax reliefs are available.
Enterprise Investment Schemes (EISs) were introduced by the Government to encourage investment into smaller companies – usually those in the early stages of establishing their business.
An EIS is designed for these companies to raise money to help grow their business. It does this by offering tax reliefs to individual investors who buy new ordinary shares in these companies.
In order to qualify as an EIS a number of conditions must be satisfied. However, for the purposes of this article I mainly focus on the tax reliefs available to individual investors.
So, what tax reliefs are available?
Investing in new ordinary EIS shares entitles the investor to the following:
- Income tax relief at 30% on the amount invested, subject to a maximum of £1,000,000 (this limit is increased to £2,000,000 if at least the second £1,000,000 is invested in Knowledge Intensive Companies);
- Loss-relief where the investor incurs a loss;
- Defer capital gains tax (CGT) on a capital gain (known as deferral relief);
- Tax-free growth (known as disposal relief);
- EIS shares held for at least two years can attract inheritance tax (IHT) business relief.
Let’s move on to look at each one in a bit more detail.
Income tax relief
Investors can claim 30% income tax relief on EIS investments. This means that if someone invests £1,000,000 in a tax year, they can claim income tax relief of £300,000 in the tax year in which the funds are invested. However, it is possible to treat an investment as if it were made in the previous tax year and benefit from income tax relief against the income tax liability in that previous tax year.
It is important to note that income tax relief is applied against the investors’ income tax liability. This means that the relief can only reduce the investor’s liability to nil – therefore it is not possible to reclaim any unpaid tax from HMRC.
Where an investor makes a loss on their EIS shares, loss relief allows them to offset the loss against their income for the current or previous tax year or against their capital gains for the current or future tax years.
To qualify for loss relief the value of an investment when it is sold has to have fallen below what is referred to as the effective cost. This is the amount invested less the income tax relief claimed. For example, if £50,000 was invested and £15,000 income tax relief was claimed, the effective cost of that investment would be £35,000.
If the effective cost is £35,000 and the shares are sold for £25,000, the effective loss is £10,000. So, for a higher rate taxpayer, if loss relief is claimed against income, the amount of income tax that could be saved/reclaimed is £4,000, (£10,000 @40%) or if loss relief is claimed against capital gains, the amount of CGT that could be saved is £2,000 (£10,000 @ 20%).
It is possible to defer CGT on a capital gain (known as deferral relief) made on any asset provided the investment into the EIS is made up to one year before making the capital gain or three years after.
For the purposes of deferral relief, it’s the capital gain not the proceeds of sale that should be invested.
The gain will be deferred until the earlier of any of the following events:
- The EIS shares are sold (otherwise than to a spouse/civil partner);
- The company ceases to qualify within three years of investment;
- The investor ceases to be a UK resident within three years of investment (unless it is because of working temporarily abroad and the investor becomes resident in the UK within three years of leaving and still holds the shares on their return).
When the deferred gain comes back into charge, it will be subject to the CGT rate which is relevant at that time, although it is possible to further defer the capital gain by reinvesting into a new EIS-qualifying investment. If, however, the investor still owns the EIS shares upon death, the deferred gain will be eliminated.
Provided the shares are held for at least three years there would be no CGT tax payable if the shares are sold for more than what the investor paid for them provided the investor had received income tax relief on the original investment and none of this relief had been withdrawn. This means the income tax relief must have been claimed and the company must remain EIS qualifying for at least three years.
Provided the investor has held (or is deemed to have held) the shares for at least two years, the value of those shares should benefit from business relief at 100%, which effectively means the value of shares will be free of IHT on death. Note that even if the EIS company loses its qualifying status, provided it remains an unquoted trading company, that is carried on for profit (and is not one of "wholly or mainly" dealing in securities, stocks or shares, land or buildings or in the making or holding of investments), the shares can still qualify for IHT business relief.
Frederick is an investment banker and earns £150,000. He has recently sold a portfolio of stocks and shares and incurred a capital gain of £180,000.
Given Frederick’s earnings, he would lose full entitlement to his personal allowance. As a reminder the personal allowance is reduced by £1 for every £2 once total income exceeds £100,000. This means that for the current tax year the personal allowance is fully lost once total income is in excess of £125,140.
With regard to the capital gain, the whole amount after taking account of his CGT annual exemption (AE) of £12,300 - i.e. £180,000 – £12,300 = £167,700 - would be taxable at the CGT higher rate, so 20%.
Frederick’s tax position is therefore as follows:
£37,700 x 20% £7,540
£112,300 x 40% £44,920
Capital gain £180,000
less AE (£12,300)
£167,700 x 20% £33,540
Total tax = £86,000
Frederick is looking for ways in which he can carry out some planning in order to reduce the amount of tax payable.
After seeking some advice, Frederick decides to subscribe for new ordinary shares in an EIS as he is aware that this type of investment would enable him to defer his capital gain and also benefit from income tax relief against his tax liability.
Frederick decides to use his annual exemption and defer his taxable capital gain of £167,700 into an EIS.
Frederick’s revised tax position is therefore as follows:
£37,700 x 20% £7,540
£112,300 x 40% £44,920
tax relief at 30% *(£50,310)
*£167,700 x 30%
Total tax = £2,150
Had Frederick deferred his whole capital gain he would have benefitted from income tax relief of £54,000 (i.e. £180,000 x 30%). However, as mentioned above, he can only benefit from income tax relief based on his actual tax liability which is £52,460.
The company must remain qualifying and Frederick has to hold the shares for at least three years otherwise the income tax relief would be withdrawn.
Ordinarily, on future sale of the EIS shares, Frederick’s deferred gain would come into charge, whereas if he retains the shares until death the deferred gain is fully eliminated. And, provided the company is still a qualifying trading company, under current legislation the shares will qualify for 100% business relief and thus be free of IHT.
This article provides a broad overview of the various tax reliefs available. However, given that investment is being made into smaller, often new companies, EIS investment does carry its risks, so it is vital for clients to fully understand the risks involved as well as the benefits prior to making such investment decisions.
The Financial Services Compensation Scheme (FSCS) and Financial Conduct Authority (FCA) have recently provided confirmation that it is possible for investors in EIS Funds to make compensation claims on the FSCS in the event of the failure of the FCA authorised firm managing that fund, should the fund manager go into default. However, it should be remembered that the FSCS is not a protection against poor investment performance.
This document is believed to be accurate but is not intended as a basis of knowledge upon which advice can be given. Neither the author (personal or corporate), the CII group, local institute or Society, or any of the officers or employees of those organisations accept any responsibility for any loss occasioned to any person acting or refraining from action as a result of the data or opinions included in this material. Opinions expressed are those of the author or authors and not necessarily those of the CII group, local institutes, or Societies.