Enterprise Investment Scheme Tax Relief – Worth the Risk?

What is the Enterprise Investment Scheme (EIS)?

The Enterprise Investment Scheme was brought in by the UK government in 1994 to help stimulate business growth and the economy following the recession of the early 1990s. 

It is a scheme that provides tax benefits to individual investors who support early-stage businesses through the purchase of new shares. 

Those EIS tax reliefs make a young company a more attractive investment opportunity to investors, allowing it to raise funds and potentially grow its business. 

Through the EIS scheme, a business is able to raise up to £12 million across its lifetime but no more than £5 million per year. 

Important Note: Those limits are not in place solely for EIS investments. They’re combined limits, meaning the maximum investment a company can raise from any and all venture capital schemes combined. 

For investors, a successful investment is doubly rewarded. In addition to making gains from the investment in an EIS-qualifying company, they can look forward to significant tax treatment. 

Those EIS tax reliefs are:

• Income Tax Relief
• Capital Gains Tax Relief
• Capital Gains Deferral
• Loss Relief
• Inheritance Tax Relief

A Detailed Look at the EIS Tax Reliefs

Let’s break down those EIS reliefs in full:

Income Tax Relief

The EIS relief that catches investors’ eyes before any other is the income tax relief the government allows on an investment. That’s not a surprise when you learn up to 30% can be shaved off an income tax bill. 

Investments in EIS-qualifying companies allow you to claim up to 30% income tax relief. The maximum relief in a tax year is £300,000 on a £1,000,000 investment. However, that increases to £600,000 on a £2,000,000 investment if the additional amount is directed toward knowledge intensive companies.

To qualify, the company must maintain its EIS-qualifying status for at least three years, and you must hold the investment for the same period to retain the tax relief.

Capital Gains Tax

Investors will know that most investments are subject to capital gains tax, which is 10% or 20% depending on your tax band when making gains on your investments. That’s quite the chunk as we’re sure you’d agree.

However, EIS investments offer capital gains tax disposal relief as an incentive. If you hold your EIS shares for at least three years, any profits from their sale are exempt from capital gains tax.

To put that into perspective, should you make gains of £100,000 when selling your EIS-qualifying shares, you could save up to £20,000 through CGT exemption. Just note that CGT only applies to your gains minus the income tax relief you’ve already received via the scheme. 

Capital Gains Deferral

The Enterprise Investment Scheme may also prove attractive to those who have sold other assets and want to avoid paying capital gains tax.

You can defer capital gains tax by reinvesting gains from the sale of an asset into an EIS-qualifying company, with no upper limit on the amount. To qualify, reinvest within three years of the gain. Only the gain itself, not the total sale proceeds, needs to be reinvested.

Loss Relief

Investing in smaller or early-stage businesses carries higher risks than investing in established companies. That’s logical, considering they’re yet to establish themselves and face stiff competition. If the company fails, your investment is gone. 

To help mitigate these risks, EIS offers tax relief. If you sell EIS shares at a loss, the loss can be offset against your income tax for the sale year or the previous tax year. Even if your overall EIS portfolio performs well, you can still claim tax relief on losses from individual investments.

Inheritance Tax Relief

Inheritance tax relief is the least discussed of all EIS relief, simply because it will not impact investors directly. It will affect their beneficiaries, however, and quite substantially.

The UK inheritance tax rate is 40%, which means almost half of your wealth and assets will not go to your loved ones. That makes the inheritance tax relief offered through the EIS investment scheme attractive to anyone who is planning for the worst and wants their beneficiaries to receive tax-free inheritances. 

The inheritance tax relief only applies to qualifying investors who have held their EIS shares for at least two years at the time of their passing. 

What are the Rules for EIS investors?

To qualify for EIS tax reliefs, investors must meet the following criteria:

• Be over 18 and pay income tax in the UK.
• Hold the EIS shares for at least three years.
• Own no more than 30% of the company’s shares.
• Not be employed by the company unless serving as a director.
• Use the scheme for genuine reasons – not as a way to avoid paying tax. 
• Receive no benefits from the company beyond their return on investment.

What Companies are Eligible for the Enterprise Investment Scheme?

There are some very specific rules to which companies must adhere if they wish to become an EIS-qualifying company and potentially attract the investment they desire.

The key rules for stage businesses are:

• Must not be listed on the London Stock Exchange or any other recognised stock exchange.
• Cannot be controlled by another company.
• Must not control subsidiaries that fail to meet EIS qualifications. Subsidiaries should be majority-owned by the parent company (over 50%), and if EIS funds are used, ownership must increase to at least 90%, including property management subsidiaries.
• Gross assets must not exceed £15 million before issuing EIS shares or £16 million immediately after.
• Must employ fewer than 250 full-time staff (or equivalent) when shares are issued.
• Must have a permanent establishment in the UK.
• Cannot raise more than £5 million in state aid risk finance, including EIS, within a 12-month period or £12 million in total.
• Must not have been trading for over seven years before securing its first EIS funding.

It is important to note that EIS-qualifying companies must adhere to those rules throughout the three-year EIS qualifying period, not just prior to investment. 

If the company breaks these rules at any point, it is bad news for the investor. In short, the tax benefits they signed up for as part of the EIS scheme could be revoked. 

Important Note: There is another status given to certain companies within the EIS scheme that allows them to raise more funds than regular businesses. Called knowledge intensive companies (KIC), they have a different set of criteria to adhere to when applying for the Enterprise Investment Scheme.

What is a Knowledge Intensive Company?

In short, a knowledge intensive company performs critical research, innovation, or development that could significantly impact the planet or mankind. An example would be a company researching a ground-breaking cure or treatment for a medical condition.

For the EIS scheme, it’s also defined by the following:

• Employs fewer than 500 people at the time of the share issuance.
• Will be engaged in activities that create intellectual property expected to drive the majority of the business over the next ten years.
• Has at least 20% of employees involved in research for a minimum of three years post-investment, with those employees holding a relevant Master’s degree or higher.

Companies classified as Knowledge Intensive Companies (KICs) are eligible for enhanced funding through the EIS scheme. They can raise up to a yearly limit of £10 million and a lifetime cap of £20 million, compared to the £12 million cap for other EIS businesses.

Investors can also support a KIC with additional investment. They can invest up to £2 million annually, which is double what is allowed when investing in regular EIS companies. With that increased EIS-qualifying investment, investors could claim income tax relief worth up to £600,000 per year if they invest the maximum amount. 

Are There Alternatives to EIS?

Yes, while they differ, you can make similar investments via the following:

• Seed Enterprise Investment Scheme (SEIS)
• Venture Capital Trusts (VCT)
• Social Investment Tax Relief (SITR)

As with EIS, make sure you seek professional advice before investing using any of the above.

How do you Invest in the Enterprise Investment Scheme?

Identify EIS-Qualifying Companies

The first step in your journey as an EIS investor is to identify an EIS-qualifying company. Our tip is to look for an SME that aligns with your interests or expertise. Many companies highlight their EIS eligibility in their investment pitches, making it easier to spot suitable opportunities.

Conduct Due Diligence

Don’t just leave it there. Even if you have a good feeling about a company or it piques your interest, you shouldn’t skip out on doing your homework. Conducting due diligence is a crucial step when investing through the EIS. Start by reviewing the company’s business plan to ensure it outlines clear objectives and realistic growth strategies.

Next, it’s time to assess the company’s leadership. Does it have the necessary experience and track record that suggests it could lead the company through consistent growth?

Finally, you should review the company’s finances to understand its current position and its prospects for the future. Also, make sure you’ve evaluated the competition to see how the company stacks up. 

Make Your Investment and Claim Your EIS3 Certificate

Making your investment through the EIS involves a straightforward process. You’ll need to purchase the newly issued company shares upfront and in cash. 

After your investment, the company will provide you with an EIS3 certificate, a crucial document that confirms your eligibility for tax relief.

Keep this certificate safe, as you’ll need it to claim your tax benefits when completing your self-assessment tax return. Make sure to hold the shares for at least three years to retain the tax relief and maximize the scheme’s benefits.

Monitor Your Investment

With your EIS investment made and your EIS3 certificate received, the only thing left to do is monitor your investment.

Stay updated on the performance of the company and keep a close eye to ensure it is continuing to comply with EIS rules. Remember, you could lose your EIS tax reliefs should the company fall foul of those rulings. 

Plan and Execute Your Exit

There will come a time when you’ll decide to sell your EIS shares. Hopefully, this is when there have been substantial gains, and you want to realise your EIS tax reliefs in full. 

If you’ve held the EIS shares for at least three years, you’ll benefit from the 30% income tax relief, and your gains will be exempt from capital gains tax. 

Make sure to keep track of any documentation required for tax reporting and consult a tax professional to ensure you’re following the necessary procedures. 

If you sell at a loss, you may be eligible for loss relief, which could help offset other taxable income. 

Exiting your investment correctly and timely ensures you take full advantage of the tax benefits available through the EIS scheme.