EIS And SEIS – There’s Many A Slip!

The enterprise investment scheme (EIS) and seed enterprise investment scheme (SEIS) both offer generous tax reliefs, but the legislation is complex and contains many pitfalls for the unwary. This article attempts to resolve some of the technical and practical difficulties which may be encountered in securing tax relief. 

 

Where to get more information on EIS and SEIS rules

This article does not attempt to explain the rules for EIS and SEIS in any detail. The income tax rules are contained in ITA 2007, Pt 5 and 5A (ss 156-257 and 257A-257HJ). That’s roughly 200 sections in all. TCGA 1992, ss 150A-G provide for exemption from capital gains tax (CGT) on disposal of EIS/SEIS shares held (normally) for three years, allowance for losses on EIS/SEIS investments, and reduction of relief where value is received; while TCGA 1992, Schs 5B and 5BB provide detailed rules, including deferral relief for EIS investments. 

 

We are therefore talking about a considerable body of legislation, and even after dealing with a number of (successful) EIS/SEIS applications, my watchword is to take nothing for granted. 

 

One of the main problem areas is the process of the issue of EIS/SEIS shares. A requirement of both schemes is that the shares must be ordinary shares which are:

 

a) subscribed for in cash, and 

b) fully paid up at the time of issue.

 

Shares are normally regarded as ‘issued’ when they are registered in the company’s register of members (National Westminster Bank plc v CIR, [1994] STC 580). The second requirement is unlikely to be met if the shares are issued before payment is received, so this is a definite ‘no-no’. The case Blackburn & Anor v Revenue and Customs Commissioners [2009] STC 188 concerned EIS CGT deferral relief in respect of a series of investments in the same company. Although payment for some shares was received after they had been registered in the register of members, the Court of Appeal accepted that the issue of the shares was conditional upon payment being received and that the shares were issued fully-paid. HMRC regard the decision as distinguished on its own facts: in other words, ‘don’t try this at home’. 

 

The issue of shares after payment is received is also not without difficulty. The payment may give rise to a debt owed to the investor until the shares are issued. Payment by capitalisation of an existing debt does not count as a cash subscription. Moreover, repayment of the debt followed by a cash subscription would be regarded as ‘value received’ by the investor and relief would again be denied. 

 

For EIS/SEIS purposes, the company must be a trading company which must carry on (or be preparing to carry on) a ‘qualifying trade’ (ITA 2007, s 181). Certain trades are excluded as listed at s 192. Any kind of financial or property-based trade is probably excluded, such as dealing in land, commodities, shares; banking and insurance; leasing or receipt of royalties; provision of accountancy or legal services; property development. Other excluded activities which are considered land-based include hotels, nursing/residential homes, farming and forestry. The legislation (s 192(1)(f)) also excludes shares in any company which supplies its services to a company carrying on any of the excluded activities where both companies are (broadly) under common control (for definitions, see s 199).

 

As noted, the money raised by an issue of EIS shares must be ‘employed’, for the purposes of the trade, normally within two years of the issue of the shares. For SEIS the period is extended to three years, but the legislation (s 257CC) refers to money being ‘spent’, which may be slightly different. In Skye Inns Ltd & Anor  v HMRC [2011] STC 174), the tribunal recognised that money which is earmarked and reserved for a specific purpose may be regarded as employed in some circumstances (though not in those of the case). In many cases, it will be clear-cut whether the money subscribed has been employed or spent, but when the company starts to generate income it might be difficult to show that the subscription monies have been spent, especially if funds are mixed. A separate bank account for the subscription monies should therefore be set up and the use of the funds closely monitored.

 

For the purposes of both EIS and SEIS, there must not be any pre-arranged exit (s 177; s 257CD), and so while the directors will naturally wish to make the investment attractive to investors it is important that there can be no prior formal arrangement to purchase the shares, sell the company, etc. A shareholders’ agreement will usually be put in place, which needs to be carefully examined for any provision which gives the appearance of a pre-arranged exit. 

 

There are various more or less absolute qualifying tests for EIS/SEIS income tax relief, categorised under ‘Investor’, ‘General requirements’ and ‘The issuing company’. Additionally, there may be a withdrawal or reduction of relief (for income tax and CGT purposes) where ‘value’ is received by the investor, though this may be ameliorated by the investor giving ‘replacement value’ to the company. One particular area where care is needed, which was touched upon earlier, concerns debt. Not only is the investor regarded as receiving value where the company makes a loan to the investor (as one would expect) but also where a debt owed to the investor, other than one incurred after the issue of the shares, is repaid.

 

In general, any payment to an investor may potentially be regarded as a return of value, but an exclusion is made under each code for dividends which do not exceed a ‘normal return’ on the investment. EIS/SEIS investments are by their nature high risk, and since there can be no guaranteed exit, it could be argued that any amount of dividends up to the level of the available reserves may be justified. What is certain, however, is that the funds raised by the share issue cannot be used to pay dividends, as this is not regarded as employed for the purposes of the trade (Forthright (Wales) v Davies [2004] STC 875. 

 

The advance assurance (AA) procedure for EIS/SEIS investments is obviously useful in order to attract investors. Applications must now be made online. If positive assurance is given, then this will be followed by the compliance statement (i.e. certifying that the requirements for EIS/SEIS relief are met), also made on-line. It is advisable to provide as full information as possible, and while for a new company accounts will not be available, a copy of the company’s memorandum and articles of association, copies of a business plan and any subscription/shareholders’ agreement will be helpful. 

 

An application for AA covers both schemes. An SEIS share issue cannot be made after an EIS issue and it is a requirement (of s 257ED) that, for SEIS purposes, a compliance statement may not be made before 70% of the money raised has been spent or four months from commencement of the trade. For EIS, the legislation (s 173B) required that 70% of the SEIS monies had to be spent before EIS shares could be issued, but this was repealed (by F(No 2)A 2015, Sch 5, para 9) with effect from 6 April 2015. However, it is important to remember that relief attaches to an issue of shares. It is not possible, for example, to claim SEIS relief up to the maximum individual investment limit of £150,000, and EIS relief for any balance. It is also necessary that the company has traded for four months before an EIS compliance statement may be made. 

 

• When issuing EIS/SEIS shares, it is probably safest for a solicitor to hold the subscription monies in escrow and to release the funds to the company’s bank account when the company is ready to issue shares, and for the shares to be issued (i.e. registered) as soon as receipt is confirmed. At any rate, the shares should be issued (see above) as soon as the money hits the bank account.
• If investment is raised under both schemes as noted, it is important to issue the SEIS shares first, and to separate the EIS investment by issuing the EIS shares a day later.