Article by Rebecca Cave, a freelance writer, regarding the use of the enterprise investment scheme as a tool to help small companies attract new equity investment. The article was published in the November 2002 issue of Tax Adviser. KEY POINTS
- The tax adviser must fully understand the proposed trade.
- EIS relief will be clawed back if non-qualifying subsidiaries are acquired.
- Informal clearance should be applied for.
- EIS relief will not be granted if the company has plans to cease trading at any time in the future.
The enterprise investment scheme (EIS) is an increasingly popular tool to help small companies attract new equity investment. Most savvy investors will not commit funds to an unknown enterprise without some assurance that EIS tax relief will be forthcoming. Unfortunately there are many potential traps that can mean the EIS tax relief is either not granted or is withdrawn with retrospective effect. This article examines the difficulties surrounding the company’s trade.
Which trades qualify?
Most trades qualify. Legislation specifies areas of trade that will not qualify if the company undertakes the listed activity to a substantial extent, Income and Corporation Taxes Act 1988 (ICTA 1988), s. 297(2). It is essential that the company’s adviser fully understands the proposed trade so he can explain it in detail to the Inspector of Taxes when required. Questions about the company’s trade will be raised following an application for informal advance clearance and can arise again when the company submits its annual accounts. The Inspector will not be restrained by the view of business presented at the time of the EIS application if later transactions cast the earlier activities in a new light.
The percentage of an activity that is ‘substantial’ is not defined in the EIS legislation, but according to the Financial Secretary to the Treasury at the committee stage of the Finance Bill 1986 (then discussing the business expansion scheme (BES) legislation), this was taken to mean about 20 per cent of the trade, (House of Commons Standing Committee, 17 July 1986, Col. 1268). This has generally been the figure that the Revenue will accept as the boundary between a minority activity and a significant one, although each case should be examined on its own merits.
The question of which item in the profit and loss account or balance sheet should be examined for the 20 per cent measure has not been resolved. An Inspector will generally look at the income produced by the different activities, but if the trade has not yet commenced it may be more appropriate to examine the value of assets, stock, or the numbers of staff to be employed.
Trade must be wholly or mainly in the UK
The company’s qualifying trade must be carried on wholly or mainly in the United Kingdom (UK) for at least three years following the issue of the EIS shares or commencement of the trade, which ever is the later. Guidance as to the meaning of trading mainly in the UK is given in the Inland Revenue Statement of Practice (SP) 03/00. This statement covers the four ‘enterprise’ schemes which can be applied to small and medium sized companies: EIS, Venture Capital Trust (VCT), Corporate Venturing Scheme (CVS) and the Enterprise Management Incentive scheme.
Essentially at least half the trade must be conducted in the UK, however the location of the trade does not depend solely on the location of the customers, or the source of raw materials. To determine where the trade is conducted the Inspector should consider the other constituents of the company’s set-up, such as where the assets are held, where the company’s employees and selling agents are engaged and the location of the activities giving rise to any services provided. Although the trade must be conducted wholly or mainly in the UK, the company may be resident outside the UK and still qualify under the EIS scheme. The UK does not include the Isle of Man or the Channel Islands.
The qualifying trade must be conducted on a commercial basis with a view to the realisation of profits, (ICTA 1988, s. 297(8)). This does not mean that a profit has to be made, but it must be possible to show that there is an intention to make a profit at sometime in the future. This future point can be a distant one and can certainly lie beyond the three-year period, (see Revenue Inspectors Manual para. 3375).
A software development company may receive informal clearance to issue EIS shares although the business plan shows that sales will not exceed costs until the start of the fourth year.
Trade in a subsidiary
The money raised by the issue of EIS shares must be used in the company that issued the shares or in a subsidiary that existed on the date of the share issue, (ICTA 1988, s. 289(2)). So when the EIS money is used to buy another trading company the newly acquired trade must be hived up as soon as is practically possible. The Revenue guidance says the trade should be hived up ‘almost immediately’ which could mean - depending on the mood of the Inspector - anytime between seven days and six months. If it is known that the trade transfer will be delayed for a short period this fact should be included in the informal clearance application, (see below).
If the qualifying trade is to be conducted in a subsidiary that subsidiary must be at least 90 per cent owned by the holding company, (ICTA 1988, s. 289(1A)). The holding company can hold between 75 per cent and 90 per cent of other subsidiaries, as these will be qualifying subsidiaries under ICTA 1988, s. 293(3), but the EIS money must not be used for the trades of those subsidiaries.
If the holding company holds shares in other companies that represent a 50 per cent interest or less, those holdings are regarded as investments. Such investments can endanger the requirement for the EIS company to ‘exist wholly for the purpose of carrying on one or more qualifying trades’, (ICTA 1988, s. 293(2)). If the value of the investments is significant the holding company will cease to be a wholly trading company.
It is essential to monitor the operations of the EIS company throughout the relevant three-year period from issue of the EIS shares or the start of the trade. If during this time the EIS holding company acquires subsidiaries in which has a holding of between 51per cent and 74.99 per cent, the EIS relief will be clawed back, as those subsidiaries will not be qualifying subsidiaries.
Preparing to trade
On the day the EIS shares are issued the company must either be:
- preparing to carry on a qualifying trade;
- undertaking research and development (R&D), or will immediately start R&D which will lead to a qualifying trade; or
- already carrying out a qualifying trade.
The Revenue believe that preparing to carry out a trade means laying the ground for a specifically envisaged trade, and not exploring markets for various trading opportunities. They also make the distinction between preparing to carry on a trade and undertaking R&D to create a new trade. In practice these two activities, if they are separate functions, are carried on side-by-side. This division can lead the Revenue to require two separate EIS issues to fund the two separate qualifying activities, which is an unhelpful approach for a small company.
There is in fact no bar to the EIS company performing R&D work on behalf of other organisations, as a qualifying trade. As long as the relationship between the EIS company and its customers is not such that one group of associated people control both businesses, and the customer carries on a non-qualifying trade, (ICTA 1988, s. 297(2)(g)). This restriction does not prevent a subsidiary providing services to its parent company.
Starting to trade
The date on which the company starts trading is important as there must be four complete months of trading, or R&D work, before the Inspector will approve the form EIS 1. Only after the form EIS 1 is approved can certificates be issued to the EIS investors allowing them to claim their income tax or capital gains tax (CGT) deferral relief.
Normally trading will be treated as starting from the date of the first sale, or when the company is a position to start selling or producing finished goods. The Inspector will be on the look out for artificial ‘seeding’ where token transactions are made with people known to the directors to bring forward the start of the trade.
Before issuing EIS shares the company should seek an informal clearance from the Inland Revenue Small Companies Enterprise Centre that the share issue will qualify under the scheme. The description of the company’s intended trade is vital for this clearance as it must be crystal clear to the Inspector that 80 per cent or more of the trade is not comprised of activities listed in ICTA 1988, s. 297(2). If the trade appears to be fringes of the trade areas listed in s. 297 the Inspector will ask a number of detailed questions. This process should be viewed as a useful safety-net for the company and its investors, as if it is found at a later stage that the trade does not qualify it will be too late, the investors will have committed their money with no tax relief to show for it.
All the documentation surrounding the issue of the EIS shares must agree as to the nature and definition of the trade, as any discrepancies may be hard to explain away. The relevant documents will include:
- the company’s business plan;
- share offer documents;
- subscription agreements for the EIS share issue;
- shareholders agreement;
- the company’s articles of association;
- warranties and indemnities given in connection with the investments made;
- board minutes; and
- publicity material, including websites and adverts in the yellow pages.
Ceasing to trade
The company must continue to trade for three years to keep the initial income tax relief on the EIS shares. If the company ceases trading during that time the income tax relief is lost completely, which also means that the shares do not have CGT exemption on disposal. However any CGT deferred on the EIS subscription is permitted because the company did commence trading, but is withdrawn in the tax year the income tax relief conditions are broken. Thus CGT deferral is achieved for the period from the issue of the EIS shares to the cessation of trading.
The company can be wound up or dissolved without breaking the tax relief conditions (ICTA 1988, s. 293(6)). However if a capital distribution is made to the shareholders the EIS income tax relief will be reduced and any CGT deferred crystallised, as the distribution will represent return of value to the investors.
Any arrangements which are in place for the company to cease its qualifying trade will prevent EIS relief from being granted, even if the cessation is planned for a date well after the three-year relevant period.
Tax Practitioners advising a company planning to issue EIS shares should be prepared to analyse and monitor its trade from the point of application to at least three years from the commencement of the trade. Anything less will risk the EIS reliefs being withdrawn and Professional Indemnity insurance (PI) claims landing on the doorstep.
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November 2002 by