A NIGHTMARE SCRABBLE HAND?
N.B. This article is relevant for those taking exams in November 2016. Minor changes are to be made to the rules by F(2)B 2016.
For scrabble players this will be a difficult block of letter to play - unless you add 'S' to lots of other words. However, for those involved in tax they unscramble to become EIS and SEIS - Enterprise Investment Scheme and Seed Enterprise Investment Scheme - both important reliefs for companies trying to raise funds to build a business - and for investors who may wish to invest but are wary of the potential loss if the company fails.
Both topics are highly examinable at ATT (mainly Paper 1) and CTA (Awareness and Advisory Individuals) and are also important to understand in a practical environment to advise clients as to whether they are suitable for their needs. This article is written for those attempting their exams in 2016.
The Enterprise Investment Scheme (EIS) was introduced many years ago to assist companies that needed to raise funds for their business activities, and allowed an income tax deduction for the investors to reduce the net cost of their investment.
The Seed Enterprise Investment Scheme is effectively 'baby' EIS - aimed at smaller start up companies, which was really what EIS was for - but it was targeted too widely and so did not achieve what it was originally intended to.
There are a lot of conditions that have to be satisfied for either relief to be available including those relating to:
- the company and its activities
- which individuals are eligible (actually the legislation defines who is not eligible)
- the shares that are issued - must be newly issued, fully paid shares, and must be acquired for cash
- the time limits for the use of the funds
- monetary limits on the amount of the investment that can qualify and how much can be raised by a company under these schemes.
- There are also two sets of rules for each of the schemes - one for the income tax relief to apply, and the other for CGT.
So let's start with EIS.
Enterprise Investment Scheme Relief
The main legislation can be found in ITA 2007 Part 5 starting at s156.
S157 requires that:
- relevant shares are issued to the investor
- the investor must be a qualifying investor (Chptr 2)
- the general requirements as to purpose of the issue of the shares and the use of the money raised must be met (Chptr 3), and
- the issuing company is a qualifying company (Chptr 4)
As you can see there are a number of hurdles that must be met for the company and the investor for the relief to be available.
Providing the relevant conditions are met the individual investor can deduct 30% of the amount invested up to a maximum cost of shares = £1m. The maximum relief is therefore £300,000 (s158).
However, relief in any year cannot exceed the individual’s income tax liability for the year. So the EIS relief can reduce the liability to nil leaving the tax deducted at source on interest and salary repayable.
A claim for EIS relief must be made by the 5th anniversary of 31 January following the end of the tax year in which the shares are issued (s202). So for 2015/16 relief this would mean the claim would need to be made no later than 31 January 2022.
S158(4) – the taxpayer can specify that an investment made in one year should be recognised in the previous year, providing it does not take the deduction over the limit in that earlier year.
If any of the qualifying conditions relating to the individual or the company are breached within 3 years of the issue of the shares the relief may be clawed back.
No clawback occurs in two situations:
- On the death of the investor,
- The investor gifts their shares to their spouse or civil partner.
If the shares are gifted to someone other than the spouse/CP within the 3 year time window all the relief is clawed back.
Where the disposal is by way of a sale to a third party the amount of the clawback depends on whether the shares are sold at a profit or a loss.
When the shares are sold at a profit the relief originally given is withdrawn. If however, the sale is at a loss the clawback is based on the proceeds of sale and the rate of relief given on the original purchase.
In 2015/16 Matilda subscribes for £50,000 shares in a qualifying EIS scheme. Her IT liability for the year before deducting the relief is likely to be £14,000.
Matilda sells the shares 2 years later for: (1) £54,000 or (2) £36,000
In 2015/16 the computation will be:
(1) Sold for more than cost - relief withdrawn £14,000
(2) Sold for less than cost - relief withdrawn 28% x £36,000 £10,080
Capital Gains Tax
There are two elements to consider for CGT - the exemption on disposal and reinvestment relief.
Where shares in an EIS company are sold after three years any gain made on the disposal is exempt. However, if the sale is made at a loss, relief will be available for that loss in the normal way - the loss allowed is reduced by any income tax relief claimed and not withdrawn.
The capital loss can be relieved under s131 ITA 2007 against income of the year of the loss and/or the preceding tax year.
There is a 'Relief Cap' - s24A ITA 2007 usually means the loss deduction cannot exceed the higher of £50,000 and 25% of the individual's income for the year. However, this does not apply if the shares qualified for EIS relief, which was not withdrawn before the sale.
The second CGT relief is referred to as Reinvestment Relief(RIR). This allows gains made in the year the shares are acquired to be deferred until a later date.
The main rules for RIR can be found at TCGA 1992 Sch 5B.
Broadly, the relief allows any gains made to be deferred where the proceeds are invested in shares that qualify for EIS relief. The amount that can be deferred is the lowest of:
- the cost of the shares
- the gain on the disposal
- any amount specified by the taxpayer.
The ability to specify an amount allows a taxpayer to leave in charge an amount equal to the annual exemption, if there are no other gains in the year. This exempts the relevant part of the gain completely, the remainder that has been deferred will be brought into charge at some time in the future.
Unlike the income tax rules there is no limit on the amount that can be deferred.
In addition, there is a rule that prevents income tax relief where the investor is connected with the company (broadly owns more than 30% of the shares or works for the company). However, this rule does not apply for CGT RIR meaning gains may be deferred even where no income tax relief is available because the shareholder is connected to the company.
There are a number of conditions that must be satisfied before this relief is available. The main ones are:
- The individual must be resident in the UK at the time of the disposal
- They must be subscribing for shares in a qualifying EIS company.
- The EIS shares must be acquired within the twelve months before and three years after the disposal that created the gain being deferred (TCGA 1992 Sch 5B para 1(3)(a)).
The claim must be made within 5 years from 31 January after the end of the tax year in which the shares are issued.
The deferred gain becomes chargeable in a number of situations:
- When the EIS shares are sold.
Where the shares are sold more than three years after acquisition the gain on the disposal of the shares will be exempt but the deferred gain will still be chargeable.
- If the investor becomes non UK resident within 3 years of the share issue.
- The shares cease to be eligible - for example the company starts to undertake non-qualifying activities.
The deferred gain does not become chargeable if the investor gifts their shares to their spouse/CP.
If the deferred gain arises on a disposal that would have been eligible for Entrepreneurs' Relief the chargeable gain will also qualify (for disposals from 3 December 2014).
Using the legislation
As a tutor I am often asked 'Do I really need the legislation - wouldn't it just be easier to learn the rules?'
Given the copious rules and limits that apply, this topic provides a great demonstration as to why students should find their way round the legislation. Why learn all of these conditions etc when providing you know where you are looking in the legislation you can highlight the relevant parts and then look them up when you need them?
Further conditions for EIS that need to be understood include:
- Who is a qualifying investor?
- What type of shares would qualify?
- The size of the company and the nature of their activities?
These can all be found easily in the legislation and should be highlighted accordingly.
Seed Enterprise Investment Scheme (SEIS)
There are a number of similarities but also a number of differences between the scheme for SEIS and EIS.
The first is the size of the company - the limits are much smaller than under EIS (ITA 2007 s257D). In addition the company can only raise a maximum of £150,000 under the SEIS scheme - based on amounts raised in the three years preceding the date of the shares being issued (ITA 2007 s257DL).
Secondly, the maximum relief available to an individual is based on an investment of £100,000, with tax relief given at 50%. Again the relief cannot exceed the individual's IT liability for the year.
SEIS relief is not available to a company that has already raised funds under the EIS scheme.
A further difference relates to individuals who can qualify for the relief. Under EIS an existing director or employee of the company is not eligible however, for SEIS a director could qualify providing they do not own (or will own after the acquisition) more than 30% of the shares of the company.
For CGT the tax treatment of the SEIS shares is the same as EIS - gains exempt after 3 years, losses allowed etc.
As an added incentive to invest in SEIS shares the Reinvestment Relief is different (TCGA 1992 Sch 5BB). Instead of deferring the whole gain it exempts an element of the gain. The exempt amount is 50% of the lowest of:
- the gain being deferred
- the amount reinvested on which SEIS income tax relief is claimed
- the amount specified in the claim
As the maximum amount in (2) is £100,000 the maximum that could be exempt is £50,000.
Should the company or the individual cease to qualify within 3 years of the share issue the exemption is withdrawn and the gain becomes chargeable.
This article does not have sufficient space to consider in depth all the rules that need to be considered, and so you should now spend some time looking at the other areas to ensure you can find the detail in your legislation so you can answer questions from both the company and the individual's perspective.
These days most people have 'brain fog' from information overload so use the tools available (the legislation) to make things less difficult.
Unfortunately, it won't help you find a word or a double word score if you did indeed end up with these letters in your tile rack.
Head of Tax, Kaplan Financial