The Enterprise Investment Scheme (EIS) and (from 6 April 2012) its earlier stage cousin, Seed EIS (SEIS) have become very popular over recent years but what, if anything, will happen to these tax reliefs as the UK looks to leave the EU?
The recession of 2008-2011 deprived small businesses of early stage funding, as their main source – banks – pulled up the drawbridge in an attempt to rebuild their balance sheets and stem lending losses. With private equity still wary of lending, options were limited and that, as a result, there was an increased interest in tax-advantaged investment structures.
EIS and SEIS defined
Both schemes help fund-raising by providing tax reliefs for high risk equity investment. Detailed conditions apply to both investor, the company invested in, and the connection between the two; these conditions are not covered in this article. Providing these conditions are met, then the investor enjoys income tax relief of 30% (SEIS 50%) on the amount invested. Existing capital gains are deferred against the amount subscribed (for SEIS, 50% of the gain is eliminated, with the rest deferred), and any gains arising on the sale of the shares (there is a minimum 3 year qualifying holding period, with no pre-arranged exits allowed) will be exempt from CGT.
There are limits to the relief. Investors can invest a maximum of £1m per tax year into qualifying EIS investments (£100,000 for SEIS). Companies can raise a maximum of £5m from EIS in any one year (£150,000 in all under SEIS).
The measure has been popular. From its introduction in 1994 (replacing the Business Expansion Scheme), over 26,000 companies have raised £15.9bn under EIS. Take-up surged in the late 1990s, peaking at 3,315 companies in 2000/2001, when £1.06bn was raised. The 2000s saw a stable pattern of investment, picking up again as the recession bit and reaching its peak of 3,330 in 2014/15, but with significantly more money being raised (£1.88bn).
However, statistics released by HMRC in April 2017 demonstrate a near 20% decline in the amount raised by companies using Enterprise Investment Scheme (EIS) tax relief, year on year. The total amount raised fell by over £200 million, with a slightly smaller drop in companies making claims. Yet the economy grew by 1.8% in the same year. Why the decline?
Decline in the use of EIS
This may be due to recent changes in legislation. The biggest changes in recent years have been to block EIS funds being used to acquire existing trades (from 1 April 2013) and more recently, denying relief to companies using EIS to raise funds for the first time if they were over seven years old (this is extended to 10 years for “knowledge intensive companies”). This change has blocked more mature companies from using EIS to fundraise – unless, of course, they had raised funds under EIS in the past.
The statistics appear to bear this out. In 2015/16, companies raising EIS funds for the first time were only 48% of the total - only the second time since its introduction (2005/06 was the last and only time) that first-time fundraising companies were in the minority. In addition, SEIS activity – both in terms of applications and funds raised – remains largely unaffected, with only a slight decline shown. This is not surprising, as SEIS is aimed at very early stage start-ups.
As matters currently stand, EIS fails early life companies from raising finance for the first time beyond their 7th birthday. So the message seems to be that if you are going to grow through external investment, you had better get a move on. But why would HMRC seek to curb a demonstrably successful scheme for risky investments? For that, we have to turn to the EU.
The impact of EU legislation
The European Commission adopted new rules in relation to risk capital in January 2014. These rules are part of a larger suite of rules which govern how state aid may be applied. The requirement to keep compliant with the new State Aid rules let to the Finance Act (No 2) 2015 introducing significant changes to the EIS rules which took effect for shares issued on or after 18 November 2015. Most of the rule changes emanated from the EU amended rules as part of their continued review of EIS and other venture capital schemes as part of the state aid provisions.
It has clearly had an adverse impact. However, until 23 June last year, companies and advisers were working under the not unreasonable assumption that the UK would vote to remain in the EU, and that as a consequence, the landscape for tax advantaged risk capital investment would not change for the foreseeable future. As we now know, that assumption was somewhat misplaced.
As the UK moves to negotiate its exit from the EU, the government may well choose to look at the relief associated with EIS/SEIS and may relax many of the EU-enforced restrictions. The target sector (small businesses which are capable of scaling up their activities) has been highlighted as a critical cornerstone of UK economic growth according to the ScaleUp Institute in a 2016 report. The first of their recommendations to encourage UK small business growth was to increase the number of UK venture capital funds that are sufficiently large to finance scale ups. That is not likely happen without relaxing the existing rules.
With the recent General Election providing political uncertainty, there is no doubt that the process of exit will be a protracted affair. Until, and only if, the UK manages to fully disentangle itself from EU derived legislation (which will be adopted wholesale at the start), any changes to EIS could be five or more years down the line.
EIS remains an important route for companies seeking investment. However, the rules are too complex. Hopefully, one positive outcome of the UK leaving the EU may be a relaxation of some of these rules, and that may lead to a wider simplification of the rules.
This article first appeared in the August 2017 edition of Accountancy magazine. You can read it here.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.