For anyone who has exhausted their entitlement to tax free investment within ISAs, National Savings and pensions, and who still has money to save, an Enterprise Investment Scheme could be worth a look.
Enterprise Investment Schemes (EISs) were unveiled in November 1993, with the aim of assisting small, higher risk, unquoted trading companies to raise capital by offering a range of tax incentives to investors.
An EIS can involve investing in a single company or you can buy into an EIS fund which invests in a number of qualifying companies.
To qualify for the full range of tax reliefs, a 'qualifying investor' must purchase 'eligible shares' in a 'qualifying company' pursuing a 'qualifying trade,' - terms which are discussed in more detail below.
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What tax reliefs do you get from an EIS investment?
The tax reliefs on EIS are extremely generous, in return for investing in what is definitely a high risk investment. The incentives include income tax relief, capital gains tax (CGT) exemptions, plus loss relief and deferral of CGT on other investments, providing you are a qualifying investor.
EIS holdings may also be exempt from inheritance tax, which makes the tax incentives more wide-ranging than those available to Venture Capital Trust (VCT) investors who cannot claim CGT loss relief or deferral relief. However VCT investors currently get a higher rate of income tax relief, 30 per cent for 2007-08.
Income tax relief of 20 per cent is given on investments of between £500 and £400,000 per tax year in an EIS company or EIS fund, providing the investment is held for at least three years. Disposal to a spouse or civil partner within three years does not result in withdrawal of relief.
However, income tax relief may be withdrawn if the investor becomes a 'connected person' (see Section 4 below) or the company ceases to be qualifying within three years of the share issue.
Income tax relief is normally granted for the tax year of the share issue because when you invest in an approved EIS fund, relief is granted for the tax year in which the fund closes, subject to 90 per cent of the money raised being invested within 12 months. Relief cannot be greater than your income tax liability for the year in question.
Non-taxpayers do not get any tax relief. For shares issued between 6 April and 5 October half of the investment can be carried back (maximum £50,000) and treated as if it had been made in the previous tax year, provided that this does not take you over your investment limit for the previous year.
Investors will normally be entitled to exemption from CGT on disposal of EIS shares or funds, providing they have been held for more than three years (and they have received income tax relief on the purchase of the shares and the scheme remains qualifying).
If you have a CGT liability from the sale of previous investments and you invest the proceeds in an EIS company or fund, CGT can be deferred.
Losses on the disposal of EIS shares can be offset against either taxable income or chargeable gains on other assets. But first the income tax relief you have received on your investment must be deducted from the losses.
These losses (after deduction of 20 per cent income tax relief) can then be set against income for the tax year in which they arise or the preceding tax year. Where there is insufficient income in either or both years, the balance of the loss can be carried forward and set against chargeable gains in future years. Where losses are set against chargeable capital gains, unused losses can be carried forward and set against future chargeable gains.
Case study: You buy EIS shares for £50,000 and receive 20 per cent income tax relief (£10,000). You subsequently sell the shares for £35,000. You claim loss relief on £15,000 - £10,000 = £5,000 which can be offset against income or chargeable capital gains.
It is not always necessary to actually make a disposal in order to claim loss relief. You can apply to HM Revenue & Customs for loss relief on the grounds that the shares have acquired a 'negligible value' even though the company is still trading.
In such cases, a disposal is 'deemed' to have been made. Although the date of deemed disposal normally coincides with the date of the claim, the investor can specify an earlier date not more than two years before the beginning of the tax year in which the claim is made. Loss relief can also be claimed in the event of liquidation of the company.
If you dispose of EIS shares within three years, or any other assets with chargeable gains, you can defer any CGT by reinvesting the equivalent of the chargeable gain in another qualifying EIS.
Investment in the EIS must have taken place in the period starting one year before the disposal of the assets giving rise to the chargeable gain or within three years after the disposal. When you dispose of those EIS shares, the pro-rata gain on the original disposal will be revised and CGT will be payable, unless the revived gain is deferred once more.
Case study 1: You sell £50,000 worth of ordinary shares on 1 December 2007 with a capital gain of £10,000. You had invested £10,000 in an EIS scheme on 5 January 2007 (within 12 months prior to the disposal). You can therefore defer CGT on the £10,000 until you dispose of your EIS shares, whereupon it will be 'revived.'
Case study: You have £10,000 worth of capital gain on your share portfolio on 1 December 2007. If you invest £10,000 in an EIS scheme before 1 December 2008 you can defer the CGT on the £10,000 gain until you dispose of the EIS shares, whereupon it will be 'revived.'
CGT taper relief on the revived gain on non-EIS assets will be based on the holding period for the original asset and will not include the deferral period.
Case study 2: In May 2002 you invested £20,000 in a portfolio of Oeics (open ended investment companies). In June 2007 you sold the portfolio and realised a £10,000 chargeable gain. Taper relief for CGT would normally be based on a holding period of five complete years for non-business assets.
You defer the CGT by investing £10,000 in the ordinary shares of an EIS company. Four complete years later, you sell the EIS shares for a tax-free capital gain. The initial deferred gain of £10,000 is now revived, but taper relief is still based on a holding period of five years at non-business asset rates, even though a further four years have elapsed.
Revived chargeable gains can be deferred repeatedly by investing an equivalent sum into a succession of EIS shares or funds. However, a distinction must be drawn between chargeable gains arising out of the disposal of EIS shares and those arising out of the disposal of the original non-EIS assets.
Gains on the non-EIS assets that have been rolled-over into the EIS do not qualify for additional taper relief in respect of the period that they remain reinvested in the EIS. Any chargeable gain arising out of the disposal of the EIS shares can be deferred by reinvesting in another EIS and taper relief will apply.
In this case, the holding period starts when the shares in the first EIS company are acquired and ends with the disposal of the shares in the final EIS company, excluding any periods during which no EIS shares are held.
Case study 3: You defer a £10,000 gain on your Oeic portfolio (realised after five complete years) by investing £10,000 in the ordinary shares of an EIS company or an EIS fund. You sell these shares two years later for a chargeable gain of £5,000, thereby reviving the £10,000 gain on the original disposal of the unit trusts.
You immediately invest £15,000 in a second EIS and thereby defer CGT on the £10,000 revived gain once more as well as the CGT on the £5,000 gain on the EIS shares. When you finally sell your EIS shares two years later, the taper relief on the newly revived £10,000 gain is still based on the original holding period of five years, but taper relief on the EIS gains is based on a holding period of four years.
Finally, holdings in EIS companies or funds will be free of inheritance tax, providing you have held the investment for at least two years before your death.
What are qualifying companies?
Companies issuing EIS shares must satisfy certain conditions. Among other things, they must be unquoted. A company listed on the Alternative Investment Market (AIM) counts as unquoted for this purpose. The funds raised through the sale of the shares must be used wholly by the company or a 90 per cent subsidiary (or 100 per cent subsidiaries of the 90 per cent subsidiary) within 12 months of the share issue or from the date that trading commences.
The company must pursue one or more 'qualifying trades' or be the parent company of a qualifying subsidiary pursuing a qualifying trade within two years of the shares being issued. The gross assets of the company, or of the whole group, if it is the parent of a group, must be no more than £7m immediately before the share issue and less than £8m immediately afterwards.
Companies are not allowed to raise more than £2m in any 12 month period from EIS investors or from using a combination of the EIS, VCT and the Corporate Venturing Scheme (CVS).
The shares themselves must be issued to raise money for the company for bona fide commercial purposes (not for tax avoidance purposes) throughout the three year period following issue. The shares must be fully paid up, new ordinary shares and may not carry any preferential rights to assets or dividends on liquidation or redemption.
Companies can engage in most trades which must take place wholly or mainly in the UK. But some activities are excluded. The main exclusions are:
dealing in land, commodities, futures, shares, securities and other financial instruments;
financial activities like banking, money-lending, insurance, debt factoring and hire purchase financing;
dealing in goods other than through ordinary retail or wholesale distribution;o receiving royalties or licence fees;
legal and accountancy services;
farming or market gardening;
holding, managing or occupying woodlands or any other forestry activities or timber production;
operating or managing hotels, guest houses or hostels;
operating or managing nursing homes or residential care homes; and
providing services to another company carrying on significant business (more than 20 per cent of the trade) in excluded activities.
Who are qualifying investors?
To qualify for all EIS tax reliefs, you must be aged 18 or over and be liable to UK income tax and you must not be 'connected' with the company issuing the EIS shares. This means that neither you, nor your 'associates,' must possess or be entitled to acquire more than 30 per cent of the issued ordinary share capital; the loan capital; the issued share capital; the voting power; or the assets of the company or any subsidiary in the event of winding up.
An associate is your spouse, civil partner, parent, grandparent, great-grandparent, child, grandchild, great-grandchild, business partner or the trustee of a family trust in which you have an interest. Brothers and sisters are not included in the list.
You are also deemed to be a connected person if within two years prior to the EIS share issue, you or your associates were directors, partners or employees of the issuing company or its subsidiaries.
However, investors who take up paid directorships with a company after the share issue can retain income tax relief on their EIS shares, provided they were not connected with the issuing company or its subsidiaries carrying on the trade before the share issue.
Investors connected with the company will still remain eligible for CGT deferral relief.
How do I claim tax relief?
To claim tax relief, you must be in receipt of an EIS3 certificate from the issuing EIS company. Companies must be authorised by their own tax offices to issue these certificates.
Authorisation is not granted until all the shares have been issued and the company has pursued the trade for which the money was raised for at least four months. If you have invested through an approved EIS fund, you will receive form EIS5 instead covering all the investments made on your behalf.
You can claim tax relief on your self assessment tax return for the year in which the shares are issued. If the tax return has already been submitted, you can complete the claim section of the EIS3 or EIS5 certificate and send it to your tax office. Income tax relief can be claimed for up to five years after the first 31 January following the tax year in which the investment was made.
To claim CGT deferral relief, you must complete the claim section on the certificate and send it to the your office specifying the amount of the chargeable gain to be offset against reinvestment in the EIS, the date on which the chargeable event arose and the apportionment against each gain where EIS investment is to be offset against more than one gain.
To claim loss relief against income, you must give written notice to the tax office within 12 months from the first 31 January following the tax year in which the disposal takes place. The claim should specify the source of the loss, the tax year of the loss and the tax year for which income is to be relieved.
Where the shares have acquired a 'negligible value, you can write to your tax office or make an entry on your tax returns stating your intention to make a 'deemed disposal' of the shares under section 24(2) of the Taxation of Chargeable Gains Act 1992. There is no time limit for making a 'negligible value' claim.
Last edited October 2007