EIS: Some Practical Aspects

This is the second of two articles on the enterprise investment scheme ("EIS").  The earlier article (EIS: An Outline Updated for March 2015 Changes) set out the main EIS reliefs and the conditions that must be satisfied in order to obtain them.

EIS can be a very valuable tax relief.

Unfortunately, the conditions that need to be satisfied, not only at the date EIS shares are issued but for (broadly-speaking) the following three years, are relatively complex and legalistic.

There is set out in this article areas where Rollits can work with you and your existing advisers to add value to the process of securing EIS relief.

HMRC Assurance

It is possible to apply to the Small Companies Enterprise Centre of HMRC to obtain assurance, before the EIS shares are issued, that the company meets the EIS qualifying conditions.  Please refer to the earlier article for those qualifying conditions.

Unfortunately, assurances will not be given as to whether the investor meets her qualifying conditions.

In common with all tax clearances and assurances, it is important to be full and frank with HMRC.

It is best practice to apply for an assurance.  It makes it easier for HMRC to deal with the main application when it is sent.  The assurance application should list the conditions that the company must meet in order to qualify for EIS relief.  This provides a useful checklist and can highlight problem areas at an early stage in the process.

The EIS Shares

Do you know the difference between the subscription, allotment and issue of a share?  Those three terms have distinct legal meanings which are crucial to qualification for EIS relief.

The EIS legislation is quite clear that shares must be "subscribed" for.  That means the shares must be new (so EIS relief is not available for buying shares from an existing shareholder).

There is an exception for the acquisition of a subscriber share.  That is treated as being subscribed for even though strictly-speaking it is being acquired by way of transfer.  Great care is needed if the subscriber share exception is being relied upon.  Take care in particular when using an "off-the-shelf" company.

"Subscription" suggests some degree of formality.  At the very least there should be an application letter from the proposed EIS investor.  Ideally, there should be a subscription agreement.  A subscription agreement is also desirable to protect the EIS shareholder (see the section below headed "The Value of a Good Subscription Agreement").

The EIS shares must be "issued".  Shares legally are not issued until the shareholders name is written in the register of members of the Company.  It is important to write up the company books promptly.  There should be carefully drafted board minutes setting out when subscription, allotment and issue of the shares took place.

Timing of the EIS Investment

It is a key condition of EIS income tax relief that the EIS investor (when combined with any interests of his "associates") does not at any relevant point hold more than 30% of the issued share capital of the company being invested in.  This can create a problem where the EIS investment is made at an early stage of its development.  A possible solution is for the founders to lend cash to the company which is capitalised so that when the EIS investment is made, the EIS investor will not hold more than 30% of the issued share capital.

If there are several investors hoping to get EIS relief, careful coordination of the investment is required.  If some make their investment before the others, they might breach the 30% rule.

Paying Cash

The investor must pay cash for his shares.  This includes a cheque.  It does not include the transfer of assets.  It might be possible to structure a transaction so an asset is first sold to the company and the proceeds of sale are then used to subscribe in cash for the EIS shares.

If there is a delay between the cash being introduced and the shares being issued, then the money introduced will be treated as a loan.  When the shares eventually are issued, they will not qualify for EIS relief as HMRC will argue that they are issued to capitalise a loan rather than to raise cash for the company's trade.

No Connection through Directorship or Employment

It is another key condition of EIS income tax relief that the investor is not connected with the company by virtue of being an employee or paid director before the investment is made or (broadly-speaking) for three years afterwards.  It is safest to avoid appointment of investors as directors until after the investment is made.  Time as well as date board minutes if it is important that investors be appointed directors on the same day.  Again, be careful with off-the-shelf companies.

Business Angels

It is possible for a director to be paid and still receive EIS relief, provided his remuneration is reasonable.  This is to allow professional entrepreneurs to make their expertise as well as cash available to EIS companies.  It is also possible for such business angels to make follow-on investments that qualify for EIS relief, even thought they will have been a paid director before that further investment is made.

Loans

It is possible for EIS investors to make loans to an EIS company and retain their EIS relief.  Beware of the use of loans convertible into shares.

What is the value of the issued share capital of a company?  A case involving an internet wedding list company made it plain that it is the nominal value of the shares issued.

The Value of a Good Subscription Agreement

Many of the conditions for EIS relief must be satisfied at the time the investment is made and (broadly-speaking) for the following three years, including: using the money for the right sort of business activity, submission of official tax forms promptly, returning value to shareholders, disposal of assets, etc.  If possible, the founders should give covenants to the EIS investors that the company will be run in a way that does not jeopardise EIS relief.

By definition an EIS investor will be a minority shareholder.  The well-advised EIS investor would want a subscription agreement to give minority protection, including rights of veto over key decisions.  The ability to participate in a sale of the company (so-called "tag along" rights) should also be considered.  If the founders want the EIS investor to be forced to sell if they are selling (so called "drag-along" rights), care is needed in drafting such a provision to avoid breaching the EIS rule that prevents an investor granting an option over his EIS shares.

Closing Thoughts

Many are scared off from going for EIS relief by the complexity of the rules and the intricate legal points that arise.

If a well structured and well documented approach is adopted a lot of stress can be taken out of the process of applying for EIS relief.

If you have any questions about the EIS scheme or any other tax issues, please contact Nasim Sharf on 01482 337336, or email nasim.sharf@rollits.com).

This article is a general guide and should not be relied upon unless Rollits LLP specifically is instructed on a particular transaction.

Posted on: 21/04/2015

This article is for general guidance only. It provides useful information in a concise form. Action should not be taken without obtaining specific legal advice.

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