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The Expectations Gap - The Impact Of UK Enterprise Investment Schemes
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The Enterprise Investment Scheme was introduced in 1994 to encourage investment into smaller businesses. However, it has not been as popular with investors as was hoped, and the UK government has proposed a number of changes to make the scheme more appealing.
An EIS can be used for entrepreneurs setting up or raising capital, or for "business angels" wanting to invest in small businesses. While there are significant benefits to EIS, the scheme is complex and full of traps for the unwary or poorly advised.
Its biggest drawback is the requirement for three levels of qualification – at an individual, company and trade level. These combine to make the EIS particularly complex and has reduced take up of the scheme.
In addition, the EIS contains layers of conditions, exclusions and anti-avoidance legislation, which have imposed commercial constraints on participants. Some of the major constraints are:
-- Individuals cannot be connected with the company. This denies relief to employees and restricts the maximum holding to 30 per cent of the equity.
-- Care needs to be taken for directors to ensure that they qualify. There are a range of rules, which can be confusing to both investors and businesses.
-- EIS relief is not available on preference shares or in respect of conversion of debt, both of which are important features of start-up companies.
-- The company must be managed carefully throughout the qualifying period to ensure that the position of the investors is not compromised. This can mean that all commercial decisions need to be considered with the EIS in mind.
Despite the scheme’s complexity, with a focused approach the major pitfalls can be avoided, and if an investor can see past the scheme’s constraints, then an EIS can offer significant tax benefits.
-- Income tax – An investor can get a tax reducer of 30 per cent of an investment of between £500 and £500,000.
-- Capital gains tax – For qualifying investors, the shares are exempt from CGT as long as they are held for at least three years and continue to qualify.
-- Capital gains tax deferral – Investors can defer CGT by making qualifying investments.
-- Loss relief – In the event of a loss, relief can be claimed against general income of the current or previous year.
-- Inheritance tax – In most cases EIS shares will qualify for business property relief to exempt them from IHT [inheritance tax] after they are held for two years.
The government wishes to portray the UK as open for business. It has reduced corporation tax rates and increased research and development allowances, and venture capital reliefs also appear to be an important part of its strategy. The office of tax simplification has reviewed the EIS and put forward recommendations for the improvement and simplification of the scheme.
The government has already made changes, subject to state aid approval, in the 2011 budget to make the EIS more attractive to investors. This included increasing the rate of income tax relief to 30 per cent, increasing the personal investment limit to £1 million from 6 April 2012, and increasing the qualifying company limits for employees, gross assets and annual investment. Plans have been announced to try to simplify the EIS and VCT [venture capital trusts] schemes and consultations are currently in place.
Other developments include the Business Angel Seed Investment Scheme, or BASIS. This is a proposed scheme targeted specifically at the seed level and business angels. Initial indications are that the scheme would be based on EIS, but intended for high net worth angel investors to bridge the gap between bank lending, which is hard to come by at present, and venture capital.
Relief would only be available on new projects, and to a narrower classification of investor and company. Suggestions are that relief will be limited to a defined class of business angels, which is likely to require active involvement in the governance of the investee company.
It is also possible that the scheme could be extended to permit up to 30 per cent of the investment to be held in debt instruments.
Although the changes to EIS will offer benefits to make the scheme more attractive to both entrepreneurs and investors, concerns about the complexity of the scheme still remain. It is clear that the government is seeking to address this issue by making the current scheme simpler, and by introducing the new BASIS scheme it is trying to focus investment where it is most needed.
There is no doubt that the right EIS scheme can bring significant tax benefits to investors, but only time will tell whether these proposals will widen their use and appeal.
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