Starting a small business requires capital, and raising the required funds is easier said than done. It’s tricky because investors seem to hear “small business” and hear “high risk!” What’s a small business owner to do?
Thankfully, the UK government has introduced EIS tax relief as an incentive. Investing in a small business is a much more attractive prospect thanks to this scheme.
Those who invest in a small business can benefit from EIS tax relief. The way it works is that 30% of the amount paid in exchange for shares in the small business is also given as a credit by the government, reducing the income tax owed for that year.
The investor feels more confident about investing knowing that they’ll enjoy this discount on their annual income tax, and the small business has the money required to get started. It’s a win-win situation.
What Is EIS Tax?
EIS stands for Enterprise Investment Scheme. It has advantages for small business owners and investors alike. It was introduced by the government in 1994 to support small business owners at an early stage of their project in raising money to start or grow their enterprise.
The need for EIS is obvious: small businesses need funds, but individual investors are often hesitant to invest in such a risky prospect. EIS sweetens the deal by offering a proportionate tax relief when they make an investment in an eligible project.
There are limits to the scheme, of course, and both investors and business owners should be careful to ensure they closely comply with the rules and regulations.
For example, under EIS you can only raise up to 5 million GBP each year. After that, benefits no longer apply. Once your company has raised 12 million GBP, it loses its eligibility for the scheme – regardless of where that money came from.
Read on to learn more about the EIS tax relief scheme and whether it could be of benefit to you — whether you’re an investor or the owner of a small business.
EIS tax relief at a glance
Make sure you’re familiar with the ins and outs of EIS tax relief. The last thing you want to do is make an investment that isn’t actually eligible for the scheme. Small business owners may find it useful to ensure their projects comply with the rules too, as the EIS tax relief scheme is a great way to attract investments at an early stage.
Income tax relief of up to 30%
Investors can receive an income tax discount equivalent to 30% of their investment. For example, an investment of 10,000 GBP would generate a saving of 3000 GBP. The more you invest, the more you save! Who wouldn’t like to pay less on taxes?
Generous contribution allowance
The EIS allowance extends up to 1 million GBP. Investing to the absolute limit would result in an incredible income tax saving of 300,000 GBP: a huge incentive for investors to take a risk on a new project! If you invest in “knowledge-intensive” companies – companies that meet certain criteria when it comes to skill and innovation – then the limit doubles to 2 million GBP.
Investors may choose to “carry back” their discount and enjoy an income tax refund instead. They can do this in whole or in part depending on their allowance amount, so long as they don’t exceed the yearly limit for EIS relief.
When the time comes to sell your EIS shares (and remember, you must keep them for at least three years!) then you won’t pay tax on any growth in value. Consider it an additional reward for making a risky investment that clearly paid off!
Capital Gains deferral
If you invest your taxable gains in a company that qualifies for EIS, then you can defer the capital gain as long as you keep your investment. This rule applies to gains made up to three years before and one year after your investment, and it doesn’t matter if you’ve already paid the tax.
Inheritance tax relief
If an investor still holds their EIS investment when they pass away, then no inheritance tax will be charged on this investment. The only stipulation is that these shares must have been in their possession for at least two years prior to their death.
Even if the investment doesn’t pay off, there is a cushion with EIS tax relief. An investor could offset their loss against their income tax bill whether for last year or this one. The amount that can be claimed depends on the loss incurred and their marginal rate of income tax.
How EIS tax relief helps reduce any losses and magnify any gains
EIS tax relief works by making the prospect of investment in small companies much more attractive. It functions on two levels: not only does it reduce the impact of any losses incurred, it also magnifies any gains. Consider the following scenarios:
In the event that the investment does not pay off, investors can still write off their losses against their income tax, reducing the overall impact by significantly decreasing their tax bill.
However, if the investment pays off, there are other, additional benefits to be enjoyed — beyond the obvious increase in share value. Because there’s no tax on growth, these shares become even more valuable in real financial terms!
How do I claim EIS income tax relief?
Of course, terms and conditions apply when it comes to EIS income tax relief. Because this is a government scheme, there are extensive regulations designed to prevent its misuse for corrupt purposes.
One condition is that investors must pay for their shares when they are received. Shares that are issued before payment has been made are unfortunately ineligible. To avoid simply passing shares back and forth for income tax relief, shares must be held for at least three years. These rules are in place to ensure that the policy achieves its goal: stimulating investment in small businesses.
Some people might attempt to exploit the system with a mutual investment: I invest in you, you invest in me, and we both enjoy the income tax relief. Any such arrangement would be rejected under EIS rules. If you have a controlling financial interest in a company, you cannot benefit from tax relief with this scheme; exclusion applies to partners, directors, and employees.
Good news – angel investors are eligible for the scheme. Remember, if you plan to apply for EIS tax relief, you must ensure that any shares that you purchase are normal shares. If they come with added risk protection, then this too would disqualify you from benefitting from the scheme.
Businesses may believe that they can apply for the scheme, enjoy an investment, and then start breaking the EIS rules. This isn’t the case. Checks will be performed for the three years that follow the investment. If rules aren’t followed, tax relief will be withheld or withdrawn. Investors won’t be happy about that!
The application process requires an EIS3 form, which the company you invest in will provide. Make sure the company that you invest in qualifies for the scheme! Although EIS tax relief reduces the risk potential of an investment, there’s always the risk that the company itself loses its qualifying status. In that event, you’d lose your claim to tax relief.
All investments involve a little risk, even when you do apply for the EIS tax relief scheme! However, this policy certainly acts as an incentive for investors to take a chance on an up-and-coming small business. Just make sure that both you and the company qualify before you commit.