What Is EIS Risk to Capital Condition?

The Enterprise Investment Scheme (EIS) allows investors in early-stage, unlisted businesses to access a range of tax advantages and reliefs while engaging in organisations with excellent growth potential and innovation (read more about the benefits of EIS here).

However, there are several conditions related to the company issuing the shares, the investor and their relationship to the business, and the EIS shares or fund shares. In March 2018, the government introduced the EIS Risk to Capital Condition, applicable to investments made in both EIS and Seed Enterprise Investment Scheme (SEIS) companies and funds. 

While sometimes considered subjective, this condition means that the investor can only claim the full extent of tax reliefs available when their investment is made in ordinary shares and paid in cash – and that capital is fully exposed to risk.


What Are the EIS Risk to Capital Requirements?

HMRC assesses all applications from companies seeking EIS status to verify whether they are eligible. The tax office will also analyse tax reliefs and deferrals claimed by investors, raising a query when any claims made do not appear to comply with the scheme rules.

The Risk to Capital Condition is split into two parts:

  • The business, or fund, must be established with a core objective of long-term growth and development. It cannot, for example, be a company founded to manage land ownership.
  • The investor must put their invested capital at risk – they cannot have protections in place over and above the loss relief offered by the EIS. The maximum loss risk should be greater than the potential return after tax relief.

Demonstrating compliance with the Risk to Capital Condition may be complex. The easiest solution is to base assessments against the criteria used by HMRC to determine whether an EIS application or investment adheres to the rules, as set out below.

Related reading: Tax-efficient investing in the UK

Proving Company Objectives for EIS Compliance

For a company to qualify for the EIS and to remain eligible for EIS status, it needs to show that it is actively pursuing growth and development and that capital raised through the EIS will support this objective.

HMRC will apply a list of statutory factors to establish a view as to whether this requirement has been met, considering:

  • Projected increases in business turnover.
  • Expected growth in customers and employees.
  • Investments made in the business’s infrastructure.
  • How funds are being allocated or invested within the company.

If HMRC decides that a business does not have a primary goal of growth and development or that funds raised through the EIS will not further this target, it may refuse or withdraw EIS status.

Proving Investor Capital at Risk for EIS Compliance

While the capital at risk belongs to the investor, this compliance assessment also considers the company while establishing the likelihood of failure or the potential for the investor to lose capital.

Tax officials will analyse the following:

  • The details in the business plan and projected returns on investment.
  • Levels of genuine commercial risk exposure.
  • Anticipated net investment returns, including interest, fees and dividends.
  • Capital assets held within the company’s balance sheet.
  • The security of the business’s revenue streams.
  • Whether the business model is proven or novel and untested.
  • Risks within the businesses and how these are communicated to investors.

In short, HMRC will normally find a company is EIS compliant if it puts the investor at significant risk of capital loss. This requirement can be complex for businesses since the norm in an investment raise is to highlight the projected returns, successes and growth of the business rather than focusing on risk factors.

However, realistic targets, business plans and investment literature are essential to avoid painting an overly optimistic picture which could clash with the EIS regulations.

The right balance means that investors recognise and understand the risks but have enough information about the business proposition to believe it is worth investing in, coupled with tax reliefs and deferrals made available.

What Is the Purpose of the EIS Risk to Capital Rule?

The Risk to Capital Condition is largely acknowledged as intentionally vague; it does not set specific limits, thresholds or metrics against which HMRC will determine whether a company or investment qualifies for EIS tax treatments.

Instead, the aim is to prevent any investments being made and investors from claiming beneficial tax reliefs, where the capital invested is managed, protected or exposed to minimal risk. 

Using a principles-based methodology means there is a certain amount of subjectivity, and investors often seek professional advice to ensure any EIS investments they make, either in direct share acquisitions or EIS funds, are entirely compliant.

The main goal of EIS tax reliefs is to incentivise investment in younger, riskier and smaller businesses. Therefore, the focus of the capital at risk tests is around assessing EIS applications and investments to ensure those which limit the investor’s commercial risk are not dually eligible for tax reliefs.

Any EIS investment that does not have any substantial risk of capital loss or is artificial in nature cannot benefit from tax reliefs. However, this condition does not affect authentic start-ups and entrepreneurial businesses seeking funding to help them progress and grow.

How Are EIS Risk to Capital Tests Conducted?

HMRC is responsible for investigating potential non-compliance and for reviewing and approving applications for EIS status, usually after an initial advance assurance assessment.

The tax office reviews each case on its own merits and will make a decision about whether it feels that there is a significant risk – noting that there is no definition or quantifiable metric that indicates how the risk threshold is met.

When calculating the potential net return on the investment, HMRC will account for income tax reliefs claimable, distributions made by the business and capital appreciation on the value of EIS shares held.

If HMRC is not satisfied that an investment or company adheres to the Risk to Capital Condition, it may withdraw tax reliefs and clawback reliefs already claimed, remove advance assurance status granted to a company, and remove EIS eligibility.

Note that post-investment assessments are included within HMRC internal guidance documents and that the tax office can conduct tests at any point where there is reason to think the condition has not been met.

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