The Enterprise Investment Scheme (EIS) offers generous tax advantages for investors – with the caveat that EIS shares or fund shares should be retained for at least a three-year period from the date of issue.
Investors who have claimed income tax relief, for example, but sell or dispose of their shares before the three-year minimum retention period may find themselves subject to a reversal of the relief, with tax clawed back.
Generally, all tax reliefs offered by the EIS are subject to the three-year rule. Relief is therefore withdrawn or retrospectively reversed, and any entitlement to capital gains tax (CGT) exemption or deferral is removed.
Related Reading: EIS and capital gains deferral
Understanding the EIS Scheme Rules
The EIS was launched to incentivise investment in early-stage businesses, with investors looking for funds and investment opportunities in companies with strong growth potential and exciting innovation – coupled with tax allowances and reliefs to offset the elevated risk.
Related Reading: What is EIS?
Individual investors must purchase shares or fund shares in cash, issued as ordinary shares by businesses that comply with the EIS eligibility criteria. They can then:
- Claim income tax relief of up to 30% of the invested value.
- Invest up to £1 million a year, increased to £2 million for investments into knowledge-intensive companies (abbreviated to KICs).
- Qualify for CGT exemption on gains made from EIS shares without a tax liability when shares are disposed of.
- Claim EIS loss relief to offset any losses on disposal or company closure, reducing the total capital loss suffered by reducing the investor’s income tax obligations.
- Defer CGT charges against other asset disposals by investing the profit into eligible EIS funds or shares.
Many of the tax reliefs provided by the EIS can be carried back or even forward in terms of reinvestment relief, making the scheme flexible and efficient. With an income tax relief claimable of up to £600,000 a year, the advantages are significant – but it is important to be mindful of the three-year rule when making any investment decisions.
What Are Knowledge-Intensive EIS Fund Tax Reliefs?
Tax reliefs offered through the EIS are higher for KICs to encourage further investment in areas considered priorities for economic growth and agility. Introduced in 2020, the updated rules for KIC fund structures mean that:
- Funds should be created solely to facilitate investment in KICs.
- At least 80% of the fund must be invested in recognised KICs.
- The funds should comprise at least 50% of the fund capital in year one and at least 90% within the first two years.
Investors still qualify for 30% income tax relief against the capital invested and can opt to carry this back to the previous tax period as best suits their tax planning objectives. The higher investment thresholds remain applicable, provided investments are retained for three years or more.
Exploring the Three-Year Rule in EIS
While the requirements and rules are fairly straightforward, there are sometimes scenarios that fall slightly outside of the norm and may mean investors are unsure how or if the three-year minimum retention period applies.
Disposing of EIS Shares Within Three Years Due to Company Closure
Direct investments into company shares are reliant on the business remaining EIS compliant and solvent for the investor to keep the shares for a minimum of three years. There could be a circumstance where a company enters into administration before the three years have ended, where an investor has already claimed income tax relief.
The outcomes will depend on the capital losses made. If an investor loses the shares due to company failure, the loss against the shares would be eligible to offset against any future CGT liability.
However, the loss for CGT purposes would be calculated as the initial subscription price, less income tax relief already received, rather than the full original investment value. Losses made on EIS shares can also be used to reduce income tax liabilities.
Investing in EIS Company Shares Before an Acquisition
Another potential issue could arise when a start-up or early-stage company has raised capital through the EIS and then is acquired or partially acquired by another commercial entity or investor within three years.
If the new investor has purchased shares from the original investor, those sold will be exposed to a clawback of reliefs already accessed through the EIS. The rule is unambiguous – the reason for the sale of the shares is unlikely to have any impact.
Investors retaining a proportion of their original shares would still be eligible for EIS tax reliefs on that investment, provided the company remained a qualifying EIS investment.
However, if an EIS company were acquired with 50% or more of the share capital purchased by an acquisition company, the independent requirement may not be met, making the company ineligible for the EIS. In that situation, the investor would lose all entitlement to EIS relief for sold and retained shares.
Can You Sell EIS Shares Within Three Years With Losing Tax Reliefs?
The only scenario where EIS shares can be disposed of within three years of the share issue date and not be subject to a tax relief clawback is if they are transferred to a civil partner or spouse. Otherwise, the outcomes would mean:
- Gains made on the share disposal are exposed to CGT.
- Income tax relief already claimed will be withdrawn – or partly removed depending on the proportion of shares sold.
- Disposal relief will no longer apply.
However, inheritance tax reliefs apply from two years of EIS share ownership. If an investor passes away, shares or fund shares are exempt from inheritance tax, provided they have been held for 24 months or longer.
As we have seen, the three-year rule is fairly rigid and almost always means that any change to the status of the EIS fund or company, change to the eligibility of the investor, or ownership of their shares will remove entitlement to tax reliefs and result in a clawback of reliefs already claimed.
It is, therefore, best to regard EIS shares as a medium-term investment and to verify the issue date on the share certificate issued by the company or fund.
Disclaimer: The information and opinions within this article are for general information purposes only, are not intended to provide an exhaustive summary of all relevant issues or to constitute investment, tax, legal, or other professional advice. They should not be relied on for, or treated as, a substitute for specific advice relevant to particular circumstances and you should seek your own investment, tax, legal or other advice as appropriate. In not doing so you risk making commitments to products and/or strategies that may not be suitable to your needs. Neither the writer nor EMV Capital Limited accept any responsibility for any errors, omissions or misleading statements in this article or for any loss which may arise from reliance on materials contained on this article.