The tax system offers various 'fiscal carrots' to encourage new equity investment in those unquoted trading companies or groups carrying an appropriate degree of investment risk. The enterprise investment scheme (EIS) is the principal tax relief for individuals. Its prime targets are 'passive' investors who do not wish to be involved in the business and also so-called 'business angels' who provide business expertise and wish to take a 'hands-on' management role in the investee company.

The EIS provisions are substantially recycled from the old business expansion scheme legislation, but they contain a number of new features that target the relief on smaller companies carrying greater investment risk. Nevertheless, the EIS regime often plays a valuable role in attracting and providing tax-efficient finance for an owner-managed business. I shall review the main features of the EIS through the use of a case study (which is set out in Panel 1). All statutory references are to the Income and Corporation Taxes Act 1988, unless otherwise stated.

Provided the necessary EIS conditions are satisfied (see below), Spock would be able to claim EIS income tax relief at the lower 20% rate on his qualifying equity investment or, if lower, the amount of relief required to eliminate his tax liability (s 289A(2)). EIS relief is given as a reduction against an individual's income tax liability before deducting various tax 'credit' reliefs, such as the new children's tax credit, and certain other special reliefs including relief for overseas taxes (s 289A (5)). The legislation normally gives relief in the tax year in which the shares are issued (ie, when the shares are entered in the company's register of members (National Westminster Bank plc v CIR (1994) STC 580)), although part of the relief may be claimed in the previous year. However, in the case of a 'start up' EIS, relief is not obtained unless and until the company has carried on the qualifying trade for four months.

Assume that, for 2001/02, Spock expects to receive director's fees from Enterprise Ltd (see below) of £20,000, freelance consultancy income of £60,000, and dividends from other UK companies of about £36,000. Based on the calculation in Panel 2, Spock's estimated income tax liability for the year ending 5 April 2002, after taking account of his EIS relief, will be £15,668.

EIS relief can currently be claimed up to a maximum of £150,000 in any tax year, but the investor must invest a minimum yearly amount of £500 in any single company to obtain the relief (s 290(1)(2)). In fact, as Spock's investment will be made before 6 October 2001, he could obtain EIS relief in 2000/01 on up to half of his investment in Enterprise Ltd (limited to a maximum amount of £25,000). This would require a claim under s 289A to relate part of the investment back to the previous year.

Spock can only make a valid claim for EIS relief if he satisfies certain conditions. The key requirements are that: he is a qualifying individual, he subscribes for eligible shares, and Enterprise Ltd is a qualifying company carrying on a qualifying trade.

Individuals are eligible for EIS relief if they subscribe for eligible shares (wholly in cash) in the qualifying investee company. This means that the shares must be new ordinary shares that do not carry any preferred right to dividends or surpluses distributable on a winding up during the relevant three-year period from the share issue date or, if later, three years from when the company starts trading. (The relevant period is five years for shares issued before 6 April 2000 (s 289(7)). The share issue must also be for genuine commercial reasons and not part of a tax avoidance scheme.

The shares issued must raise money for the purposes of a 'qualifying trade' carried on wholly or mainly in the UK. At least 80% of the share monies must be wholly used for that purpose within one year of the share issue (or, if later, from when trading starts). The balance of the monies must be similarly applied within the following year. (For pre-8 March 2001 issues, the entire share subscription proceeds had to be used within the first 12 months of issue.)

The shares purchased by Spock appear to be eligible for relief since:

Spock has subscribed for the new shares (for example, relief would not be available if he had purchased the shares 'second-hand' from another shareholder).

Spock's shares rank equally in all respects with Enterprise Ltd's existing ordinary shares - thus, they have no preferential dividend rights, etc.

The proceeds of the share issue will also clearly be applied for qualifying trading purposes in the UK. This would not be the case, for example, if Enterprise Ltd spent the proceeds of the share issue on acquiring an investment asset.

EIS income tax relief is not available if the individual investor is 'connected' with the investee company at any time during the period beginning two years before the share issue (or, if later, the date the company is incorporated) and ending three years after that date (the 'designated five year period').

In the case of Spock's investment, several aspects must be considered.

Directorship or employment. If Spock takes up Jim's offer to become a director and he subsequently receives fees or remuneration, he would not be 'connected' with Enterprise Ltd (s 291A). Under the EIS rules, an individual previously unconnected with the company may become a paid director and still qualify for EIS relief, provided the remuneration is 'reasonable' in relation to his duties. If the investor is an existing director or employee of the investee company or any of its 51% subsidiaries (before the share issue), they will not qualify. Indeed, the investor (or any associate of his (see below)) must not be an employee or partner (for this purpose a director is not an employee) of the investee company or any of its 51% subsidiaries in the five-year period beginning two years before the share issue. This rule does not apply in Spock's case as he will only occupy a seat on the Board and there is no intention to make him an employee.

Material interest. Spock would also be connected under s 291B if he (together with his associates) directly or indirectly possesses (or is entitled to acquire) more than 30% of the investee company's: issued ordinary share capital; or loan capital and issued share capital; or voting rights.

Exceptionally, the 30% connection test does not apply to the period between the incorporation of the company and the earlier of (a) when the company started to prepare for trading and (b) its first share issue (after the original subscriber shares) (s 291B).

Although Spock and Jim would normally be associated with each other for tax purposes (see s 417(3)(4)), the EIS 'associate' definition is narrower - notably, brothers and sisters cannot be treated as associates (s 312(1)). Thus Spock is not associated with Jim for EIS purposes. Immediately after the EIS issue, Spock would have 28.6% of the issued ordinary share capital (and voting rights) of the investee company, calculated as follows:

Thus, where the size of an individual's investment is likely to breach the 30% connection test, it is worth considering issuing the shares at a premium (as has been proposed in Spock's case). This reduces the number of ordinary shares required to be issued to the potential investor(s) and the voting rights they will hold. This may also be a commercial requirement of the existing shareholders who will wish to avoid any unnecessary dilution of their interest.

Enterprise Ltd must be a 'qualifying company', which will be the case provided it satisfies the various conditions summarised in Panel 3. It will be seen that the general aim of the prohibited activities rule is to prevent perceived 'lower risk'/asset-backed activities from attracting EIS relief. However, most retail, wholesale, manufacturing and service trades will qualify for relief. Reference must always be made to the detailed legislation to determine whether a particular company will qualify for relief. The investee company's trade must also be conducted on a commercial basis with a view to realising profits (s 297(8)).

The Inland Revenue operates a formal advance clearance procedure to confirm whether a potential investee company satisfies the relevant conditions for being a qualifying company and whether the rules for the share issue are met. (The clearance application should be sent to Small Company Enterprise Centre, TIDO, Ty Glas, Llanishen, Cardiff, CF14 5ZG). The company completes form EIS 1 (1998) after the EIS share issue. The Revenue will then authorise the company to issue the EIS 3 (1998) certificates to the relevant investors.

The 'qualifying company' requirement must be satisfied both at the date the shares are issued and (except for the 'gross assets' test) for at least the next three years. If the company ceases to qualify, the investor's EIS relief is completely withdrawn.

Similarly, if the company is wound up during the relevant three-year period, it will cease to qualify unless the winding up is for genuine commercial reasons and not tax avoidance. A similar rule applies where a company appoints a receiver or administrator (s 293(4A)(6)).

Enterprise Ltd would currently appear to be a qualifying company (manufacturing high quality sci-fi toys and memorabilia is not a prohibited activity). However, there would be a problem if Spock's brother decided to sell the company within the three-year period to 31 July 2004 since this would lead to a clawback of Spock's entire EIS relief of £18,000.

Any disposal of the shares within the relevant three-year period (even by means of a gift, except to a spouse) would lead to a full claw-back of EIS relief (and, if appropriate, crystallise any gain deferred under the EIS CGT deferral rules (see below)).

The 'return of value' rules broadly restrict or completely extinguish the EIS relief to the extent that a 'non-permissible' return of value is enjoyed by the individual investor (or their associate) within the year before the share issue or three years afterwards. However, certain types of receipt, such as reasonable remuneration, dividends paid at a commercial rate, market value consideration for assets sold to the company, etc, are all treated as a permissible receipt and will not prejudice the investor's EIS relief (s 300).

Spock will be able to defer his CGT liability of about £8,000 (ie, £20,000 x 40%) arising on the sale of his holiday home . The EIS CGT deferral claim can be made independently of the EIS income tax relief claim and is not dependent on EIS income tax relief being available. The EIS CGT deferral rules are slightly more relaxed in that the investor can be connected with the investee company without jeopardising their deferral relief. The investor can make a claim to defer a specified amount of their capital gain (before taper relief) by matching it against the amounts subscribed on the relevant EIS shares. This gives complete flexibility in the amount of the CGT deferral relief taken and sufficient gain may be left in charge to mop up the annual exemption (adjusted for any taper relief).

Provided Spock holds his Enterprise Ltd shares for three years, any gain arising on the disposal of those shares will be completely exempt from CGT (s 150A(2), TCGA 1992). If Spock makes a loss on the sale of his shares at any time, he can obtain relief for his capital loss, either as an income tax loss (under the venture capital relief rules in s 574) or as an allowable capital loss. For the purposes of calculating the allowable loss, the EIS tax relief must be deducted against the individual's CGT base cost (s 150A(1)(2), TCGA 1992; s 305A, ICTA 1998).

Peter Rayney FCA FTII TEP is a tax partner with BDO Stoy Hayward's West Midlands practice, where he provides a tax consultancy service to accountants, lawyers and owner-managed businesses. He is the author of the loose-leaf work The Practical Corporation Tax Manual, published by ABG Publications.

Spock has substantial capital and has been approached by his brother, Jim, to invest around £90,000 by way of fresh equity investment into Jim's company, Enterprise Ltd. Enterprise Ltd is currently wholly owned by Jim and has manufactured 'sci-fi' models, toys and memorabilia for many years.

The funds raised by Enterprise Ltd from the share issue are required for the acquisition of new machinery in August 2001. It is proposed that Enterprise Ltd will issue Spock with 60,000 new £1 ordinary shares at £1.50 each (ie, at a premium of 50p per share). The new shares will rank pari passu with the existing ordinary shares.

Jim has promised to give Spock a seat on the board if he invests in the company. Although Jim has no immediate plans to sell Enterprise Ltd, he predicts that it would be 'ripe' for a trade sale within the next few years.

An extract from the summarised balance sheet of Enterprise Ltd on 31 July 2001, immediately before the proposed share issue, is shown below:

In October 2000, Spock made a capital gain (before taper relief) of £20,000 on the sale of his Welsh holiday cottage and was wondering whether the investment in Jim's company would enable his CGT liability to be deferred.

1. The investee company must be unquoted with no arrangements for it to be quoted (but AIM or OFEX companies potentially qualify subject to the 'gross assets' test - see (2) below) (s 293)).
2. The gross asset value of the investee company's assets (per its balance sheet under GAAP) must not exceed £15m before the share issue or £16m immediately afterwards. If the investee company is a holding company with one or more qualifying subsidiaries (see below), the consolidated balance sheet value is used (s 293(6A)(6B)).
3. No other company must exercise 51% control over the investee company - this uses the broader s 840 definition of control and ignores the potential future rights of, for example, venture capital companies in a winding up.
4. The investee company must exist wholly or substantially for the purposes of: (a) carrying on one or more qualifying trades wholly or mainly in the UK, or (b) being a holding company of a qualifying trading group holding at least one qualifying subsidiary (ie, broadly a subsidiary that carries on a qualifying trade). The company or group is broadly treated as satisfying the 'substantial' test if its non-qualifying 'excluded activities' (see below) account for less than 20% of its total activities (measured by reference to various factors including turnover, net profits, capital employed, etc).
5. For these purposes, a qualifying trade is any trade except one that substantially consists of certain 'prohibited' activities, the more common ones being:
   • land, commodities or share dealing;
   • dealing in goods otherwise than in the course of an ordinary wholesale or retail distribution trade;
   • banking, insurance, money lending and other financial services;
   • leasing of assets (including letting assets on hire) or receiving royalties or licence fees (but for post-5 April 2000 share issues, royalty income, etc, derived from internally generated intellectual property will qualify);
   • legal and accountancy services;
   • property development*;
   • farming and market gardening*;
   • forestry and timber production*;
   • operating or managing hotels, guest houses, nursing homes, etc, but only where the operator/ manager has an interest in or occupies the relevant establishment *;
   • the provision of administration services, etc, to a commonly controlled company that carries on one of the above trades (s 297).

* Only prohibited activities for post-16 March 1998 share issues.