One of the UK's most effective tax shelters is being refocused - but investors can still reap the benefits with proper planning, says Steven Harris
EIS investment offers one of the most effective tax shelters in the UK market at present. The government introduced the Enterprise Investment Scheme in 1994 in order to encourage private investment into promising smaller UK companies - a sensible plan given the role this sector of the economy plays in driving both employment growth and innovation.
However, a significant proportion of EIS investment has flowed into asset-backed businesses, capital protection schemes, companies already attracting government subsidies and many of these businesses are some way away from meeting the original purpose of the legislation.
Investors should be aware that recent changes in EIS legislation have re-emphasised the initial purpose of EIS to encourage smaller high-growth UK companies, particularly those creating and developing intellectual property. In spite of this, EIS offers significant opportunities for high net worth investors based in the UK as well as those who may be resident in the UK but not UK domiciled.
In general terms EIS remains very attractive: government-backed tax incentives include a 30 per cent initial income tax relief, CGT exemption on EIS investments, inheritance tax exemption, and unlimited capital gains tax deferral (on capital gains made in the three years prior to or the year following the date of investment). Loss relief at up to 45 per cent is available.
Since its launch, almost 22,900 companies have received investment through the scheme and over £12.2 billion worth of funds have been raised. Technology companies currently represent the highest proportion of any sector in the UK for businesses using EIS, with over 650 companies having raised funds through the scheme in the last year alone. Committed Capital is a finance house investing in promising high-growth UK companies, frequently in the technology sector and has seen strong growth in investor interest in the sector.
EIS has undergone quite a few changes in 2014 and 2015 budgets; the frequency and scope of these changes has resulted in significant confusion and will change the EIS sector considerably. In our view the logic of these changes overall is to refocus UK early stage investment, in particular where the underlying business is in the all-important area of creating or developing intellectual property in the UK.
In summary, these changes will mean that many clean energy companies will now no longer qualify for EIS tax relief if already receiving public subsidies in relation to energy production but, otherwise knowledge intensive businesses will benefit.
Equally, older companies may not now qualify for EIS and, in future, neither will companies not showing the potential for significant growth. More specifically, changes include:
- With effect from Royal Assent to the Finance Bill 2014, companies cannot benefit from investment via EIS schemes if they also benefit from relevant subsidies (eg DECC Renewable Obligations Certificates or Renewable Heat Incentive subsidies). The logic of this is to prevent clean energy companies from benefitting from two separate layers of government subsidy.
- A new category of company (a knowledge-intensive company [KIC]) has been defined. Some of the EIS conditions are more generous for KICs than other companies. To qualify as a KIC, companies will need to demonstrate that they have research and development costs that account for at least 10-15 per cent of their total operating costs (depending on when the expenditure was incurred), and either create intellectual property, or have 20 per cent of their workforce, qualified to relevant Masters or equivalent higher degree level, engaged in R&D or innovation.
- A lifetime limit for the issuing company has been introduced to cap the maximum amount it can raise under EIS schemes. This limit will be £12 million for most companies, but there will be an enhanced £20 million for KICs.
- The employee limit for knowledge-intensive companies will be increased to 499 employees, from the current limit of 249 employees; the limit for other EIS qualifying companies is 249 employees.
- EIS relief will not be available in general for share issues in companies which have been trading for more than seven years in general or ten years for a KIC.
- The previously announced requirement that EIS investments are for the purpose of growth and development is also being introduced (HMRC guidance is expected on this shortly).
As an investor in knowledge-based fast growing businesses, we like these changes but do recognise that the EIS sector will change dramatically as a result.
We believe that the new caps introduced in relation to pensions and ISAs will reinvigorate interest in the EIS sector.
In addition to these general benefits for UK taxpayers, we believe specific categories of investor stand to benefit from EIS; these include:
- As an offset to taxes on bonuses or dividends, particularly for business owners. Increases in dividend tax and reductions in dividend tax credits in April 2016 make this particularly timely.
- As part of a plan for UK residents who are not UK domiciled to benefit from EIS benefits while preventing any applicable remittance tax.
- As an alternative to pension funding. The total lifetime amount that can be tax efficiently saved into a pension is now capped at £1.25m and the annual tax efficient contribution is £40,000. EIS provides a complimentary tax efficient solution.
- As part of a plan for the payment of school fees. Average day school fees for example have risen by some 342 per cent. since 1990; annual contribution to EIS schemes, including rollover where appropriate, can result in considerable financial benefits.
- As part of a plan to offset or defer CGT, or to mitigate inheritance tax.
In order to illustrate the power of EIS in these areas we provide more detailed information on two of these possible solutions below.
Dividend planning for Business Owners pre-6 April 2016. As a result of the financial downturn and high effective rates of personal tax, business owners in the UK have increased the amount of cash held on their companies' balance sheets, which stands at an estimated £170 billion.
How a business owner extracts money from their company, and the amount extracted, drives the amount of tax payable, with a higher rate tax payer suffering 40 per cent income tax on a bonus or 25 per cent on a dividend receipt. An additional rate taxpayer has to pay 45 per cent income tax on a bonus or 30.56 per cent on a dividend receipt. However, from April 2016 dividend tax rates will increase, and the dividend tax credit will be replaced with a meagre £5,000 tax-free dividend allowance.
Dividend tax rates will increase from where they are now (25 per cent) to 32.5 per cent, and for additional rate taxpayers, it will increase to 38.1 per cent from the current 30.56 per cent. This is why it's essential that business owners consider planning ahead of the new tax year, either by investing some of the money extracted in to an EIS to generate an income tax credit of 30 per cent together with investment growth to offset the tax payable; or by extracting money through a loan, a dividend and loan, or a bonus and loan.
Remittance planning for UK residents not domiciled in the UK
Another significant announcement to emerge from July's emergency budget was the chancellor's decision to abolish permanent non-dom status for income tax and capital gains tax with effect from April 2017. For these individuals who pay tax on a remittance basis, EIS provides a further incentive to bring money onshore by reducing their exposure to UK tax on that remittance.
These individuals need to ensure any funds they bring in to the UK are invested within 45 days after arrival in order to avoid paying on the remittance, so can claim Business Investment Relief and EIS relief on their investment.
As outlined in the example below, by remitting £1.56 million with an EIS investment, an individual could potentially end up £450,000 better off than if they didn't do this.
The EIS sector will change as a result of recent budgetary changes; we believe that these changes are perhaps best understood in the context of a sensible requirement to refocus EIS investment on supporting high growth, knowledge-based, smaller companies. In our view this is the underlying purpose of the legislation.
Investors can benefit tremendously from making the most of the tax-efficient investment options available to them and considering the significant role EIS can play in their tax planning, but is essential to plan ahead and avoid rushing to invest at the end of the tax year.
Steven Harris is chief executive of Committed Capital