How Does EIS Tax Relief Work? Explained with Real Life Examples

It can be thrilling and risky to invest in small, startup companies. The Enterprise Investment Scheme (EIS), which offers tax breaks that lower risk, is intended to promote investment in growing UK businesses. EIS can significantly improve your financial situation by reducing your income tax and deferring capital gains. In this blog, we’ll explain how does EIS tax relief work, and provide real-world examples to show how these incentives can benefit early-stage investors.

What is the Enterprise Investment Scheme (EIS)?

The UK government’s Enterprise Investment Scheme (EIS) offers substantial tax breaks to encourage investment in small, high-risk businesses. It provides benefits like income tax relief, capital gains tax deferral, and protection if the business fails, helping to lower the risk of investing in startups.

Example: Tom uses the Enterprise Investment Scheme to invest £10,000 in a small UK company (EIS). The programme allows him to claim 30% income tax relief, meaning that HMRC will return £3,000 to him. As the business expands, he might also be able to avoid paying capital gains tax on any profits from the sale of his shares.

EIS Eligibility – Who Qualifies?

The Enterprise Investment Scheme is not available to all investors or companies. Both sides are subject to regulations to ensure that the proper kind of investors and enterprises are supported.

A] For Companies:

To be eligible for EIS, a company needs to:

• Have a UK headquarters and not be listed on a major stock exchange.
• Employ fewer than 250 people full-time.
• Possess pre-investment gross assets of no more than £15 million.
• Be involved in an established profession; other sectors, like banking, real estate, and legal services, are not qualified.
• Be less than 7 years old in most cases.

B] For Investors:

Investors who wish to take advantage of EIS tax benefits must:

• Be a taxpayer in the United Kingdom.
• Make an annual investment of up to £1 million (or £2 million if you’re investing in knowledge-intensive businesses).
• Keep the stock for a minimum of three years.
• Be disconnected from the business (for example, not working for it or having excessive authority).

Here’s an example to help you understand the concept:

• Companies: Suppose BrightApps is a small IT startup in the UK. With 20 employees and £5 million in gross assets, it is headquartered in London. Because BrightApps is under five years old and specialises in software development, it is eligible under EIS regulations. Investments under the Enterprise Investment Scheme are available to it since it satisfies all requirements.

• Investors: Let’s now introduce Emma, a taxpayer from the UK who wishes to invest in BrightApps. She makes the decision to invest £50,000 and intends to hold onto the shares for a minimum of three years. She satisfies the “disconnected” criteria because she is not involved in the day-to-day operations of the business. Emma can defer any capital gains if she has profits from other investments and receives 30% income tax relief through EIS, which will lower her upfront tax liability by £15,000.

Full Breakdown of EIS Tax Benefits

There are five types of EIS Tax benefits that we will be understanding in this section.

A] 30% Income Tax Relief:

• You are eligible to receive a 30% income tax reduction on your investment when you purchase qualifying EIS shares.
• For instance, you can lower your income tax liability by £3,000 if you invest £10,000.
• Up to £300,000 (or £600,000) in tax relief is available for investments up to £1 million per year (or £2 million if at least £1 million is invested in knowledge-intensive companies).
• There is flexibility in whether the relief is carried over to the prior year or applied to the current tax year.

Example: James puts £10,000 into a business that meets EIS requirements. He is eligible for 30% income tax relief, which lowers his tax liability by £3,000, thanks to EIS.

James is also free to choose when to use this relief. If it is more beneficial, he can carry it back to the prior tax year and utilise it to lower that bill rather than applying it to this year’s tax bill.

B] Capital Gains Tax (CGT) Exemption:

• Any profit from the sale of EIS shares is exempt from capital gains tax if you have owned them for at least three years and the business is still eligible for EIS.
• This implies that, if all EIS requirements are fulfilled, your investment can increase tax-free.

Example: James invests £20,000 in a business that has received EIS approval. After three years of holding the shares, the business expands, and his investment now has a £50,000 value.

The profit of £30,000 would typically be subject to capital gains tax (CGT). James, however, does not have to pay any CGT because he invested through EIS and complied with the standards.

C] Capital Gains Deferral Relief:

• When you sell other assets, you can postpone paying CGT by reinvesting the proceeds into EIS shares.
• Paying the deferred gain only occurs when:
  • The EIS stock is either sold or
  • They lose their EIS eligibility, or
  • You cease to dwell in the UK.
• As a result, investors can better control when they will be liable for taxes.

Example: James gets a capital gain of £30,000 after selling some shares in another company. He would normally be required to pay capital gains tax on that sum immediately. He reinvests the £30,000 in a business that has received EIS approval instead.

James will be able to delay paying CGT in this way. He is only required to make the deferred tax payment if,

1. He gets rid of his EIS stock,
2. The business no longer qualifies for EIS, or
3. He is relocating overseas.

This gives James more flexibility and makes his money work harder in the interim by allowing him to choose when the tax bill is due. See our guide on tax planning and carry-back strategies for more on timing and carry-back options.

D] Loss Relief:

• Loss recovery is available to you if the EIS business fails and you incur a loss on your investment.
• The negative risk is decreased by the ability to deduct the loss from either capital gains or income taxes.
• This implies that a higher-rate taxpayer may be eligible to receive additional reimbursement, bringing the net loss down.

For example: If James invested £10k in an EIS company, he loses the entire sum if the business fails. Because of EIS, James first gets 30% income tax relief (that’s £3,000 back). His real loss is now £7,000.

James can receive an additional £3,150 back because he is a higher-rate taxpayer at 45% and is eligible for loss relief on the £7,000. Ultimately, he only lost £3,850 rather than the entire £10,000.

This shows how EIS lowers the risk of funding businesses; even if things don’t work out, the plan helps safeguard your funds.

E] Inheritance Tax Relief:

• Since EIS shares are held for at least two years, they often qualify for 100% Business Relief at the time of death.
• The value of the shares can therefore be transferred without incurring inheritance tax.
• As it eliminates these investments from the taxable estate, it is very beneficial for estate planning.

Example: James has been holding EIS shares for over two years. These shares would typically be eligible for 100% Business Relief if he died after this time.

This implies that there would be no inheritance tax due when the shares were transferred to his relatives. For instance, the entire sum might be given to his heirs tax-free rather than being subject to the standard 40% inheritance tax rate.

Because of this, EIS is an effective estate planning tool that aids investors like James in preserving the value of their capital for future generations.

Claiming EIS Tax Relief

It is not automatic for investors to get an EIS tax reduction; they must actively make a claim to HMRC. There are minor differences in the procedure based on whether you are requesting loss relief, capital gains tax exemption, or income tax relief.

Receiving an EIS3 Certificate:

• After investing, the business you support needs to be authorised by HMRC as an EIS-qualifying business.
• You will receive an EIS3 certificate from the company after it has been approved, which is typically a few months after the investment.
• You must obtain this certificate before you can claim any tax reduction.

Claiming Income Tax Relief:

• On your Self-Assessment tax return, you can seek relief.
• Details from your EIS3 certificate, including the investment amount, share issue date, and HMRC reference, are required.
• If you have a sizable income tax due to offset, you could claim relief for the current year or carry it over to the previous tax year.

Example: Sophie invests £20,000 in an EIS-approved company. She gets her EIS3 certificate a few weeks later, which includes the HMRC reference number, the investment amount, and the date the shares were issued.

Sophie adds these facts to obtain her relief when she fills out her Self-Assessment tax return. Sophie’s tax burden is lowered by £6,000 because EIS provides a 30% income tax reduction.

Now, suppose Sophie had a larger tax bill last year but didn’t owe much this year. She still receives the entire return on her investment if she chooses to carry the relief back and apply it to her return from the previous year.

Claiming Capital Gains Tax Exemption:

• Any gain from the sale of your EIS shares that you have owned for at least three years is automatically free from CGT.
• You only indicate that the disposal is eligible for EIS exemption and record it on your Self-Assessment return.
• If all EIS requirements are satisfied, there is no CGT to pay.

Example: Three years later, Sophie makes £40,000 from the sale of her £20,000 EIS investment. Normally, she would have to pay Capital Gains Tax (CGT) on that £20,000 gain.But, since she held her shares for more than three years, the profit is entirely tax-free because they qualified under EIS.

The sale is simply noted as EIS exempt when Sophie completes her Self-Assessment tax return.

Claiming Capital Gains Deferral Relief:

• Reinvesting capital profits into EIS shares allows you to postpone paying taxes.
• Using your EIS3 certificate, the claim is submitted on your Self-Assessment tax return.
• The EIS shares must be sold or cease to qualify for the deferred CGT to become payable.

Example: Sophie received a £15,000 capital gain from the sale of some shares in another company before investing in her EIS company. Ordinarily, she would have been required to pay capital gains tax on that sum immediately.

Rather, she puts the £15,000 profit back into her EIS stock. She makes a claim for Capital Gains Deferral Relief on her Self-Assessment tax return using her EIS3 certificate. As a result, Sophie is exempt from paying CGT on the £15,000 at this time. Payment is only due later if she:

• Sells her EIS shares,
• The company stops qualifying for EIS, or
• She moves abroad

By deferring CGT, Sophie keeps more of her money working for her in the meantime.

Claiming Loss Relief:

• If the EIS business fails, you can deduct the net loss from your CGT or income tax.
• The claim is submitted on your Self-Assessment return, and the calculations show the amount of loss after the initial income tax reduction.

Example: Sophie invested £20,000 in her EIS firm, but regrettably, it collapsed and her shares lost all of their value. She was able to receive a 30% income tax reduction when she invested thanks to EIS, which allowed her to get £6,000 back. That comes to £14,000 (£20,000- £6,000) as her net loss.

Because Sophie is a higher-rate taxpayer (45%), she can claim Loss Relief on her remaining loss (£14,000).
14,000×45%=6,300
This reduces her loss further: 14,000−6,300=7,700
Sophie eventually loses just £7,700 rather than the entire £20,000.

Inheritance Tax Relief:

• When valuing your estate, your executors file for Business Relief instead of Inheritance Tax Relief, which typically requires no claim.
• Your taxable estate should not include the investment if the shares were held for at least two years and qualified at the time of death.

Example: Over two years have passed since Sophie acquired her £20,000 worth of EIS shares. Sadly, if she passed away after that, her EIS shares would frequently qualify for 100% Business Relief coverage. This would eliminate the requirement for her executors to submit a particular petition for inheritance tax relief. Rather, they merely use Business Relief to value her estate, and the EIS shares are not included in her taxable estate.
For instance, if Sophie’s shares had increased to £50,000, the entire sum might be transferred to her family tax-free rather than subject to the standard 40% rate of inheritance tax.

Important Holding Rules & Risks

While the Enterprise Investment Scheme (EIS) provides substantial tax advantages, investors must be aware of the stringent regulations pertaining to holding periods and specific hazards.

Minimum Holding Period:

• To maintain tax benefits, you must own EIS shares for a minimum of three years from either:
  • the date of issue of the shares, or
  • the date of the business’s launch (if later).
• Tax relief and the possibility of repaying previously claimed advantages are typically lost when shares are sold, given as gifts, or otherwise disposed of before this time.

Qualifying Company Requirements:

• For the duration of the minimum holding period, the business must continue to be EIS-qualifying.
• Investors may lose tax benefits if the company stops meeting EIS requirements (for example, by exceeding asset or staff restrictions or altering business operations).

Example: Sophie makes an EIS-eligible investment in a small tech business. The corporation must adhere to the regulations for at least three years, such as having fewer than 250 employees and only engaging in qualified business operations, to maintain its tax benefit.

Sophie might lose her EIS tax benefits if the business subsequently moved to a non-qualifying venture, such as renting out real estate.

Restrictions on Investor Control:

• A maximum of thirty percent of the company’s shares, voting rights, and loan capital can be held by investors.
• You are not allowed to get paid more than the allowed director fees or work as an employee. Tax assistance may be void for violations of these regulations.

Example: Sophie only purchases a 10% stake in the tech business that has received EIS approval. This is acceptable since she is not allowed to own more than 30% of the company’s shares, voting rights, or loan capital, according to EIS regulations. Sophie would lose her EIS tax breaks if she attempted to purchase 40% of the business or accept a paid position there.

Liquidity Risk:

• Investing in EIS companies means purchasing stock in newly formed, private companies that aren’t yet listed on the stock exchange. This indicates that selling your shares early is typically difficult.

• The majority of investors only receive their money back when the business experiences an exit event, such as a sale, IPO, or buyout. Your funds are locked up until then, often for years.

• To put it briefly, EIS investments are not opportunities for rapid cash. You must be willing to wait.

How EIS Compares to SEIS and VCTs

The purpose of the Venture Capital Trusts (VCTs), Seed Enterprise Investment Schemes (SEIS), and Enterprise Investment Schemes (EIS) is to promote investment in smaller, riskier UK businesses. They vary, nevertheless, in terms of their reach, degree of risk, and available tax breaks.

Here’s a Practical Example to Illustrate the Concept

Let’s say three friends, Sophie, James, and Priya, each want to invest in UK businesses but in different ways.

• Sophie decides on EIS. She contributes £20,000 to a growing IT company. Her gains after three years will be tax-free if the business is successful, and she receives a 30% income tax reduction (£6,000). But she also realises that until the business is sold or goes public, her money might be locked up.

• James chooses SEIS. He immediately receives a 50% income tax reduction (£5,000) after investing £10,000 in a new firm. He may be eligible for loss relief if the business collapses. The tax benefits are the greatest, but the risk is substantially higher because early firms frequently fail.

• Priya chooses VCTs. Instead of backing one company, she invests £20,000 in a Venture Capital Trust. This gives her 30% tax relief (£6,000), and she earns tax-free dividends along the way. Her money is divided across many small businesses, which lowers risk, and she can trade VCT shares more easily since they’re listed on the stock market.

How an Accountant Can Help You Maximise EIS?

It can be challenging to get the most out of EIS because the regulations are intricate and the claims procedure demands precision. A competent management accounting service provider is essential to ensuring that you maintain your HMRC compliance while taking advantage of all available reliefs. They can first determine if the business you are investing in is eligible for EIS and then offer advice on how much you can invest under the annual cap.

When it comes to filing, an accountant will help you with your Self-Assessment to obtain Capital Gains Deferral, Income Tax Relief, and Loss Relief, if applicable, while making sure the reliefs are used as tax-efficiently as possible. Accountants offer long-term planning assistance in addition to the immediate tax benefits. They can help you establish a portfolio spanning SEIS, EIS, and VCTs and offer advice on inheritance tax issues through Business Relief.

E2E Accounting helps businesses and investors navigate the full EIS process. We handle every step of the process, from verifying business eligibility and managing compliance to submitting your claims and coordinating investments with your broader financial objectives. You can be sure that you are maximising tax benefits, guarding against downside risk, and making wise plans thanks to our experience. Contact us today to find out how we can help you make the most of your EIS investments while minimising risk and planning for long-term growth.

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