September 6, 2013

• Thus, EIS offers a total tax saving and deferral of nearly 60% of the investment. Downside risk for 50% tax payers is effectively capped at 35% of original investment

• The annual investment per individual is limited to £1m. For shares issued after 6 April 2012, companies can raise up to £5m p.a. through EIS (and other VCT reliefs) – subject to final EU approval, expected imminently

• An “active trade” is needed: special rules allow licensing of intellectual property. So EIS is available for most projects in the film industry (from pre-development through production and on to distribution), along with games/app development and music recording

• Investors with stakes greater than 30% or who are employees/directors do not normally qualify

Overview of EIS

EIS is a UK Government scheme that provides tax reliefs for investors who subscribe for shares in smaller unquoted trading companies.  The scheme can be used to raise finance either for initial start-up or for expansion.  EIS funding can be used in conjunction with other financing e.g. bank debt, production incentives (e.g. UK film tax credit), pre-sales or equity investment.

The maximum investment in any one tax year per individual is £1 million.  The maximum each company can raise in any year from EIS (and other EU State Aid sources, e.g. venture capital tax reliefs) is currently £5 million for shares issued after 6 April 2012.  Note that the UK film tax credit does not count towards this £5 million State Aid limit.

The primary tax relief takes the form of a reduction in the investor’s UK income tax relief at a fixed rate of 30% on the amount invested.  Additionally, any gain arising on a disposal of the shares after three years should be free of capital gains tax.  Investors can also defer any recent capital gains on any other assets by re-investing all or part of the gain into an EIS company.  Losses made on the disposal of EIS shares can be set off against capital gains tax or, in some circumstances, income tax.  As a result of the reliefs, an individual could have a total tax saving and deferral of nearly 60% of his investment.  Conversely, if his investment totally fails, his net loss would be limited to 38.5% of his initial cash outlay.

Since these tax breaks are so attractive they are restricted to genuine “at risk” investments in smaller trading companies.  The investment must remain in place for a minimum three year qualifying period.  The scheme is limited to companies with gross assets before investment of up to £15 million, and £16 million post-investment, with fewer than 250 full time employees.

To satisfy the aim of the tax breaks, the focus is on “active” trades so financing and asset rich activities are excluded.  Licencing of intellectual property where the value has been created by the company is expressly allowed, thereby enabling companies in the media sector such as TV and film production to qualify.  Co-production can also, with care, qualify.  Indeed, the EIS scheme has proved most attractive to the media and film sector.  A broad spectrum of companies – including film development, pre-production, production, post-production, CGI, games/aps development and music recording/production companies – have all qualified.  It is also possible to establish an “EIS Fund” as a collective vehicle to diversify investment risk in an EIS wrapper.  These can be HMRC approved or unapproved:  both offer the generous EIS tax breaks and a spread of risk.

Outline of Scheme Rules

Throughout its relevant three-year qualifying period, the EIS company must:

• Be an unquoted company (Note: The UK AIM market is “unquoted”)

• Be a trading company, carrying on a qualifying trade

• Exist for genuine commercial purposes, and not be part of a scheme for the avoidance of tax

• Not be a 51% subsidiary of another company, or otherwise under the control of another company

• The company must not be in “financial difficulty”

• The company must have a permanent establishment in the UK.  Historically it had to have its business wholly or mainly carried on in the UK so the relaxation of this requirement permits EIS relief for non-UK operating companies (e.g. in the US or elsewhere)

In addition:

• An investor cannot be “connected” with the EIS company – i.e. broadly cannot own more than 30% of the shares/votes, directly or indirectly

• Individuals who are paid directors or employees of the EIS company at the time of the issue of shares are normally disqualified from claiming EIS relief.  However, qualifying investors can, in certain circumstances, be paid for their work as a director provided that the total remuneration package is reasonable

• The money raised by the EIS share issue must be wholly used for the qualifying business activity within a 2-year period

• Schemes that underwrite the equity risk, e.g. guarantees or exit arrangements, will not attract tax relief

• To prevent abuse, there is a “no disqualifying arrangements” rule.  Thus, the scheme will not attract tax relief if the shares are issued in connection with artificial arrangements whereby the EIS company is effectively a hive-off of a larger pre-existing enterprise or a mere shell lacking risk and substance.  However, HMRC have assured Wiggin LLP that this rule is not intended to catch genuine commercial arrangements in the film and creative industries.  Moreover, the rules should not prevent the normal film industry practice of setting up an SPV to make the film, or typical “sub-contracting” arrangements. 

Seed Enterprise Investment Scheme (SEIS)

To complement EIS, since 6 April 2012 SEIS offers smaller early stage companies a similar scheme to EIS.

• Income tax relief of 50% of the investment for individuals who invest in qualifying companies, irrespective of their marginal rate tax
• Annual investment limit of £100,000 per individual; cumulative limit of £150,000 over 3-year period for company
• Gains arising on the disposal of other assets in 2012/13 will be tax free if reinvested in SEIS in same year
• Company’s gross assets immediately pre-investment must not exceed £200,000, with less than 25 employees
• Funds raised must be for genuine “new” (i.e. less than 2 years old) trading venture. Relief not denied if trade is never commenced – so SEIS helpful for exploratory projects (e.g. film development or games/apps creation)
• Most of the EIS restrictions (e.g. unquoted, independence, no exit/guarantee arrangements) apply equally to SEIS.

Conclusion

The EIS and SEIS schemes have gained particular popularity in the film sector – offering not only the upsides of income and capital gains tax reliefs but also downside mitigation.  Historically, EIS players could be divided into those that are genuinely aiming to recoup large returns for investors specialising in new entrepreneurial businesses and those playing as risk-free a strategy as possible to preserve capital and convert the 30% tax relief into a fixed return over the 3 year play.  As mentioned, the UK Government perceived that certain schemes lacked substance and risk and have tightened the rules from April 2012 so that only genuine small entrepreneurial businesses qualify rather than hive-outs from large existing businesses.  More care is now needed in structuring schemes, but EIS/SEIS funds will nevertheless continue to provide valuable resources to the UK film sector.  The SEIS scheme will be an important tax relief (worth a maximum of 78% with the income tax relief and potential CGT exemption) attracting smaller investments into risky start-ups.

Wiggin LLP has considerable expertise in setting up EIS schemes acting for both investors and the EIS company. Our advice ranges from obtaining HMRC pre-clearance to structuring the arrangements (including all necessary documentation) and establishing EIS Funds – whether HMRC approved or not (including all regulatory aspects). The EIS group works closely with the film/TV/film financing group to maximise opportunities.

If you require advice or have any queries please contact Sue Crawford T: +44 (0)1242 631228; E: sue.crawford@wiggin.co.uk) or your usual contact at Wiggin LLP.