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Twelve novel ways to destroy SEIS & EIS tax relief

Last updated
29th April 2022
Written by
Sam Simpson

Maintaining (S)EIS eligibility for your investor(s) should be towards the top of your priority list. In this article we explore the various ways in which you could inadvertently cause an issue with these schemes and, by extension, how you can avoid such a scenario.

There are plenty of ways to make your company ineligible for (S)EIS investment – time limits, substantially being involved with non-qualifying trades, asset tests, permanent establishment and ownership rules, shares being not ‘paid wholly in cash’ and much more.

Let’s not forget that there are quite a few ways that investors can make themselves ineligible for the schemes – for example by being a director in a business before trying to invest under (S)EIS or making an investment outside of the scheme and then trying to make use of (S)EIS at a later date.

But, let’s say that you’ve got (S)EIS advance assurance in place to ensure investors have comfort that their investment will qualify for the lucrative tax break. You’ve taken the cash, issued share certificates, sent (S)EIS1 forms to HMRC and issued (S)EIS3 forms to investors.

The paperwork is done, your (S)EIS worries are over, and you can forget about those schemes now?

The (HMRC) Empire Strikes Back

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Not quite...The (S)EIS schemes remain very brittle – you need to ensure that you don’t do anything to inadvertently destroy the tax relief for your investors. This article details many, but not all, scenarios under which this can occur.

If you do breach the rules, then investors stand to lose all (S)EIS benefits, specifically:

  1. They will need to repay any upfront relief (50% for SEIS, 30% for EIS) that they’ve already received;
  2. They lose the inheritance tax relief that would normally be afforded once the investor owns the shares for two years;
  3. They lose the loss protection afforded by these schemes; and
  4. If you do successfully exit and they make a profit on the shares, then they may have to pay capital gains tax on the gain in value.

That is a very disappointing outcome for your investor(s) and there are a few good reasons why you should do all you can to preserve relief for your investors:

  1. You will annoy your investors – which means they are very much less likely to put more money in during later rounds; and

  2. You have (probably) given an undertaking in your shareholders agreement to not destroy tax reliefs. If you do so, you are potentially facing a breach of contract claim against the company.

Nuances of SEIS vs EIS

Just before we dive into the detail, it is interesting to note that the SEIS and EIS rules are 90% identical – but there are some nuances to both schemes that are very much worth watching out for. We identify some of those below – there are plenty more lurking around!

As an example, under SEIS there is a rule that “The company has never been controlled by another company“, whereas under EIS there is a similar but more relaxed rule ‘At the date of share issue, the company will not be controlled by another company’.

Anyway, on to the SEIS / EIS-destroying situations to be aware of:

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1. Investment outside of the two year time limit

Many think that the two-year time limit for SEIS starts when you receive advance assurance, when you incorporate or something else. Using SEIS within the time limit is essential if your investors are to benefit from the scheme.

According to the HMRC manual: A ‘new qualifying trade’ is defined as being one which has not been carried on by either the company or by any other person for longer than two years at the date of issue of the shares; and where neither the company nor any qualifying subsidiary had carried on any other trade before the company in question began to carry on the new trade.

When does the two-year countdown start? Unfortunately, the legislation and written HMRC guidance is opaque. However, HMRC inspectors use the following analogy: you are preparing to open a new shop. Whilst the shop is being fitted out, the stock is being put on shelves for the first time, the sign on the front door would indicate ‘Closed’. As soon as you flip the sign to open, you have then commenced trading, even if nobody buys from you (or even enters the shop) for a couple of months.

2. Raising via EIS or VCT before SEIS

This item is very straightforward – at the point you issue shares under the SEIS scheme you will be asked to confirm that no shares which qualified for EIS have previously been issued or that the company has not received any previous investment from a Venture Capital Trust. You therefore must ensure that all SEIS shares are allocated before you go on to issue shares under EIS or VCT.

3. Raising SEIS and EIS on the same day

This potential gotcha is easy to trip over – if you are doing a ‘dual round’ – i.e. raising £150k via SEIS and £150k via EIS, for example, and even just one EIS gets their shares on the same day as the SEIS shares are issued then this could destroy eligibility under one of the schemes.

You may wish to use a process similar to the following to avoid this item:

  1. Before you close your funding round for signing communicate specifically to each and every investor that they shouldn’t transfer any investment funds until you communicate with them again.

  2. Once all documents are signed, communicate to all SEIS investors that they should transfer the SEIS funds only at this point. At this stage I would specifically advise investors individually regarding how much they should be transferring under SEIS. Note: If you have investors subscribing for both SEIS and EIS investment during this funding round (e.g. someone is investing £10k which has been split as £7k SEIS and £3k EIS) then this investor should be instructed to only transfer the £7k SEIS portion at this stage.

  3. Check your bank account for received funds and chase investors. When you do receive a payment from a specific SEIS investor, you should mark the investment as received on the FounderCatalyst platform. This step ensures that the share certificates will be issued on the correct date.

  4. Only once you have confirmed receipt of all SEIS investment and issued all SEIS share certificates should you pass this point on the process.

  5. Wait a day – you must not issue SEIS and EIS shares on the same day.

  6. Now instruct EIS investors to transfer investment funds.

  7. Again, mark the funds as received on the FounderCatalyst as you get visibility of the funds arrive in the company bank account

Clear and consistent communication with your investors is key in this scenario, to prevent the loss of either SEIS or EIS eligibility for all investors.

4. Repaying a loan with EIS

Another oddity between the two schemes – you can pay a director’s loan with SEIS funds, but not EIS funds. True story!

Usually, your investors will not want you to do this anyway, and indeed they may well have investor consents to limit your ability to do so, so this item may not be a huge issue in practice.

5. Exiting too soon

To continue to benefit from the tax breaks with both SEIS and EIS you need to hold the shares for at least three years.

Some businesses get acquired sooner than anyone envisages. As an example, one of my investments had an amazing offer for acquisition after two years and nine months. If they were acquired before the three-year anniversary then I’d have felt some tax pain – I’d have had to refund any tax relief already received and then pay CGT on the increase in value of my shares. Not ideal! Thankfully, the negotiation dragged on a little and the exit actually occurred just after the three-year anniversary, so all of the EIS reliefs remained intact.

6. Not spending the investment money within the relevant period

Again, this is slightly different between SEIS and EIS:

For SEIS, you must spend the money within a three-year period.

For EIS, this period is a little different:

  1. 2 years from the issue of the shares;

  2. if the activity consists of preparing to carry on a trade, 2 years from the issue of the shares or, if later, 2 years from when the company begins to carry on the trade.

7. Changing / adding a trade

A business wanting to use the SEIS to raise funds can carry on some excluded activities, but these must not form more than 20% of the company’s total activities. This test doesn’t just apply when the investor subscribes for shares, but you must also ensure that this remains true for the relevant three year period.

If your business pivots, branches out or in any way expands its scope of operation then you should consider the ongoing ‘excluded activities’ rules.

8. Ignoring the 30% ownership rule

An (S)EIS investor can only hold up to 30% of the company’s shares. This isn’t just about the number of shares, economic rights or voting rights. It can also be based on the nominal value of the shares in issue. Care is therefore needed when introducing different classes of shares or complex and unusual nominal value structures.

9. Subsidiaries and parent company considerations

Creating one or more subsidiaries, or restructuring a company’s existing subsidiaries, (including changing or adding a trade) requires care. We would urge you to seek specialist advice before considering undertaking any change at all in this area.

On a related note, you should be careful to ensure that any investment, made directly or indirectly, by another company doesn’t result in the investee company becoming a subsidiary of that investing company. This could happen if an organisation invests and owns 51% or more of the share capital.

10. Selling equity to an existing director

Whilst it is not possible to sell SEIS or EIS shares to an employee or current director, it is possible to sell shares to an individual before they become a director.

Ensuring that the shares are issued before the individual is appointed as a director and that the arrangement doesn’t breach the 30% ownership rule detailed above, are key considerations.

11. Creating a preference

Per, the HMRC manual, shares issued under the SEIS and EIS schemes must carry:

A right carried by a share is a preferential right if it takes priority over a one carried by another share. Preferential rights refer to a right to something in advance of another shareholder, not necessarily that dividends or liquidation can’t be distributed asymmetrically across different share classes.

HMRC helpfully clarifies that they do not consider the allocation of a specific dividend to one class of shares a preference.

As an interesting aside, offering voting shares to investors where some existing shareholders hold a class of shares not conferring voting rights is not considered a preference by HMRC. You do need to ensure that this arrangement doesn’t push an investor above the 30% ownership rule detailed above, though.

Care must be taken when reorganising share capital, restructuring share classes or altering rights to ensure that SEIS/EIS investors don’t inadvertently benefit from a preference.

12. No EIS after non-VCT schemes

This rule only applies to EIS - another quirk between SEIS and EIS. This item relates to Section 164A of the Income Tax Act 2007 - in short, an investor can only receive the benefits of EIS if they only hold subscriber shares (ie shares issued on incorporation) or shares issued under SEIS or EIS.

If, for example, the potential investor was previously offered shares as an advisor (and therefore not under the SEIS / EIS scheme) then they can make use of SEIS, subject to all of the other rules being followed, but cannot make use of EIS again.

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