More and more people these days are taking the plunge and having a go at starting their own business. Whether it’s a small, local outfit, or the next big tech innovation, obtaining the necessary cash is obviously one of the key challenges would-be Richard Bransons or Mark Zuckerbergs face. You’ve got the idea, you’ve got the drive, you’ve got the passion, you’ve got the skill… but how to get the funding?
It might be useful to know that there a couple of different tax breaks on offer that are designed to make investing in small, growing or start up businesses more attractive to investors. Whilst the tax incentives are very attractive, there are myriad rules and criteria that apply and here we provide a simple guide to the main schemes available and how to qualify for them.
Have a Plan
However attractive the tax system makes investing in small companies, any investor will want to see or hear a clear and comprehensive business plan. This should include, amongst other things:
- What the company will do and how it will be resourced
- Background on the market for its products/services
- The competitive landscape
- How and why you will reach your market and persuade people to buy
- What is special or strong about your idea/venture that means it will succeed
- Sensible, prudent financial projections (profit and cashflow)
- Details about the experience and skills of the key people involved
- An indication as to how the investor will get their money back… and more on top, i.e. the return they will receive
Sources of Funding
There are a number of sources of funding available to the go-getting entrepreneur, which can roughly be divided into:
- Debt: essentially a loan, usually provided by a bank, invoice or asset finance company or peer-to-peer lender, which is repaid over time, in fixed, agreed amounts and on which interest is paid. The lender does not own any of the company but is usually entitled to take their repayment in preference to all other claims on the cash of the business and will often require some security.
- Equity: investment in a business in return for shares, where the investor then owns part of the business and receives their reward as a share of the profits generated.
It is equity investment that is the subject of the tax incentives referred to above.
Enterprise Investment Scheme (EIS)
The aim of the scheme is to boost the attractiveness of investing in smaller, high risk companies and in a nutshell, a qualifying investor buying shares in a qualifying company will enjoy:
- A reduction in their income tax bill, relating to the tax year in which the investment is made, equal to 30% of the cost of the investment (effectively meaning an investment of say £100,000 could be achieved at a cost to the investor of only £70,000)
- For a purchase that qualifies for income tax relief, the investor will have no capital gains tax to pay on the subsequent sale of shares
- The income tax relief can also be carried back to the preceding tax year
In order to qualify for the tax relief, there are a number of criteria that must be met by both the company and the investor and it is wise for businesses looking to attract this type of investment to ensure they fit these rules before touting for funds.
The investment itself must be made in the form of the purchase of full risk-bearing equity, i.e. shares in the company and the shares must be paid for in full, in cash, when they are issued.
The investor must keep the shares for a minimum of three years from the date of purchase (or from the date the trade of the business started if later), though shares can be transferred between spouses.
A maximum investment of £1 million can be made, so £300,000 is the maximum amount of income tax relief available.
The investor must not be ‘connected’ with the company. This means he or she must own 30% or less of the business they are investing in (and be entitled to 30% or less of the assets on winding up) for the entire five-year period starting 2 years before the date of the share issue on which investment relief is sought and ending 3 years after. The 30% also includes any shares owned by ‘associates’ – business partners or close relatives.
The investor must also not be an employee, partner, or director of the business in which they are investing – though there is an exception allowing them to be a director as long as they receive no remuneration (and are not entitled to receive any) and they have not previously been involved in the trade of the business.
The investor will obtain their tax relief by submitting the relevant approval form with his/her self assessment tax return at any time up to 5 years after the 31 January following the tax year in which the shares were purchased and the investment was made.
Companies can receive up to a maximum of £5 million in EIS investments (including any SEIS and VCT investments) in any 12 month period. If this threshold is breached by a given investment, none of it will qualify for EIS relief.
For the entire 3-year period from the date of the issue of the shares, the company in which the shares are issued:
- Must have gross assets of no more than £15 million immediately before the investment and £16 million immediately afterwards
- Must have 250 employees or fewer
- Must be unquoted, i.e. not listed on the stock exchange
- Must not control a non-qualifying company or be controlled by another company when the shares are issued (a holding company can be introduced later if done correctly)
- Must have a permanent establishment in the UK (though the business can be conducted abroad)
- Must carry on a qualifying trade, on a commercial basis with the intention to realise a profit (or be the parent company owning 90% or more of a business that does)
Most types of businesses are deemed as carrying on a qualifying trade but certain types are specifically excluded, including: dealing in shares, commodities or land, banking, insurance, legal, accountancy, finance, property development, hotels, nursing homes, farming, coal, steel and shipbuilding (though a company will be allowed to carry out 20% or less of its business in these areas).
The funds raised by the business must be used in an existing qualifying trade, or in preparing for one, or in research and development, within 2 years of the share issue/purchase and can even be used to acquire a business, as long as 90% or more is acquired and that business subsequently uses the funds in one of the aforementioned ways.
Seed Enterprise Investment Scheme
The SEIS is very similar to the EIS but is designed to make investment in early-stage and start-up businesses more attractive by increasing the tax benefits associated, recognising the level of risk involved and therefore the difficulty such companies find in getting funds.
It works in a very similar way and as with EIS, the subsequent sale of shares is free of capital gains tax. The key differences are:
- The investor enjoys income tax relief equal to 50% of the investment
- The maximum investment is £100,000 (i.e. £50,000 maximum benefit in a tax year)
- The company must have gross assets of £200,000 or less and 25 employees or fewer, at the point of investment/share issue
- The company can receive a maximum of £150,000
- The trade carried on must be a maximum of 2 years old and the company must have carried out no other trade prior to that
- The funds must be used within 3 years of the investment/share issue
- The investor may be a director of the company
How to Benefit
The EIS and SEIS are controlled by the Small Companies Enterprise Centre (SCEC) within HMRC. The investee company must submit a form to the SCEC at some point after it has been trading for 4 months and before the date 2 years after the end of the tax year (5 April) in which the shares were issued.
If approved, the SCEC will issue an approval to the company as well as forms to be provided to investors to enable them to claim the income tax relief. Once the income tax relief is accepted/approved, the investor is automatically entitled to the capital gains tax relief, as long as he/she and the company continue to meet the above criteria for the 3-year period after the investment.
Reaping the Rewards – Entrepreneurs’ Relief
So… after years of hard work and innovation, you’ve built a thriving business and you’re looking to realise some value (and some much needed rest) by selling it.
The sale of any asset, including a business or shares in a company, is subject to capital gains tax on any profit made – i.e. the amount it is sold for less the initial amount paid for shares in the business. Usually, this is taxed at 18% for basic rate tax payers and 28% for higher rate tax payers and selling a business of any size is likely to result in the latter.
However, if certain conditions are met, a seller can benefit from Entrepreneurs’ Relief, meaning he or she will only need to pay 10% of the profits in capital gains tax.
Again, the primary reason for this tax break is to reduce the disincentive for entrepreneurs to build businesses that help grow the economy and provide jobs and investment and also to make it easier for them to sell equity to gain finance to grow their businesses further.
You can qualify for ER if:
- You sell shares in a company in which you own 5% or more of the shares and voting rights
- You sell all or part of a sole trader business or partnership, or its business assets
You must have owned 5% or more of the shares and been an employee or director of the company (or member of a group of companies) for a continuous period of one year or more before the sale.
For a sole trader, you must have owned the business and operated the trade for a year before the sale and you must sell the business assets with 3 years of closing or selling the business itself.
The above is a guide only and does not constitute advice. We strongly recommend you seek specialist advice from an expert before acting on any of the information above or attempting to take advantage of any of the schemes explained.