Lifecycle of a tech startup series: Tax reliefs

14 September 2021

In episode 4 of our lifecycle of a tech startup blog series the founders of KNow Wear Limited decided it was time to take the business to the next level by finding external investment. After a brief detour to consider the essentials for e-commerce businesses in the UK in episode 5, you and the other founders are now once again focusing your efforts on raising investment. You are hoping to attract angel investors, who, in addition to investing funds in the company, will bring with them their own expertise and experience to help the business grow further. In preparing for external investment, you have starting putting together a pitch deck and a cap table. You have also taken steps to set up a data room so interested investors can carry out due diligence on the company and its business and you have discussed with Chris and Sarah the merits of putting a shareholders’ agreement in place.

You are aware that the Seed Enterprise Investment Scheme (SEIS) and the Enterprise Investment Scheme (EIS) are two tax incentive schemes for individuals who invest in early-stage companies. You are also aware that these tax reliefs will be important for your investors. A number of angel investors have indicated their interest in investing in the KNow Wear Limited and they have asked you whether the company qualifies for these reliefs. As such you have decided to take steps to ascertain whether KNow Wear Limited is a qualifying company for this purpose and if so, how this might be evidenced to the interested investors.

So what are the key considerations when determining whether a particular investment is eligible for SEIS/EIS relief?

What is SEIS/EIS relief?

Investing in early stage companies can be high risk. The SEIS/EIS schemes encourage investment in early stage companies by giving tax breaks to investors who are subscribing for relevant shares in those companies as a way to offset some of the risk. The reliefs can benefit investors by providing income tax relief and an exemption from capital gain tax (CGT) on the sale of the shares. Further, if a loss is made on the shares an investor may claim such loss against income rather than CGT.

In respect of SEIS relief, an investor may be able to reduce their income tax liability by up to 50% of the subscription price for the shares, subject to a maximum investment of £100,000 per tax year. For EIS relief, an investor may claim relief up to 30% of the subscription price for the shares, subject to a maximum investment of £1,000,000 per tax year. If an investor does not use their entire relief quota in one tax year, they may elect to treat some or all of the shares as being issued in the previous tax year and claim relief accordingly.

In order to be eligible for SEIS/EIS relief the company and the investor must satisfy certain qualifying criteria.

 

Do all startups qualify for the reliefs?

In order for a company to be eligible for the SEIS/EIS schemes it must meet certain qualifying criteria. These are:

  • the company must have a permanent establishment in the UK;
  • it is not trading on a recognised stock exchange at the time the shares are issued and it has no arrangements in place to do so;
  • it does not control another company other than qualifying subsidiaries. For a subsidiary to be a qualifying subsidiary the company must own more than 50% of the subsidiary’s shares, no one other than the company or one of its other qualifying subsidiaries can control the relevant subsidiary, and there cannot be any arrangements which would put someone else in control of the subsidiary. If the business activity that the investment will be spent on is to be carried out by the qualifying subsidiary or the subsidiary’s business is mainly property or land management, the subsidiary must be at least 90% owned by the company in order to be a qualifying subsidiary;
  • it is not controlled by another company, or does not have more than 50% of its shares owned by another company; and
  • it does not expect to be wound up after completing a certain project or series of projects.

In addition to the above requirements, the nature of the company’s business is also taken into account when determining its eligibility for SEIS/EIS relief. The company must carry on a qualifying activity or be carrying out research and development which will lead to a qualifying activity. There are a number of activities which are expressly excluded which would prevent the company from being eligible. These include, but are not limited to, dealing in land, farming, coal or steel production, legal or financial or insurance services, property development, running a hotel or a nursing home, shipbuilding, and generating, producing or exporting certain fuels. A company will not usually qualify if it receives licence fees or royalties unless it created the underlying intellectual property.

Further, to be eligible for SEIS, the company and its subsidiaries must not have gross assets over £200,000 when the shares are issued, not be a member of a partnership and have less than 25 full-time equivalent employees in total. This is slightly different to the eligibility requirements for EIS. To be eligible for EIS, the company must not have gross assets worth more than £15 million before the shares are issued, and not more than £16 million immediately afterwards. Further, it must have less than 250 full-time equivalent employees at the time the shares are issued. Subject to certain exceptions, a company is only eligible for investment under EIS if the raise is within 7 years of the company’s first commercial sale.

 

Which forms of investment qualify for the reliefs?

The investment must present an actual risk of loss of capital to the investor. For an investment to be eligible for SEIS/EIS relief it must be a subscription for new non-redeemable ordinary shares. The shares must not carry any current or future preferential rights to dividends or the company’s assets on a winding up. The shares must be fully paid at the time of issue and the subscription price must be satisfied in cash. Therefore, a loan that converts into shares (such as a Convertible Loan Note) will not be eligible but, if it is structured correctly, an investment made by way of an Advanced Subscription Agreement can be eligible.

 

Do all investors qualify for SEIS/EIS relief?

Individuals who are “connected” to the company are not eligible for SEIS/EIS relief. For these purposes, with certain exceptions, a person is connected to the company if they hold or are entitled to acquire, together with their associates (being their spouse, children or parents) more than 30% of the issued share capital or voting rights of the company or they are, or an associate of theirs is, an employee, partner or paid director of the company.

 

How much can a company raise under SEIS/EIS?

A company can raise up to £150,000 through SEIS investments, which includes certain forms of state aid the company has received in the 3 years up to and including the date of the investment. In respect of EIS, a company can a maximum of £5 million in any 12-month period. This includes any funds raised via SEIS, subject to a maximum of £12 million over the company’s lifetime.

 

What can the company use the funds for?

The funds raised by the company must be used towards a qualifying activity (as discussed above), preparing to carry out a qualifying activity (which must start within 2 years of the investment), or research and development that is expected to lead to a qualifying activity. Further, the funds raised must be spent within 2 years of the investment or, if later, the date the company started trading, to grow or develop the business. In addition the funds must not be used to purchase another business. Using the funds to repay a loan is unlikely to satisfy the growth and development condition and therefore a company should be clear at the outset what the SEIS/EIS funds will be used for. This can become complicated where the company is simultaneously raising funds which are EIS eligible and funds which are not. In these circumstances, thought will need to be given to how on a practical level the SEIS/EIS investment monies can be kept separate from other investment funds e.g. the company might use a second bank account to keep the funds separate.

 

Is it possible to lose the reliefs?

In certain circumstances SEIS/EIS relief may be reduced or lost altogether. The loss can be triggered by a change in circumstances of the company or the investor, within the period beginning two years before the relevant shares are issued, and ending three years after the date of issue (with some exceptions). Some of the common pitfalls to watch out for which could result in the loss of relief are that the company ceases to be a qualifying company or the shares cease to be relevant shares (for example the company issues a new class of shares which results in the shares held by the investor to enjoy a preference) or the investor ceases to be a qualifying investor or there is a buyback of shares by the company.

 

How can a company evidence to interested investors that the company is eligible for SEIS/EIS?

A company who is seeking to raise investment via SEIS/EIS can ask HMRC if the investment is likely to qualify before shares are issued. This is known as advance assurance. To apply for advanced assurance the company, or more likely the company’s accountant, will submit a bundle of information to HMRC setting out, amongst other things, how much the company hopes to raise, the business plan and financial forecasts of the company, a copy of the latest accounts, details of all trading and activities to be carried out, details of any previous investments, copies of the company’s memorandum and articles of association, etc. If HMRC is satisfied that the investment should be (although it is no guarantee) eligible for SEIS/EIS, it will provide a statement saying so, which the company can then show to its proposed investors.

 

Whilst SEIS/EIS is predominately a tax matter and it will therefore be driven by the company’s accountants, the company’s lawyers and accountants will work closely together to structure the investment in a way that is SEIS/EIS compliant.

You have now instructed the company’s accountant to check that the investment into KNow Wear Limited will be eligible for these reliefs and to apply to HMRC for advance assurance that the investment would meet the conditions for these schemes. You have also recommended that each of the potential investors take their own tax advice in connection with their investment. You are now in a position to proceed with the raise. What does this involve in practice? Find out in our next episode.

About the author

Luke Gregory works on a broad range of corporate and commercial matters including advising on company incorporation, bespoke articles of association and shareholder agreements, corporate governance, and Companies Act procedures such as off-market share buybacks and the removal of company directors.

 

Lifecycle of a tech startup series

Episode 1

Case study

Welcome to the first blog in the series on the lifecycle of a tech startup.

Read the blog

Episode 2

The basics

Last time we met the founders of a wearable tech startup, who wanted to take the next steps towards establishing their business.

Read the blog

Episode 3

Intellectual Property

As part of the incorporation process, our founders started to think about any intellectual property rights (IPRs) the business was using and ownership of the same. In this blog we shall be exploring the IP considerations founders should be considering in a bit more detail.

Read the blog

Episode 4

Preparing to raise investment

In the last instalment we talked about the ways in which the founders of KNow Wear Limited could protect the intellectual property in their business. Since then, the business has been progressing well and our founders have been working on developing a prototype.

Read the blog

Episode 5

Tech in Two Minutes/Lifecycle of a Tech Startup - Essentials for e-commerce businesses in the UK

Alex Torpey speaks about the legal notices and key points to note for online retailers and platform operators in the UK.

Listen to the podcast

Episode 6

Tax reliefs

After a brief detour to consider the essentials for e-commerce businesses in the UK in episode 5, you and the other founders are now once again focusing your efforts on raising investment.

Read the blog

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