SEIS Tax Relief
The Seed Enterprise Investment Scheme (SEIS) is a government-backed scheme that is designed to help new businesses raise equity finance. SEIS tax relief benefits are available to investors in return for investing in small and early-stage start-up businesses in the UK. The aim of the SEIS is ‘to stimulate entrepreneurship and kick start the economy’.
SEIS investors can invest a maximum of £100,000 in a tax year which can be spread over more than one company. In return for their investment, the investor can then receive up to 50% SEIS tax relief in that tax year and providing shares are held for the qualifying 3-year period. There is also an exemption for any capital gains tax on an exit.
To qualify for SEIS tax relief, a company must be based in the UK, be no more than 2 years old, trade in an approved sector, have fewer than 25 employees and have assets of less than £200,000. A company cannot raise more than £150,000 in total from SEIS investment.
SEIS Tax Relief Example
In the following example, the investor has invested £100,000 in a start-up and pays income tax at 40%.
Initial SEIS Investment: £100,000
In return for the SEIS investment the investor can claim SEIS tax relief which reduces their income tax liability for that tax year. The amount of the reduction is equal to tax at the SEIS rate of 50% of the overall amount invested under SEIS.
Income Tax Relief at 50%: £50,000
Or, if this 50% would exceed the liability for the tax year, the amount of the reduction is whatever amount will reduce that liability to nil.
If however the company the investor holds shares in fails before the end of the 3-year period, any loss suffered by the investor, net of income tax relief, can be set against income of the current year or previous year. The value of the loss is multiplied by the rate at which the investor pays income tax.
So to use the example above:
Initial SEIS Investment: £100,000
Income Tax Relief at 50%: £50,000
Net cost to the investor: £50,000 (£100,000 – £50,000)
Loss Relief: £20,000 (£50,000 X 40%)
Cost to the investor after Loss Relief: £30,000 (£50,000 – £20,000)
Therefore, when the investor chooses to invest the £100,000 in a company, the maximum amount that is at risk should the company fail is £30,000.
If, however the investor receives a certain amount of money from the company when it fails, there will be a clawback of the Income Tax Relief that was initially given to the investor.
The amount of the SEIS tax relief to be withdrawn is equal to the amount of value received from the failed company multiplied by the SEIS rate of 50%. This clawback is capped at the amount of relief received by the investor originally.
HMRC will clawback the relief by raising an assessment for the tax year in which the income tax relief was initially received, rather than the year in which the investor received the value from the failed company.
To use the example above, if the investor receives £1,000 from the failed company, initial income tax relief of £500 (£1,000 X 50%) would be clawed back from the investor by HMRC.
The investor would therefore have to pay £500 income tax back to HMRC, increasing the net cost to the investor to £50,500. They could then claim income tax relief of 40% X £50,500 = £20,200. The cost to the investor after loss relief would therefore be £50,000 – £1,000 + £500 – £20,200 = £29,300.
If after 3 years, the company has not failed, and the investor has received Income Tax Relief in full on the whole of their subscription for the SEIS shares with none of the Income Tax Relief having been withdrawn, the investor will be eligible for disposal relief.
If this is the case, the investor will not have to pay Capital Gains Tax on a gain they acquire from the disposal of their SEIS shares.
Disposal relief is not available on any gain arising on a disposal within 3 years of the date the SEIS shares were issued to the investor. If the investor does sell their SEIS shares within 3 years of the date they were issued, the SEIS Income Tax Relief for those shares they sell will be wholly or partly withdrawn. Any gain the investor makes on the disposal of these shares will be chargeable to Capital Gains Tax.
If the investor makes a loss on the disposal of their SEIS shares at any time, they can set this loss against chargeable gains. In calculating the loss, the cost of the shares must be reduced by the amount of any Income Tax Relief given and not withdrawn.
Continuing the above example, if the investor sold their shares for £60,000 and £30,000 of Income Tax Relief is withdrawn, the allowable loss is calculated as follows:
Disposal Proceeds: £60,000
Cost of shares: £100,000
Income Tax Relief initially received: £50,000
Income Tax Relief withdrawn: £30,000
Income Tax which has not been withdrawn: £20,000
Allowable loss: £20,000 (£60,000 – £100,000 + £20,000).
So how do convertible loans interact?
SEIS/EIS & Convertible Loans
A convertible loan is a short-term loan that converts to equity, usually at a discounted rate. Although the investor does not have the rights of a shareholder, he/she can claim repayment of the loan, instead of conversion, at the maturity date if the start up is not doing well. Furthermore, interest on the loan gets accumulated and converted to equity on the conversion date along with the initial investment.
There are several reasons why a company may use a convertible loan. Firstly, it can be a source of capital before the next round of investment. This gives the company the stability of extra funds whilst they prepare for the funding round. The issue with this is that, by issuing a convertible loan, it may knock the confidence of other investors as it could indicate that business is not going well. The second reason a convertible loan is used is when the share price valuation has not yet been determined meaning the company cannot issue shares at the present time. The terms of convertible loans vary by a number of factors such as maturity date, interest rate, conversion discount and the conditions of the conversion date.
Many start-ups and growing businesses are using convertible loans at the early stage of investment, but are loan notes eligible for EIS/SEIS? Unfortunately, you cannot claim SEIS/EIS relief on a convertible loan. This is because, in order to be eligible for SEIS/EIS relief, the shares must be issued to raise funds for the purpose of business activity. The conversion of loan stock to equity is not considered to raise money for the company and therefore doesn’t qualify for SEIS/EIS relief. HM Revenue & Customs provide further information at ITA07/S257CB.
SEIS/EIS & Advance Subscription Agreements
However, it may be possible to get around this by issuing an Advance Subscription Agreement (ASA) instead. An ASA is not a loan and repayment cannot be claimed. It allows investors to pay for shares in advance of their issue, raising funds for the company outside of a funding round. ASA carries a higher risk to the investor than a convertible loan, but it may be eligible for SEIS/EIS relief if the business meets all other SEIS/EIS criteria.
Although there is no guidance from HMRC on ASA and SEIS/EIS relief, case law has shown that a company does not have to issue shares immediately after the money has been invested. As long as it is obvious that the investment is for shares only, the company can take up to one year to issue shares after an ASA. It is important to note that the qualifying period for SEIS/EIS relief is three years after the shares have been issued, not when the investment was made. Therefore, if the business goes into liquidation before issuing shares to the investor, they would not be eligible for SEIS/EIS relief.
Whilst it is possible that an ASA is eligible for SEIS/EIS relief, it will depend on the agreement. If a company is looking to raise funds in this way, they should apply for SEIS/EIS Advance Assurance for, stating the conditions of the ASA, to check the investor should be entitled to relief.
What Happens If A Company Fails?
If the company that the investor holds shares in fails before the end of 3-year period, any loss suffered by the investor, net of income tax relief, can be set against income of the current year or previous year. The value of the loss is multiplied by the rate at which the investor pays income tax.
For example, if the investment made is £50,000 and the investor pays income tax at 40%:
SEIS investment: £50,000
Income tax relief at 50%: (£25,000)
Net cost to investor: £25,000
Loss relief £25,000 x 40%: (£10,000)
Cost to the investor after tax: £15,000
However, the investor may receive a certain amount of money from the company when it fails. If this is the case, there will be a clawback of income tax relief that was given to the investors initially.
The amount of SEIS income tax relief withdrawn is equal to the amount of value received multiplied by the SEIS rate of 50%. The clawback is capped at the amount of relief received by the investor originally.
HMRC will clawback the relief by raising an assessment for the tax year in which the income tax relief was initially received, instead of the year in which the investor received the ‘value’ from the company.
Using the example above, if the investor received £1,000 from the failed company, initial income tax relief of £500 (£1000 x 50%) would be clawed back from the investor by HMRC.
Therefore, the investor would have to pay £500 income tax back to HMRC, making their loss £25,500. They could then claim income tax relief of 40% x £25,500 = £10,200. This would then make the net cost to the investor £25,000 – £1,000 + £500 – £10,200 = £14,300.
At Sleek, we specialise in SEIS/EIS and undertake SEIS Advance Assurance free for all start-ups. If you are looking to raise funds in the most tax efficient way, do not hesitate to contact us and speak to one of our expert advisors.