The constant battle between owners and investors in Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) companies is complicated and costly.
Investors have to read the articles of memorandum – the rule book that dictates how the company works – carefully if they want to reap the benefits of generous tax breaks offered on SEIS and EIS by the government.
This is evidenced in the latest case to go before First Tier Tax Tribunal, Flix Innovations Ltd v HMRC [2015] TC04710.
The tribunal stripped the shareholders of EIS income tax and capital gains tax reliefs because ordinary shares in the company were afforded preferential rights.
Qualifying conditions for tax relief
EIS rules give a comprehensive list of qualifying conditions for tax relief – including, depending on the date of issue:
- The shares must be unredeemable ordinary shares
- Must have no attached preferential rights, including no current or potential right to assets owned by the company on winding up
Flix Innovations had received HMRC pre-approval for EIS investment, but the company wanted to raise more funding from a further share issue.
The company founders held ordinary A shares, while investors held ordinary B shares. The A shares had extra rights that improved their voting power and allowed the founders to control the board.
The investors refused to increase their stake in the company, because this would dilute their voice on the board.
The founders could not cancel their shares because the company did not have enough cash in the bank.
Tax tribunal rejects appeal
The company decided to revise the articles and change the rights of the ordinary A shares into non-voting deferred shares. The nominal value was repaid in preference to that of the deferred shares.
Only ordinary shareholders would then have rights over the remaining surplus on winding up.
On winding up, the company presented documents to HM Revenue & Customs (HMRC) stating the shares had no preferential rights at any time.
HMRC withdrew EIS status from the company because the share carried preferential rights on winding up.
The company argued the money involved was small and HMRC guidance suggested this would not affect their EIS status and appealed the HMRC decision.
The tribunal rejected the appeal on the grounds that companies had to follow a statutory procedure to allow investors to claim tax relief under EIS or SEIS and that no de minimis rules applied.