What effect do share buybacks have on EIS?
Share buybacks can be detrimental to EIS eligibility whether the company has already received EIS investment or if it will do so in the future. We have discussed share buybacks in more detail here.
Buying back EIS shares
If a company has already issued EIS shares, they must be held by the shareholder for at least three years following the issue to maintain EIS eligibility. If the EIS shares are disposed of (whether through selling them through a share transfer or a buyback) within the qualifying period (which is a minimum of 3 years from when they are issued) they will not benefit from the tax relief that comes with EIS eligibility. It should also be noted that a share buyback is by default taxed as a distribution subject to income tax and is therefore generally not efficient for holders of EIS shares as this takes away the benefit of being exempt from a charge to capital gains tax.
Buying back non-EIS shares
A company may wish to buy back shares from a shareholder who does not hold EIS shares. This type of buyback can still cause issues in terms of EIS eligibility if it is made within the four year period starting 12 months prior to the EIS share issue and three years after the EIS share issue (“Period C”). A buyback of shares within Period C can result in the EIS shareholders losing their EIS tax relief completely or in part. If EIS relief is lost it part, it will be proportional among the EIS shareholders.
A buyback of non-EIS shares can result in the total or partial loss of the tax relief due to EIS shareholders as funds from an EIS share issue cannot be used to fund a buyback.
EIS withdrawal or reduction
Whether EIS relief will be withdrawn entirely or just reduced will depend on the following formula:
R x EISR
where R is the amount received by the shareholder having their shares bought back, and EISR is the EIS rate for the tax year for which the EIS relief was obtained.
The EIS relief must (a) if it is greater than the amount given by the above formula be reduced by that amount, or (b) in any other case be withdrawn.
It should be noted that where the payment made by the company is insignificant, it may not result in a reduction and withdrawal of the relief, but this should always be checked with a professional advisor.
Example
Company A has three shareholders who have subscribed for EIS shares. All three have subscribed for 1000 shares at £10 a share. EIS shareholder 1 subscribed for their shares 4 years ago and is no longer within period C. EIS shareholders 2 and 3 invested in a later issue and are still within period C. It is proposed that one of the founder shareholders who is leaving the business “under a cloud” is to have his 1000 ordinary shares bought back at a price of £10 a share. The founder shareholder was not eligible for and did not claim EIS Relief.
In this example EIS shareholder 1 is not affected and as the founder shareholder does not have EIS shares so s/he is taxed on the buyback in the normal way (distribution taxed at the rate applicable to dividends unless by exception s/he qualifies for capital treatment). As there is no clawback of EIS relief from the founder shareholders we now need to consider the impact on EIS shareholders 2 and 3.
Using the formula above R=£10,000 and EISR is 30%. Applying the formula the claw back of EIS relief is £3,000 (30% of £10,000) and will be applied proportionately between EIS shareholder 2 and 3 meaning they will have to make a payment of £1,500 of income tax each. Both EIS shareholders 2 and 3 would originally have claimed £3,000 of income tax. This will mean that in addition to having to pay back income tax they will lose the right to an exemption from capital gains tax on the proportion of shares subject to the claw back. In this example they will be left with 5000 EIS qualifying shares each and 5000 shares that will on a sale be subject to capital gains tax in the normal way.
If using the facts above but with the founder shares being bought back for £100 a share then the potential claw back would be £30,000 (R=£100,000 and EISR 30%). As £30,000 is in excess of the aggregate of the two amounts of £3,000 income tax relief claimed by EIS shareholders 2 and 3 the claw back of relief is limited to the original claim made. Both EIS shareholders 2 and 3 are left with ordinary shares that do not qualify EIS.
If you are considering a share buyback and want to know more about the effects it could have on any current or future EIS eligibility, please contact your lawyer or professional advisor.
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