With the continuation of the 50 per cent. income tax rate, investment through the enterprise investment scheme ("EIS") continues to be an attractive proposition for high net worth individuals, bringing a growth in recent times in the launch of EIS funds in the market. However, EIS funds are unique in their structure and give rise to particular considerations for fund managers looking to establish a fund of this kind.

Tax Advantages of the EIS

Investment in EIS qualifying companies provides a number of tax advantages to individual investors.

Investors may claim a reduction in their income tax liability for the tax year in which they make the investment of an amount equal to 30 per cent. of the amount invested in shares in EIS qualifying companies, provided that the shares in the qualifying company are held for at least three years. This is subject to an annual investment limit of £500,000, set to increase to £1 million from 6 April 2012.

Where an investor qualifies for income tax relief on shares held in EIS qualifying companies, the investor will also be entitled to exemption from capital gains tax on any gains realised on disposal of the shares provided income tax relief has not been withdrawn.

Additionally, an investor who has realised gains on other assets can defer the tax on those gains by re-investing the proceeds in shares in EIS qualifying companies.

There are a number of criteria that apply both to investors in qualifying companies and to the qualifying companies themselves in order to qualify for relief under the EIS, and care will need to be taken to ensure that all of the relevant requirements are met prior to any investment being made.

Seed EIS

For shares issued on or after 6 April 2012 there will be an additional type of EIS relief known as Seed EIS. This will apply only to investments made in small companies within two years of incorporation and will entitle investors to a reduction in their income tax liability for the tax year in which they make the investment of an amount equal to 50 per cent. of the amount invested. The same capital gains tax exemption will apply as for EIS.

The qualifying conditions for a company will be broadly similar to EIS, although Seed EIS will apply only to companies with gross assets not exceeding £200,000 and with fewer than 25 employees. The annual investment limit for an individual will be £100,000.

Structure of an EIS Fund

Whilst EIS funds are termed such, an EIS fund is not a fund in the usual sense of a collective investment scheme, where the fund vehicle is the client of the manager, and a fund structure sits between the manager on the one hand and the underlying investor on the other. Rather, the fund operates as a series of discretionary investment management agreements between the manager and the respective investors in the fund.

Each individual investor's investment into the fund is pooled across investors and investments are made in EIS qualifying companies. However, investments are not held collectively, and each investor receives a separate parcel of shares in the EIS qualifying company in proportion to his or her investment in the fund, which are usually held by a nominee company on behalf of each investor. A custodian is usually appointed to hold the relevant investments and an administrator appointed to provide fund administration services. In order to qualify for EIS tax relief, shares in qualifying companies must be held for at least three years, after which the investments are usually exited and the fund wound up in due course.

Regulatory Considerations

Fund managers looking at establishing EIS funds will need to ensure that they have the correct regulatory permissions in place in order to do so. The scope of permissions required is likely to depend on the regulated activities undertaken by the manager as a whole, and the relevant management structure adopted in relation to the fund. However, the following are issues that are likely to arise in relation to the management of an EIS fund:

Regulated Activities
As noted above, an EIS fund is structured as a series of discretionary investment management agreements between the manager and each individual investor in the fund. It is therefore likely that managers will be undertaking the regulated activities (amongst others) of managing investments and advising on investments as manager of the fund. Managers will therefore require to have these activities included within their regulatory permissions in order to act as manager on behalf of the fund. Managers should also ensure that their regulatory permissions do not include any limitations which may affect their ability to manage the fund; for example, a limitation to corporate advisory business only or in relation to investments which do not include shares.

Regulatory Status of the Client
The absence of a fund structure in relation to an EIS fund means that the investor will be the direct client of the manager. As the EIS investment is only available to individual investors, managers will be required to treat investors as either retail clients or elective professional clients, provided certain conditions are met. Where management of the fund involves activities caught by the Markets in Financial Instruments Directive (which will be the case in the context of an EIS fund), clients must meet an additional "qualitative test" in order to be treated as elective professional clients, which involves the client meeting two out of the following three criteria:

• the client has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters
• the size of the client's financial instrument portfolio, defined as including cash deposits and financial instruments, exceeds €500,000
• the client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged

For this reason, and in order to maximise exposure of the fund to the widest possible group of potential investors, most managers will want the ability to treat investors as retail clients. Where not already obtained, managers will need to consider whether their regulatory permissions should include managing investments on behalf of retail clients and this may involve the manager and individuals within the management entity meeting additional regulatory requirements.

Contact Us

If you would like more information on EIS funds please contact:

Guy Norfolk
Partner, Financial Services
020 7002 8568
guy.norfolk@mms.co.uk

Alastair MacLeod
Associate, Tax
020 7002 8538
alastair.macleod@mms.co.uk

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This briefing is written as a general guide only. It is not intended to contain definitive legal advice which should be sought as appropriate in relation to any particular matter.