Are convertible loans eligible for SEIS/EIS tax relief?

The Seed Enterprise Investment Scheme and Enterprise investment Scheme are designed to provide tax relief to investors looking to invest in start-up seed businesses and smaller high-risk companies. SEIS allows income tax relief of up to 50% of the funds invested and EIS allows tax relief of up to 30%. 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.

At Accounts Lab, 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.