Ken Moody looks at recent changes which potentially affect the availability of tax relief for certain categories of investment.
The tax reliefs available for enterprise investment scheme (EIS), seed EIS (SEIS) and venture capital trust (VCT) investments are generous, and are obviously not intended to be used for tax avoidance purposes.
Changes to the venture capital schemes introduced in FA 2018 were aimed at focussing reliefs on growing and innovative business and excluding activities deemed to be ‘lower risk’.
Outline of recent changes
For shares issued on or after 6 April 2018, an EIS investor may obtain income tax relief on up to £2 million a year, where at least £1 million is invested in ‘knowledge intensive’ companies. The amount which such companies can raise under the EIS rules in any year is also raised to £10 million (from £5 million), subject to an overall limit of £20 million.
The main change to the VCT rules is to increase the minimum level of ‘qualifying holdings’ from 70% to 80% in order for the company to obtain HMRC approval as a VCT (for accounting periods beginning on or after 6 April 2019).
However, perhaps the change of most immediate relevance is, for shares issued on or after 15 March 2018, the introduction of the ‘risk to capital’ condition in relation to EIS investments.
The risk to capital condition
The ‘risk to capital’ condition is introduced at ITA 2007, s 157A in relation to EIS investments, and in almost identical terms at s 257AAA and s 286ZA in relation to SEIS and VCT investments.
Part of the policy objective is to exclude tax-motivated investments where tax relief provides most of the return on the investment with minimal risk to capital.
The condition is in two parts and is met if, having regard to all the circumstances, it would be ‘reasonable to assume’ that:
(a) the company has long-term objectives to grow and develop its trade, and
(b) there is a significant risk of a loss of capital which is greater than the net investment return, taking into account the value of the EIS relief.
There is some clarification of (a) at s 157A(3) ITA 2007, but this is not helpful. A non-exhaustive list of factors is given which includes the extent to which the company’s objectives include increasing the number of employees or its turnover, the nature of the sources of the company’s income, and the risk of some of the income not being received.
I don’t recall any EIS/SEIS start-ups that I have advised on where (a) would not apply, so it ought to be a ‘no-brainer’ in most situations, but how long is ‘long-term’? Since we are talking about private companies where the shares are not readily marketable, the investment return (net of relief) is almost always uncertain anyway.
It’s always a good idea to draw up a business plan which might show potential returns if profit targets are achieved. But a lot of guesswork is usually involved and most plans don’t provide for dividends to investors, so they may only realise a return on (uncertain) exit. And there is almost inevitably a risk that the company will go bust and so the tax relief will merely cushion a negative return.
It seems to me that the risk to capital condition potentially poses a real problem for EIS/SEIS start-ups because it depends upon assertions and assumptions which are difficult to test and which, with the benefit of hindsight, might be challenged and relief withdrawn. That, in turn, may make it difficult to reassure investors that they will obtain and retain the expected reliefs.
Practical Tip:
What impact the risk to capital condition will have on how HMRC’s Small Company Enterprise Centre processes applications for EIS/SEIS ‘advance assurance’ and approval remains to be seen. No changes have yet been made to form EIS/SEIS AA, and perhaps most applications will be unaffected, but an element of uncertainty may nevertheless linger.
One certainly needs to be mindful of the new condition in considering and preparing future applications for advance assurance and EIS/SEIS compliance statements.
