EIS guide

29 RULES FOR INVESTORS AND QUALIFYING COMPANIES 28 RULES FOR INVESTORS AND QUALIFYING COMPANIES Rules governing the size and type of company There are rules which set out in detail the criteria for firms that wish to issue EIS-qualifying shares. In summary, a qualifying company must: Not have been trading for more than seven years (ten years for a knowledge-intensive company) unless specific conditions are met. 7 Be operating in a qualifying trade, preparing to trade and commence trade within two years, or conducting research and development. Most trades qualify, however, there are a number of exclusions: • Dealing in land, commodities, futures, securities or financial instruments (including investment activities) • Dealing in goods other than normal retail or wholesale distribution • Banking, insurance, hire purchase, money lending, and other financial activities • Leasing • Receipt of royalties or licence fees • Legal and accounting services • Property development • Farming and market gardening • Forestry • Operating or managing hotels or residential care homes • Coal production, steel production and shipbuilding • All energy generation activities (from6 April 2016) 8 1 NOT be in financial difficulty (as defined by EU guidelines). 2 Be unquoted (however, the AIM market is not a recognised exchange for this purpose). 3 NOT control another company which is not a subsidiary of the company; and it cannot itself be controlled by another company and there can be no plans in place at the time of the share issue that would jeopardise this independent status. 4 Have a permanent establishment in the UK (the company does not need to be a UK company, however). 5 Have fewer than 250 employees (or 500 for a knowledge-intensive company). 6 Have gross assets under £15m immediately before shares are issued and under £16m immediately after shares are issued. However, the company can continue to grow afterwards. Excluded activities must not be a ‘substantial’ part of the company’s trade. HMRC takes ‘substantial’ to mean more than 20% of the company’s activities. A group of companies may carry out “non- qualifying activities” and still be eligible to receive EIS investment providing those activities do not amount to a “substantial part” of the group’s activities. HMRC guidance states they will normally accept that such activities are not substantial if they account for no more than 20% of the activities of the trade as a whole. Explaining this provision to clients often brings a palpable sense of relief as they realise that they may still be able to raise EIS investment, a critical source of funding to young, high-risk trading companies. On hearing that, they often think everything is fine and want to move the conversation on without further consideration. However in our view there are two main risks which companies and their advisers should consider carefully before deciding to raise EIS investment by relying on this exception. First, in determining whether or not the 20% threshold is breached, HMRC’s guidance states that you can use “any measure which is reasonable in the circumstances of the case”. A CEO or adviser could be forgiven for thinking that they only have to find one reasonable measure on which the activities are below 20% for the exception to be available, even if other reasonable measures are above 20%. We believe that is the correct interpretation of that guidance. However, we have seen a number of examples (and are aware of a number of others) where HMRC argues that the only measure which is reasonable is the one which gives a figure of above 20%. Given the potential damage to a company’s relationship with its investors if HMRC tries to withdraw EIS relief at a later date, we would strongly recommend that an advance assurance is sought prior to any EIS investment where the substantial exception is relied upon. Second, a large number of EIS conditions have to be met for three years following investment (and possibly longer). Whilst the “substantial” test is no different, in our view the risk of breach and frustration for all parties is greater! It is much more difficult to ensure that a portion of a business remains below a 20% threshold, compared to, say, making sure that a company does not become controlled by a corporate shareholder. For example, if turnover is being used to show that the 20% threshold is not met, changing economic or market conditions can mean that an area of the business that was anticipated to be successful underperforms, whilst the non- qualifying area performs significantly better than expected. If this occurs, the company will be left with the unenviable choice of breaching the EIS legislation or having to scale back an area of the business that is performing extremely well and could be critical to the future success, or even survival, of the business. THE SUBSTANTIAL PART TEST FOR QUALIFYING BUSINESSES Thought Leadership PARTNER, SHOOSMITHS TOM WILDE RULES FOR INVESTORS AND QUALIFYING COMPANIES