VCT guide

20 RULES FOR VCTS Risk-to-capital condition Announced at the Autumn Budget 2017, the risk-to-capital condition applies to all investments made on or after Royal Assent of the Finance Act 2018 on 15 March 2018. However, HMRC has applied the test for all advance assurance applications submitted from December 2017. From this point, HMRC has declined to provide advance assurances for investments that, taking into account all the facts available to them, appear likely to fail the risk-to-capital condition. The government is keen to stress that the Venture Capital Schemes are intended to support early-stage, entrepreneurial companies that have the potential to grow in the long term. The company must be set up to carry out trade on an ongoing basis, not to carry out a single project before being wound up. Following the government’s 2017 consultation, ’Financing growth in innovative firms’, the enactment of the 2018 Finance Bill on 15 March 2018 saw the introduction of new conditions. The conditions are intended to exclude tax- motivated investments, where the tax relief provides most of the return for an investor or with a limited risk to the original investment (that is, preserving an investor’s capital). The condition depends on HMRC taking a ’reasonable view’ as to whether an investment has been structured to provide a low risk return for investors. THE RISK-TO-CAPITAL CONDITION HAS TWO PARTS: 1. Whether the company has objectives to grow and develop over the long term (which broadly mirrors an existing test with the schemes); and 2. Whether there is a significant risk that there could be a loss of capital to the investor of an amount greater than the net return. The condition requires all relevant factors about the investment to be considered in the round. The legislation contains a non-exhaustive list of the factors that may be considered. Even if one or more indicators of potential capital preservation are present, this does not necessarily mean that the risk-to-capital condition will not be met in a particular case. A judgement about whether capital preservation activity is taking place will depend on the overall context of the investment. Likewise, even if none of the indicators listed in the legislation are present, the risk-to- capital condition may NOT be met if the wider circumstances of a case suggest that capital preservation is taking place. Ultimately, a judgement will depend on the level of risk posed to investors’ capital and whether the company has genuine intent to grow and develop in the long term. Following Royal Assent of the Finance Act 2018 on 15 March 2018, the new risk-to-capital condition will sit above the other existing eligibility requirements for the venture capital schemes. Even if the new condition is met, all other requirements must also be met for an investment to be eligible for tax relief under the schemes. If new VCT shares are subscribed for they attract initial income tax relief of up to 30% of £200,000 and qualify for tax free disposal after five years. In addition, VCT income and gains can be paid to investors by tax-free dividends (VCTs typically aim to pay a stream of tax-free dividends to investors). A VCT can invest a mixture of equity and long- term debt into investee companies. The investors hold shares in a listed entity and therefore, unlike direct unquoted EIS investments, VCT shares do not qualify for inheritance tax business relief. The most significant change for VCTs was the introduction of an age limit for investee companies. Generally, companies can only raise VCT funds in the period up to seven years after their trade started, or within 10 years for Knowledge Intensive Companies (KICs), with a few limited exceptions. Historically, VCTs have tended to invest in more mature companies which are at the point of paying dividends but now they have to focus on younger companies and can find follow-on investments problematic. Historically, VCT investments have been used to fund management buy-outs or the acquisition of other businesses. This is no longer permitted; the VCT’s investment must now be used for the ‘growth and development’ of the investee company. Finally, there were well publicised changes to prevent VCTs investing in low risk, so-called ‘capital preservation’ investments. In practice, most VCTs have always invested in genuine risk capital investments and so the ‘risk to capital’ rules have had less of an impact than for some Enterprise Investment Scheme (EIS) funds. The changes above apply to VCT and EIS investee companies but there have also been some changes specifically applying to VCTs. VCTs have to deploy 30% of the funds they raise in qualifying investments within the first 12 months; 80% of the VCT’s funds must be invested in qualifying investments (previously 70%) within three years. This means VCTs have to deploy the funds they raise more quickly into qualifying investments. The VCT industry has adapted well to the changes. The main challenge is finding suitable investee companies which are less than seven years old and then meeting investors’ expectations of receiving dividends. It is also difficult to launch new VCTs because they are competing with established VCTs with an existing portfolio of ‘older’ companies paying a reasonable level of dividends from day one. Despite the tighter rules, with the restriction of pension tax relief and very few tax efficient investments available, the future still looks bright for VCTs. A YEAR UNDER THE NEW RULES Thought Leadership TAX PARTNER, BDO DAVID BROOKES 21 RULES FOR VCTS