EIS 2018 report (web)

13 12 The budget outlined the following changes: The annual investment limit for KICs to increase from £5m to £10m The annual investment limit for individual investors will double from £1m to £2m. However, any amount invested above £1m must be invested in KICs. KICs currently have to take their first investment within 10 years of their first commercial sale. Going forward, they will be able to choose whether to apply the 10 year period from that date or when turnover reaches £200,000. In terms of a definition of a KIC, HMRC has given the following prerequisites: The following conditions must be satisfied: R&D or innovation costs are at least 15% of the company’s operating costs in at least one of the previous three years, or at least 10% of the company’s operating costs in each of the previous three years. 4 A minimum of 20% of full-time employees must be classified as skilled employees at the time of the investment and for the following three years. Or, the company should be engaged in work to create intellectual property (IP) at the time of the investment, and within 10 years most of the company’s business activities might be expected to consist of (i) the exploitation of the IP, (ii) business that uses the IP or (iii) both. SHARE CONVERSIONS FOR SEIS AND EIS More regulatory updates are to be implemented to the rules on share conversions for the EIS and SEIS schemes. EIS and SEIS share conversions to another share class will no longer be regarded as an arrangement for the disposal of the shares. If currently held shares have rights for conversion to another class - conversion will be treated as a pre-arranged exit, which would eradicate the tax relief available of EIS or SEIS. The legislation will take effect for shares issued on or after 5 December 2016. There are exceptions to the rule: Share conversions may take place where there is a reorganisation of share capital prior to a flotation or exit, or for a fundraising round. But, HMRC sees the conversion of these shares as a disposal of shares. Therefore, tax reliefs may be withdrawn when the conversion takes place within the three year holding period for qualification. 5 DEMYSTIFYING THE RISK TO CAPITAL CONDITION One of the most crucial updates to the VC (venture capital) landscape from the Autumn budget has been the introduction of a set of conditions to assess whether investments are aligned with the “spirit of EIS”. The risk-to-capital condition, as stipulated in Clause 14 of the updated Finance Bill, is a principles- based condition that depends on taking a ‘reasonable’ view as to whether an investment has been structured to provide a low-risk return for investors. The new condition comes in response to the scrutiny that VC schemes have received for de-risking investments and providing a capital preservation solution, whilst also giving tax relief for investors. HMRC released its updated Venture Capital Schemes Manual 6 , approximately a week after Chancellor Philip Hammond’s budget. It outlines the two overarching principles to the risk-to-capital condition, and an investment must meet both parts: a) The company in which the investment is made must have objectives to grow and develop over the long term; and b) The investment must carry a significant risk that the investor will lose more capital than they gain as a return (including any tax relief). The legislation contains a non- exhaustive list of factors that may be considered, and it’s worth noting that the principles-based test will not come into effect until the Royal Assent of the Finance Bill 2017-18, which is likely to be implemented in mid-March 2018. However, the principals will be implemented immediately for new Advance Assurance applications. One concern for providers and advisers is that a principles-based approach (as opposed to a rules-based approach) will generate an initial element of uncertainty for the industry. This is likely to mean that there is a bedding- in period as the industry deals with the grey areas that a principles-based approach can generate. David Scrivens, Director at Club Finance, told Intelligent Partnership: “The government is trying to put a principle into place that says that if you’re investing purely for tax reasons, it’s not an investment that should get relief, but if it’s for a proper growing company where you’re exposed to significant risk – then you will get relief.” Scrivens raised the point about how this would be calculated. He surmised: “How am I going to input the right data to prove that the investor is at significant risk of losing all of their capital, and then how am I going to promote to the investor that it’s still a good investment?” He added: “We’ve got to prove that the schemes are riskier than the potential gain – that’s how I’m reading it.” 7 WHAT IS THE SPIRIT OF EIS? The “spirit of EIS” is often referred to in the VC industry. Although the gist of it is to make sure that EIS focuses on investing in growing UK companies for the long term, what that truly represents needs some clarification. The VC schemes manual does give some guidance on how the principals should be interpreted, but the practical application is unlikely to be fully clear until the Advance Assurance system starts to produce real life judgements about where the boundaries lie. At this point, the main questions are how much risk is enough, and how much risk mitigation is too much? The manual outlines the conditions that apply. Also, tucked away in Annex A 8 of the government’s consultation response to the PCR are examples of how the risk to capital condition could be applied: Condition: Intention to grow and develop Companies using EIS for investment should have objectives for organic growth through increasing profits, number of employees, product markets, and so on. (This follows on from the 2015 rules changes) Condition: Restrictions on SPVs A company, including a special purpose vehicle (SPV), that is set up solely to deliver a project that will generate a certain amount of money once the project is complete – either a reasonably steady income stream or gains on disposal of the asset created – would not be considered appropriate. A parent company that uses SPVs may meet the risk-to-capital condition as long as the profits from the SPV’s activities are used to continue to grow and develop the group’s trade in the long term. Condition: Restriction on asset purchases Purchasing an asset that is expected to be sold on, either at a profit or a small loss, will not be permitted. This does not prevent companies from using money raised to buy or create assets, so long as the intention is to make use of the asset in the company’s trade (for example, an item of plant or machinery). Holding the asset mainly with a view to its disposal, or used to secure the investment or generate a low-risk income stream will not be permitted. Condition: Stopping assured income streams Companies that are using assured income streams in order to obtain capital preservation will not be eligible for tax relief. However, HMRC suggests that securing a future source of income, such as a contract to deliver products to a customer on a regular basis, does not necessarily mean that capital preservation is taking place. In terms of meeting the risk to capital condition, there has to be significant risk to the investor of losing capital, and that the company intends to grow over the long term. Condition: Restrictions on subcontracting Where an investee company subcontracts all or most of its activities to others, this may indicate capital preservation activity. Use of subcontractors may not, by itself, point to capital preservation. Capital preservation may be taking place if the company holds assets but subcontracts all of its trading activity, and where decisions about the business are made largely by others, for example external industry specialists, fund managers or the ultimate customer. Condition: Ownership or management structure If the investee company’s investor base consists largely of individuals using a tax-advantaged scheme alongside the promoter and their associates, with little entrepreneurial involvement, then capital preservation is deemed to be taking place. Condition: Fragmentation Companies that achieve capital preservation by investing in companies that carry out similar activities will likely not qualify for EIS. This is done by identifying an activity that qualifies for tax relief under the VC schemes, and fragmenting the activity into a series of companies. This results in investors gaining more tax relief than investing in one company. Where a company is carrying out an activity that is closely aligned with another company, such as the same activity but in a different geographical area, it could indicate capital preservation. A company’s relationship to other companies will therefore be taken into account for its eligibility for tax relief schemes. “EIS is now investment-led rather than tax driven if it wasn’t before and frankly, that has to be right.” — IAN BATTERSBY, SENECA PARTNERS “EIS Investors have never had it made quite so clear that they need to be taking genuine risk in order to benefit from the generous tax reliefs potentially available.” — ANDREW ALDRIDGE, DEEPBRIDGE