By way of brief background, EIS and SEIS offer tax incentives to individuals who invest in certain qualifying companies. EIS is targeted at small and medium sized trading companies whereas SEIS applies to individuals investing in "seed stage" trading companies. In each case, EIS and SEIS aim to provide a platform for funding to companies which may otherwise struggle to obtain traditional bank financing. Similarly, VCTs can be a tax-efficient vehicle for investors to invest on a diversified basis in the SME arena; the VCT regime itself requires the investee listed company to invest in similar qualifying companies to which the SEIS and EIS regimes apply.
Such schemes are particularly important since the onset of capital retention requirements on UK banks following the previous financial crisis which have led to a so-called 'lending gap' in the UK economy, which has, in turn, led to the development of alternative finance providers (such as hedge funds) and peer-to-peer lending platforms.
While the UK remains a centre for innovative startups, the provision of finance to potential high-growth companies is clearly a prescient issue in the economy. The UK Government acknowledged this point in the conclusion of its "Patient Capital Review" in January 2017, which considered "how to support innovative firms to access the finance that they need to scale up". The Patient Capital Review acknowledges the issue of funding and proposes certain initiatives to combat this lending gap; and recent changes to and trends in EIS, SEIS and VCTs should be viewed in this context.
There is clearly a need to improve access to finance for UK businesses, but the UK government is also very keen to limit any perceived abuse of the tax incentives offered to investors who use these schemes, particularly in the prevailing climate in the UK concerning tax. Therefore, while EIS, SEIS and the VCT regime have been subject to a degree of liberalisation to encourage their use and to increase the availability of funds to UK businesses, conversely there has also been a tightening up of certain conditions, which has arguably worked against the spirit of this aim.
Among the changes to these schemes introduced by The Finance Act 2018, certain investment limits were increased under EIS and for VCTs in relation to "knowledge-intensive companies". This was to facilitate and encourage additional investment in innovative companies developing and exploiting new technologies.
The maximum amount an individual can invest under EIS in a tax year has been increased from £1m to £2m provided that at least half the £2m investment is in shares in a "knowledge-intensive" company.
In addition, knowledge-intensive companies are allowed to raise up to £10m, as opposed to £5m, of EIS investment (and other venture capital and state aid funding) in the year ending with the date that the shares in respect of which an investor seeking EIS relief are issued. A similar amendment has been made to the VCT regime to define a qualifying company for the purpose of the VCT's qualifying investments.
The Finance Act 2018, also tweaked the definition of "knowledge-intensive company". Beforehand, such a company had to comply with certain criteria which generally had to apply at the time the investment was made and in the three preceding years. Now, under EIS, investors may invest in companies which have not been making the required levels of expenditure on R&D or innovation in the preceding three years to the investment; providing instead that these criteria are met within a certain timeframe after the investment is made.
Similar amendments have been made to widen the scope of companies that VCTs may invest in as qualifying investments. Previously, VCTs could only invest in knowledge-intensive companies before the date ten years after the first commercial sale made by the company. Now, however, investment can be made within ten years of the knowledge-intensive company reaching an annual turnover of £200,000.
The overall effect of these changes is to increase the amount of capital which may be invested in knowledge-intensive companies (both by raising thresholds relating to the company receiving the investment, as well as, under EIS, raising the amounts in respect of which individuals can obtain EIS relief).
The government clearly has a concern that investors may have been using venture capital investments as a form of "capital preservation"; in other words, investing cash into businesses to secure income tax relief with the expectation that the cash would be returned fully intact after a period of time. It has always been the government's expectation that tax reliefs would only apply to genuine "at risk" investments.
Accordingly, the Finance Act 2018, introduced a new "risk to capital" condition, which acts as an additional gateway to an investor's eligibility to obtain EIS or SEIS relief, and which is also factored into a company's eligibility as a qualifying investment for a VCT.
Essentially, the condition imposes a two-tiered test on the relevant investment to be made by either the individual (under EIS/SEIS) or the VCT (depending on which regime applies):
Whether this condition is met will be determined on a case by case basis and HMRC has provided certain examples of factors which may indicate "potential capital preservation"; this includes (i) a lack of genuine intention for the investee company to grow and develop and (ii) investee companies with assured income streams in place which make up a significant proportion of their overall revenue.
HMRC have provided some examples of investments which would not meet this condition. In particular (and in brief), HMRC describe a situation where a company is set up to undertake a trade which relies on using a property. It receives investment to construct the building, and once constructed, the company will engage subcontractors to carry out trading activities from the building until the end of the qualifying holding period in respect of the investments made. Once this ends, the building will be sold to a previously identified buyer and the proceeds will be distributed to investors and promoters. In this case, the construction and sale of an asset is the sole focus of the investment; there is no trade concept and the asset is not intended to be used as a part of a trade but instead is always intended for sale. Similarly, in this example the company is marketed as a low-risk investment opportunity and the fund manager marketing it is connected to the company. These are all indications of a capital preservation arrangement.
Similarly, under the VCT regime, loans which offer an "excessive" return to the investor or under which the investor acquires security or preferential rights in relation to the assets of the company, are now excluded from the definition of "qualifying holdings" - essentially the type of investments a VCT can hold.
Clearly these changes are intended to act as a focal point to draw investment from VCTs and investors under EIS/SEIS into smaller companies with a plan for growth, but at the same time to act to ensure that investors make bona fide commercial investments where capital is placed at risk; as opposed to using the scheme in a purely tax-driven manner to shelter capital and receive the resultant income tax benefits.
Overall, we have seen some encouraging changes made to venture capital schemes which should increase the availability of investment finance for startups operating in the UK (particularly in technology, life sciences and other knowledge-rich sectors). However, there has also been a somewhat countervailing trend of tightening the requirements to be met in respect of obtaining EIS/SEIS relief, and approval as a VCT in recent years, which continues with the new and somewhat imprecisely formulated risk to capital condition.
The key problem in introducing yet further and more difficult to interpret conditions to accessing the regimes is that for the companies targeted and their investors, highly complex and opaque rules impose greater and potentially unviable compliance costs and may even act as a disincentive to using the schemes.
As ever, the concern is that in targeting limited examples of arrangements that may act contrary to the spirit of the regimes, damage is done to the many companies and investors using the regimes in the best of faith.
If you have any questions on this article please .
If you are a software developer, you will know all about open source software (OSS). OSS is software whose source code is publicly available to be used, adapted, modified and re-licensed, usually free of charge. Because it is unusual for software developers to give away their source code, some people think OSS is released without being subject to licence terms.
2 of 5 Insights
There is a lot to think about when setting up a new business. It's crucial to take protecting your intellectual property rights seriously from the outset. Don't believe the following myths!
3 of 5 Insights
This article looks at the wider implications of the General Data Protection Regulation (GDPR), how SMEs are affected and sets out a short term compliance plan for startups seeking to prioritise before 25 May 2018.
4 of 5 Insights
One of the key issues an investor or buyer will look at is whether a company owns the intellectual property rights used in the course of its business. Securing this right at the beginning will save you money and time in the long run but may be more complicated than you might suppose.
5 of 5 Insights