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  • Risk to Capital Condition (“R2CC”) – an in-depth analysis

    4 October 2021

    Andy Wood

    Introduction

    The Government has specifically set out a number of so-called Venture Capital reliefs for investors who stump up funds for small, and sometime start up, growth companies.

    EIS and Seed EIS is one of the most popular venture capital reliefs with investors. The quid pro quo of taking a punt on a, lets face it, risky investment is the offer of generous tax relief including an income tax reducer of up to 30% x investment for EIS and 50% for Seed EIS. 

    More details about the reliefs on offer can be found here.

    Clearly, it doesn’t take a genius to understand that, wherever generous tax reliefs are plentiful, there will be individuals interested in exploiting them.

    It is from this perspective that the most recent VCM condition was introduced – the R2CC.

    It should be noted that R2CC is a quite separate condition and must be applied alongside the other tests. For example, an excluded activity which passed the R2CC test, would still be excluded by virtue of that pre-existing test.

    As such, the R2CC could be considered as a gateway condition.

    You can find further information on EIS more generally by visiting our EIS and Seed EIS ‘signpost’.

    If you are a TPP member then you can visit our EIS and Seed EIS webinars here.

    HMRC Manuals – background context to R2CC

    Background

    HMRC’s manual entries (VCM8500 onwards) provide some interesting context to the VCM tax relief regime. At first glance, it perhaps looks like garnish. However, a closer inspection enables one to tease out the types of features one wants an EIS or Seed EIS project to have. In addition, it also tells us the type of scheme that R2CC is intended to kibosh!

    Apologies for the long excerpts, but VCM8520 sets out the following:

    “The tax-advantaged venture capital schemes

    The tax-advantaged venture capital schemes, including the EIS, SEIS and VCTs, are intended to encourage individuals to invest in certain small, higher risk, early-stage trading companies that would otherwise struggle to access the funding needed to enable them to grow and develop, as they have little or no track record.

    Tax relief is offered as an incentive to invest directly in these companies, or indirectly through a VCT, because of the higher risk such investments pose to the investors’ capital. The tax-advantaged venture capital schemes are therefore aimed at investors who are prepared to lose some or all of their capital in making a higher risk investment.”

    We are then given a steer on the types of scheme that the VCM reliefs are intended to support:

    The schemes are intended to support early-stage, higher risk, entrepreneurial companies that have the potential to grow in the long term. Typically, such companies will be set up by one or more entrepreneurs who, as directors, have the intention of expanding it over the longer term but need financial support from a third party to realise this ambition. The company will be set up to and the investment sought to carry out its trade on an ongoing basis, not as the means to finance and deliver one or more projects before being wound up.

    The directors develop a business plan setting out their intentions for the company’s growth but struggle to access funding because the company has little or no track record. They present their business plan as part of a ‘pitch’ to one or more investors or an investment house.

    Once they obtain the funding, the directors work to grow the company over the longer term. The money raised is reinvested to support the company’s growth and development, often helping it to attract future rounds of funding, ultimately from the market.

    The investors are generally independent third parties who are interested in supporting the company and participating in its success. They know their capital is at genuine risk of substantial loss and is not secured. They are minority investors and have no intention of running the company; though they may support the company’s directors to run the company, they are not able to determine the company’s future direction by themselves. They do not expect their capital to be repaid shortly after the end of any scheme holding period; they expect the company to retain the capital and reinvest profits, to support the company’s growth and so increase the value of their investment.

    Finally, we are told what types of scheme should be turned away from the door of the venture capital relief regime:

    The generosity of the tax reliefs available through the venture capital schemes has resulted in the creation of tax-motivated, low-risk investment opportunities, where the tax relief provides a considerable proportion of the gain. Such arrangements are often referred to as ‘capital preservation.

    Capital preservation arrangements enable investors to take advantage of the tax reliefs the schemes offer, at minimal risk to their capital. These arrangements may, depending on the facts, comply with the letter of the current law but are contrary to the policy intention of the schemes.

    VCM8520: The R2CC ‘shopping list’

    The above passages set out a helpful shopping list as to what a scheme should look like in order to satisfy the R2CC. In addition, it also sets out the unwelcome features which coalesce under the umbrella term of ‘capital preservation schemes’.

    What does the R2CC say?

    The legislation

    The relevant legislation is found at ITA 2007, s157A. For Seed EIS, it is the fantastic reference of ITA 2007, s257AAA! Insert joke about batteries here.

    [157A Risk-to-capital condition

    (1)     The risk-to-capital condition is met if, having regard to all the circumstances existing at the time of the issue of the shares, it would be reasonable to conclude that—

    (a)     the issuing company has objectives to grow and develop its trade in the long-term, and

    (b)     there is a significant risk that there will be a loss of capital of an amount greater than the net investment return.

    As such, the test has two living and breathing heads.

    We will consider each of these in terms shortly.

    However, the legislation (at subsection 3) also tells us what circumstances we should consider when considering whether the requirements of the two tests are satisfied. This is a non-exhaustive list:

    (3)     For the purposes of subsection (1) the circumstances to which regard may be had include—

    (a)     the extent to which the company’s objectives include increasing the number of its employees or the turnover of its trade,

    (b)     the nature of the company’s sources of income, including the extent to which there is a significant risk of the company not receiving some or all of the income,

    (c)     the extent to which the company has or is likely to have assets, or is or could become a party to arrangements for acquiring assets, that could be used to secure financing from any person,

    (d)     the extent to which the activities of the company are sub-contracted to persons who are not connected with it,

    (e)     the nature of the company’s ownership structure or management structure, including the extent to which others participate in or devise the structure,

    (f)     how any opportunity for investment in the company is marketed, and

    (g)     the extent to which arrangements are in place under which opportunities for investments in the company are or may be marketed with, or otherwise associated with, opportunities for investments in other companies or entities.

    It should be noted that VCM8542 provides further detail on how these factors should be applied

    Test 1 – Objective to grow and develop the trade in the long term

    General

    There is no statutory definition of what might fulfil this test. It must therefore take its ordinary meaning.

    HMRC’s guidance states that plans to increase the business’ revenues, its customer base and / or the number of people it employs would be indicators of growth objective. This is uncontroversial.

    However, this is by no means exhaustive, and whether the test is satisfied will be determined on a case-by-case basis.

    The Manuals give an example whereby a Company achieves growth by automating a manual process which actually leads to a reduction in the Company’s workforce. 

    Similarly, there is no definition of what is meant by ‘long term’. 

    As we saw from the above, the venture capital schemes are intended to encourage long term, patient capital.

    As anyone familiar with EIS will be aware, in order to claim and retain the attractive tax reliefs, the investor must broadly hold the shares for a three-year period. However, this is a minimum period and HMRC’s manuals state that: 

    “patient capital investors would be expected to hold their shares for longer, subject to the company’s need to expand, for example by securing scale-up funding from new investors through flotation.” 

    Further, it goes on to say that:

    “Any indication that the company’s future operation or existence could be compromised to enable investors to exit their investment will be considered to be contrary to any stated objectives to grow and develop in the long term.”

    This perhaps further galvanises the rules around no ‘pre-arranged’ exit requirement.

    Special purpose vehicles (“SPVs”)

    Test 1 of R2CC poses a major problem for SPVs.

    The Manuals state that:

    A company with limited assets and few, if any, employees that is set up solely to deliver a project, or a limited series of projects, often referred to as a Special Purpose Vehicle (SPV) – that will generate a certain amount of money once the project is complete, such as a reasonably steady income stream or gains on disposal of the asset created, would not be considered to have objectives for long-term expansion.

    HMRC recognises that the use of SPVs within a group structure is sometimes a normal commercial practice in some sectors – the creative industries are mentioned – and they will take this into account when determining whether the risk-to-capital condition has been met.

    Test 2 – Significant risk that there will be a loss of capital

    Test 2 is whether a potential investment poses a significant risk of a loss of capital to the investor This is considered at the time the investment is to be made,

    The amount that is being put at risk must exceed all returns that are likely at the time of making the investment.

    The risk of loss is determined by considering:

    • the risk of losing the money invested;
    • the net investment return for the investors to whom the shares or securities in the company were issued

    Here, when we talk about risk, we are contemplating commercial risk only. In other words, the risk of the company failing in the market. For example, the risk of the company failing to satisfy any of the EIS or Seed EIS conditions does not constitute a risk for the purposes of this test.

    There is no definition of a ‘significant risk’, which depends on the circumstances of the company, and of the investor.

    The net investment return includes:

    • any income, such as dividends, interest payments or other fees;
    • capital growth; and
    • the amount of upfront income tax relief the investors may be eligible to claim. I

    If the investment is protected, for example by assured future income streams or capital repayment, the investment is unlikely to meet the condition.

    The condition is designed to allow investments on the presumption that there will be real growth of the company and capital accretion over the long term. The net investment return is not the future return an investor making an investment in a genuine growth company hopes to realise, should the company be successful. As long as the investment remains at significant risk, the prospect of potential large returns in the future is not caught by this condition. Such growth cannot be guaranteed and therefore there is significant risk to that kind of investment.

    Examples

    It should be noted that some examples of how R2CC might apply to an applicant can be found at VCM8560.

    These examples are as follows:

    • Example 1: Postgraduate research company – the Company can meet the R2CC
    • Example 2: Trading company that relies on property asset – unlikely to mee the R2CC condition as the asset is the sole focus of the investment
    • Example 3: Film company – an investment in the parent might qualify but an investment in a SPV would not

    Some of the reasoning might be helpful in determining your own cases.

    Conclusion

    This new gateway condition provides a hurdle over which each and every potential EIS and Seed EIS must clear.

    It is important that proper thought is given to this condition and each application should address each of the points and precisely how the applicant will satisfy each of the relevant tests. If an applicant fails to do this, or does not go in to sufficient detail, then HMRC will ask for further details. At best, this will delay the process.

    If you, or your clients, need any assistance with the Risk to Capital Condition or EIS or Seed EIS in general then please get in touch.

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