A new principles-based test has been introduced by the Finance Act 2018 which imposes a ‘risk-to-capital’ gateway condition. The condition is designed to ensure that the schemes focus investment in companies with genuine intentions for long-term growth and development, as opposed to companies which exploit the schemes by participating in ‘capital preservation’ activities which provide a low-risk return with the primary benefit taking the form of EIS & SEIS tax relief. The condition requires the taxpayer to take a reasonable view in determining whether the condition is met, and with no established practice and limited guidance from HMRC, this may prove difficult. In order to take a view, one must understand the mischief at the heart of the new condition with due consideration to the objectives of the EIS & SEIS. HMRC have also stated that they will not give advanced assurances where the risk-to-capital condition appears unlikely to have been met and intend to carry out post-investment checks on a risk basis.
- The Objectives – Government Policy underpinning Enterprise Investment Scheme (“EIS”) and Seed Enterprise Investment Scheme (“SEIS”)
The EIS & SEIS schemes provide a valuable tax relieved investment incentive for investors parting with their capital and improve the access to equity finance for smaller high-risk growth companies. There are clearly strong tax incentives, with investors receiving tax relief equal to 30% (or 50% for SEIS) of their investment along with CGT deferral relief and CGT exemptions on the future sale of their investments. However, this is a measure to assist in offsetting the inherently greater level of risk which comes with investing in such companies.
The schemes have vast potential to positively impact the UK economy by opening the taps on investments into high-risk growth companies. It’s no secret that these schemes have been within Government’s spotlight.
The Chancellor announced in the 2017 Autumn Budget a plan to unlock £20bn of investment over the next decade to further boost the UK economy. Evidence gathered from various consultations has suggested that UK companies in the innovation and growth sector are suffering difficulties in obtaining long-term capital, regardless of the tax incentives offered by Enterprise Investment Scheme EIS and SEIS.
This was further expanded on in the recent spring-statement highlighting the government’s intentions to further understand the difficulties faced by the knowledge intensive sector and the potential for an ‘EIS-fund’ model.
The policy objective of EIS & SEIS is clear. Its aim is to incentive the market to employ capital in growth and innovative high-risk trading companies. Why? Because the benefits of a thriving growth & innovation sector resonate throughout the economy via greater employment, economic growth, increased social welfare and future tax revenues.
However, as is often the case with generous tax reliefs, EIS & SEIS has been subject to exploitation. In response to a consultation – Financing Growth in Innovative Firms – evidence was provided suggesting that over £450m of investments by EIS funds in 2016-17 alone was focused on ‘capital preservation’ activities as opposed to genuine long-term growth investment.
Indeed, ‘capital preservation’ is within the crosshair of the new condition.
The Failures – Capital Preservation
What is capital preservation?
Consider the scenario where a fund manager is closely connected with a company which is looking to raise investment. The company is seeking to carry on a new trade which falls within the conditions for EIS. The fund manager makes an investment in the company, which then utilises those funds for the benefit of its trade – by acquiring land from which to trade. The underlying intention is that the company will trade in the short-term and after the minimum EIS holding period (3 years), the company is liquidated.
After 3 years, the company enters liquidation and the assets of the company are sold and distributed to the investors. As the funds were invested in land, which is generally a low-risk capital investment, the original capital is easily recovered. The bulk of the return for the investors takes the form of the generous Income Tax and Capital Gains Tax (“CGT”) reliefs afforded by EIS & SEIS.
The element of risk is reduced by adopting a ‘capital preservation’ strategy with the funds being employed in capital. When considering the policy objectives, the scheme has failed as funds are being employed into capital preservation activities as opposed to genuine business ventures.
This example is intended to highlight the basic principles of capital preservation.
Effectively, an investors funds were never at risk, and were not employed in line with the policy objective – investments into growing companies – as there was no intention to grow the trade, only to preserve the investors capital with the view to benefiting from tax relief.
This type of capital preservation activity will no doubt contribute towards the failures of the EIS & SEIS schemes providing the required long-term capital to knowledge intensive and innovation companies.
Therefore, the Government have introduced the ‘risk-to-capital’ condition – a new principle-based condition as a means to filter out those capital preservation activities
The Solution – The Risk-To-Capital Condition
This condition was brought into effect with the Finance Act 2018. It is a new ‘gateway’ provision aimed at preventing capital preservation activities benefitting from tax relief.
Broadly, this considers whether an investment has been structured to provide a low-risk return for investors or whether it is a genuine long-term risk investment for which the benefits of the SEIS and EIS schemes are targeted at.
As a new condition, there is no established practice in respect of when this condition is met. What is clear is that this legislation aims to prevent short-term, low-risk activities and in particular, capital preservation, from qualifying from EIS/SEIS. It seeks to ensure that funds are raised for the purposes of growing and developing a trade and that the investors are taking a genuine risk, for which the ‘reward’ or offset of that risk is tax relief.
This is achieved by imposing two tests which require one to take a ‘reasonable’ view as to whether those tests are met. The tests are met when considering all the circumstances, it is reasonable to conclude that
- 1) Whether the company has objectives to grow and develop its trade in the long-term; and
2) There is a significant risk that there will be a loss of capital of an amount greater than the net investment return
In respect of the first part, objectives to grow and develop might include an ambition to increase staff number or revenue in the long-term. The second condition is somewhat more elusive and requires a more complex analysis. It would be considered whether there is a guaranteed source of income or asset backing and this weighed against the risk of these not returning an investment.
Clearly, the example highlighted above would most likely be excluded by the new risk-to-capital condition. However, the fact that a company acquires substantial assets does not mean a company loses eligibility. The circumstances surrounding the investment need to be considered in the whole.
The legislation provides a non-exhaustive list of factors, which I’ll not go into, which may be considered when determining whether the risk to capital condition is met.
The EIS & SEIS conditions are already tortuous at best with a reported number of cases being denied relief on the basis of a minor mistake which caused a condition not to be met. However, the new risk-to-capital condition re-aligns the schemes with their intended objectives.
The other conditions can generally be met with careful planning and are prescriptive at worst. However, the risk-to-capital condition will require some careful thought and one must take a ‘view’ as to whether this applies or not – this may be difficult given the lack of established practice.
As part of HMRCs attempts to streamline the advanced assurance process, it is understood that HMRC will not be willing to provide advanced assurance if it does not appear the condition is met. Furthermore, HMRC intend to carry out post-investment checks on companies on a risk basis.
HMRC have also stated in their manuals that these checks will also consider whether a company has used the money it has raised for the purposes stated at the time of the investment.
In order to mitigate this risk, we would advise that investments are carried out properly. It would always be advised that an investment intended to benefit from one of these schemes should be supported with a business plan, investment agreement and the necessary documentation.