A mixed bag of news for the EIS industry

Cliona Kirby, Tax Partner, CMS

Clampdown on so-called capital preservation

As was widely expected, the Government intends to change the EIS, SEIS and VCT rules to ensure they are focussed on high-risk, “genuine entrepreneurial” IP-intensive companies and are not used in a way that provides “capital preservation” for investors.   Whilst the good news is that no one industry has been singled out and added to the excluded trades list (such as had been widely reported in the press as a possibility for film and TV), the new risk to capital condition has the potential to be far reaching.

A new “risk to capital” condition will be introduced for investments made on or after 6 April 2018 which will contain two limbs;

  1. the first will effectively mirror the existing “growth and development” requirement already in the EIS and VCT (but not the SEIS) legislation; and
  2. the second will require that there is a significant risk that the relevant investor could lose capital which is greater than his net return (being income or capital growth as well as any up-front income tax relief).

Additionally, HMRC will cease to provide advance assurance to applications appearing to meet the new condition from 1 December 2017 which could have a significant impact on the ability to fund raise in the current tax year even before the introduction of the new condition, given investors require an HMRC advance assurance.

It will be necessary to form a “reasonable” view as to whether an investment has been structured to provide a low risk return for investors.  Detailed guidance has been promised on 1 December 2017 including a list of factors that HMRC will take into account when assessing whether the risk to capital condition is met.   These seem to include (i)  whether fund managers are involved as nominees for investors – which we would argue to be a completely irrelevant point for the purposes of this test given this is simply a mechanic to enable investors to pool investments across a range of companies and (ii) whether income from an asset forms a substantial part of the trade.

In the meantime, the Government’s response to its consultation on financing growth in innovative firms (published today) provides some high-level examples of where it considers the new condition will affect the availability of EIS, SEIS and VCT reliefs which includes (i) where assets are created which can be sold after 3 years (ii) assets that are constructed and operated by a sub-contractor where a fund manager/nominee is involved.  In the latter case, the key difference to examples of acceptable structures seems to be the fact that the company is not engaging employees and is part of an EIS fund.

HMRC have helpfully clarified that film and media production companies can use SPVs as is the industry norm and re-invest profits in future activities.  However, in order for EIS or SEIS investment to fund a proportion of presales or other support, the investor must remain at significant risk of losing its capital.

Whilst we do not know how widely HMRC will apply the new condition, it is disconcerting that the consultation response includes HMRC’s estimate that up to 80% of its SCEC senior officers’ time is spent on advance assurance applications that may be deemed as “capital preservation” in future, meaning the new risk to capital condition should “free up significant resource”.  80% is a substantial proportion and hints that HMRC may apply the new condition very broadly.

This is really disappointing news as EIS has been such an important means of funding companies that cannot access the more traditional forms of finance from banks who generally do not lend on such projects.

 Boost for “knowledge intensive” companies

Changes have been proposed to the EIS and VCT legislation in order to encourage investment in “knowledge intensive” companies by:

  • increasing the annual investment limit for EIS investors from £1m to £2m;
  • increasing the annual limit from £5m to £10m (albeit the overall £20m investment limit for “knowledge intensive” companies will remain);
  • providing greater flexibility on maximum age limit, so companies can choose whether the 10 year period commences on the date (i) on which the company’s turnover exceeded £200,000 or (ii) the company’s first commercial sale; and
  • consulting on setting up a new EIS approved fund structure to attract investment in “knowledge intensive” companies by giving flexibility to deploy capital raised over a longer period of time.

The test of whether a company is “knowledge intensive” in the VCT and EIS legislation is detailed and not straightforward to apply.  A company must show that it meets conditions relating to the quantum of its operating costs spent on R&D in the last three years, and that it either has a requisite proportion of skilled employees (with the qualifications to support this) or is engaged in innovative activities.

The measures announced today include limited revisions to the “operating costs” condition in respect of companies under three years old.  Without more substantial simplifications to the test we anticipate that it will remain an involved and occasionally convoluted process for some companies to evidence that they satisfy all of the requirements.

The measures announced are all subject to state aid approval and intended to apply to investments made on or after 6 April 2018.

Advance assurance service response

The Government response to the consultation on streamlining the advance assurance service will be released on 1 December 2017.  The Government has noted that the measures to be announced, when combined with the new “risk to capital” restriction, should ensure that the vast majority of advance assurance applications are dealt with within 15 working days by Spring 2018.    It is disappointing that the method of reducing the waiting time has been to reduce the number of companies that can benefit from this very valuable and important relief.

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