Qualifying companies need to be aware of the rules that go with enterprise investment raising. Venture capital tax specialists David Brookes and Mark Ward discuss the care required to protect investors.
The enterprise investment scheme (EIS) has been a part of the tax landscape since 1994. In that time, 33,000 companies have raised £24bn in equity finance. The scheme’s newer cousin, the seed enterprise investment scheme (SEIS), was introduced in 2012, in order to focus on start-ups and very early-stage companies, and since then more than £1.4bn has been raised by more than 14,000 companies.
It is clear from those statistics alone that the SEIS and EIS are both important aids for entrepreneurial businesses raising money for growth. However, the schemes are also notoriously complex, with myriad traps for the unwary. The implications for investors who have backed the company can be expensive and onerous if a company is disqualified before the termination date.
This article (which refers to ‘EIS qualifying companies’ throughout, for ease of reading) briefly summarises the main requirements for companies to be aware of, after raising SEIS or EIS money from investors. Similar rules will also apply to companies with investment from venture capital trusts (VCTs).
Termination date
Before looking at the rules in detail, it is important to understand the termination date. The company must continue to comply with the scheme legislation up until this date, which will be the later of the third anniversary of the share issue date, or, if the company was not trading or carrying on research and development at the date of the share issue, three years after trade commenced.
The termination date will be shown on the EIS2 (the email sent by HMRC that authorises a company to issue EIS3 certificates to investors), and on the EIS3 certificates. The company should keep copies of these documents safely and permanently.
Many companies will go through multiple EIS fundraising rounds, in which case there will always be a new, later termination date for each share issue, (although earlier share issues will retain their earlier termination date).
Scheme requirements
Broadly speaking, the requirements can be split into two categories – those that must be met at the time of the share issue, and those that must be met at both the time of the share issue and throughout the three-year qualifying period, ending on the termination date.
The requirements that have to be met only at the time of the share issue cover:
- the age of the company;
- the number of full-time equivalent employees;
- the gross assets of the company;
- the financial health requirement; and
- the unquoted status requirement.
Provided these conditions were met at the date of the share issue, the company will not be disqualified if, for example, it hires more people, or decides to become fully listed.
The conditions that must be met throughout the three-year period are:
UK permanent establishment:
if an overseas company has qualified under EIS by virtue of having a UK branch or agent, it must maintain that UK branch or agent until the termination date. Any company in this situation should consider its position very carefully before scaling back its UK presence and activity from the position it set out in its advance assurance application and/or EIS1 compliance statement.
Control:
an EIS company must not control any other company that is not a qualifying subsidiary, and there must be no arrangements in place that could breach that condition. A qualifying subsidiary is a 51% subsidiary (s191, Income Tax Act 2007 (ITA 2007)). Importantly, if arrangements are put in place – before the termination date – for the EIS company to take control of a non-qualifying subsidiary after the end of the qualifying period, that will disqualify the company.
Independence:
an EIS company must not be under the control of another company, and there must be no arrangements to allow that to happen. Again, no such arrangements must exist during the three-year qualifying period, even if those arrangements only allow for the company to be taken over after the termination date. However, this is waived where the arrangements are for a share-for-share exchange with a ‘Newco’, where that falls within the requirements of s247, ITA 2007 (see below).
One example of where this point can inadvertently lead to EIS disqualification is the issue of convertible loan notes to another company. If such loan notes create a situation where conversion could result in the loan note holder taking a majority in the investee company, that is likely to be an arrangement by which the EIS company could come under the control of another company.
Reorganisations:
many companies will go through a reorganisation as they grow. Sometimes, perhaps in anticipation of an initial public offering on the Alternative Investment Market, this will involve creating a new holding company and then undertaking a share-for-share exchange, so that the original EIS company becomes a 100% subsidiary of the Newco.
This can be done without loss of EIS reliefs for investors provided certain conditions are met, including that it is a mirror share-for-share exchange and s138, Taxation of Chargeable Gains Act 1992 clearance has been received from HMRC. The conditions in s247, ITA 2007 must be strictly adhered to. If the company has more than one share class and the process involves consolidating into a single share class, the company should seek specialist advice, as HMRC’s view is that a share conversion can be a disposal for EIS purposes.
Employee share schemes and new share classes:
in a similar vein, advice should be taken if a company is considering creating any new class of share – EIS shares must not have preferential rights to dividends or assets on a winding up, so creating a share class with inferior rights to the EIS shares could inadvertently disqualify them. In practice, this tends to happen when a company adopts a ‘growth share’ or ‘flowering share’ scheme.
Such schemes generally have a hurdle and receive no dividends or rights to assets on a winding up before the hurdle is reached. This puts the EIS shares in a position where they have preferential rights ahead of the employee shareholders, thus disqualifying the EIS shares.
Enterprise management incentive share options should not cause any problems.
Acquisitions and the maximum age requirement:
be aware that if an EIS company acquires another, older, company, the EIS company may also acquire an earlier ‘first commercial sale’, preventing future EIS investment. Additionally, though, spending EIS money that has already been raised in an older, newly acquired business may disqualify the relevant EIS share issue.
Whenever an EIS company is making an acquisition, it should establish the date of the target’s first commercial sale and its SEIS/EIS/VCT and state-subsidised risk finance history and consider the impact on its own EIS position. The same will apply to a ‘trade and assets’ acquisition.
Shareholders:
care must be taken if an EIS shareholder becomes a director or non-executive director. The relevant legislation is at ss168-169, ITA 2007. One bear trap that often catches companies out is that an investor can lose EIS relief if they or an associate become an employee (s253, ITA 2007). The important investor who asks a company to give their grandchild a holiday job may find they have disqualified themselves!
Trading and excluded activities:
if an EIS company ceases trading before the termination date, it is likely to be disqualified. However, the requirement is that the company exists for the purpose of carrying on a qualifying trade.
An EIS company can therefore change the trade it conducts, subject to the excluded activities points (see following paragraph), and there is a degree of wriggle room if a company ceases one trade and subsequently starts another (see HMRC’s Venture Capital Scheme Manual at VCM13050). A company that ceases trading as a result of going into administration or receivership for genuine commercial reasons will not automatically be disqualified (s182, ITA 2007).
There is a long list of ‘excluded activities’ that apply to the EIS, SEIS and VCT schemes (eg, s192, ITA 2007), and a qualifying company’s activities may not comprise more than 20% of any of these activities. In a group situation, it will be the activities of the group as a whole that are considered. HMRC’s Venture Capital Schemes Manual says at VCM3010 that the 20% is applied to “any measure which is reasonable in the circumstances of the case”. This is typically, profit, turnover, management time etc, but in practice, HMRC’s approach seems to be that most appropriate means anything that exceeds 20%.
Common issues that arise include: when does a pub with rooms become a hotel with a bar? Similarly, an EIS company that rents out surplus space, perhaps in its office or warehouse, will need to ensure that the rental activity remains within 20% of its overall activity.
In a group scenario, intra-group lending or investment is ignored, but companies should be careful, particularly immediately after an investment, that the cash is kept in a normal business account and not in any longer-term investment.
Use of money:
not strictly a three-year requirement, but an EIS company must spend all EIS money on a qualifying purpose within two years of the share issue or, if the company is preparing to trade at that time, within two years of the trade commencing. Not spending it in time, or diverting it for a non-qualifying purpose, will disqualify the whole share issue.
The belt and braces approach is to keep the EIS money in a separate account, to ensure it is properly spent. While HMRC’s Venture Capital Schemes Manual states that “insignificant” amounts not spent on a qualifying purpose will be disregarded, insignificant is not defined (see VCM12060). In practice, few companies have a problem spending money, but this issue does come up from time to time.
Receipts of value:
the receipt of value rules are complex, but providing any benefit, or making any payment to EIS investors, should be carefully considered.
Share buy-backs:
investors will lose relief if a company repays any of its share capital, even if the shares are bought back from a non-EIS investor (s224, ITA 2007).
This is most commonly seen where a founder, who did not claim EIS relief, is leaving as a ‘good leaver’ and the company’s Articles or a Shareholders’ Agreement requires that the company buys back their shares. Doing so will result in a withdrawal of some or all of the EIS relief from all EIS investors pro-rata to their investment.
Knowledge-intensive companies
Knowledge-intensive companies (KICs) can attract a greater level of EIS investment, but the threshold conditions are higher. If a company meets the KIC definition because it depends upon meeting the skilled employees condition, it must continue to meet that condition for at least three years following the date of investment.
New companies applying for KIC status without three years’ accounts can qualify as KICs if their research and development (R&D) expenditure meets one of the operating costs conditions in the three years following the investment. Failure to meet this condition means the company will be disqualified, so companies will need to monitor their ongoing R&D spend against relevant operating costs.
Dealing with a breach
If a company has breached the EIS requirements before the termination date, it must notify HMRC’s Venture Capital Reliefs Team within 60 days of the event and should also notify its EIS investors, who are also required to disclose the event within 60 days of becoming aware of the position.
There is no requirement for an annual audit of the EIS qualifying conditions, but advisers should encourage their EIS clients to always seek advice before doing anything that could affect their EIS qualifying status. The costs of getting it wrong can be substantial, and it is rarely possible to undo a disqualifying event.
About the author
David Brookes, Partner, and Mark Ward, Associate Director, Venture Capital Taxes, BDO LLP