EIS: Stuck in the mud?

The enterprise investment scheme (EIS) is valued by both companies and investors, helping the former to secure investment and providing the latter with income tax and capital gains tax reliefs. However, EIS is complicated and full of traps for the unwary, making it easy to make mistakes. A common-sense approach from HMRC is needed if EIS is to continue to deliver on the policy intention of making it easier for a smaller company to attract the investment needed to grow its business.

Background

The forerunner to EIS, the Business Expansion Scheme (BES), was introduced in 1983. The then Chancellor, Sir Geoffrey Howe, explained the scheme in the following terms: “These proposals will transform the position of unquoted trading companies seeking outside equity. It is a further move towards removing the bias in the tax system against the personal shareholder and a further measure to encourage wider share ownership. By concentrating help on those companies which do not have ready access to outside capital the scheme will assist many more small or medium companies to realise their undoubted growth.” 

These sentiments were echoed by the then Chief Secretary to the Treasury, Michael Portillo, when EIS was introduced in its current form in 1993: “The purpose of EIS is to recognise that unquoted trading companies can often face considerable difficulties in realising relatively small amounts of share capital. The new scheme is intended to provide a well-targeted means for some of those problems to be overcome.”

Consequently, EIS was an area where positive engagement with HMRC was possible, with a dedicated team focused on EIS who were available to talk through particular issues.

In our experience, this began to change in 2015 when the government introduced additional requirements to ensure EU state aid compliance. From that point on EIS became increasingly complex, with a raft of additional tests needing to be considered before qualification can be confirmed. At the same time, HMRC has become less accessible generally and in recent years has become more adversarial where EIS compliance is concerned. 

Recent experiences

Over the past two years we’ve seen a change in HMRC’s approach at all stages of the EIS process. It is correct that HMRC acts to ensure compliance with the rules, but its activities must be proportionate, taking into account the risk of tax loss and the impact on businesses. An EIS advance assurance was once a relatively straightforward process. Now we expect HMRC to ask detailed questions on a much higher proportion of applications, meaning that the advance assurance process typically takes twice as long as it used to, even for relatively small and/or low risk fundraises. 

Often there will be a higher level of focus on issues related to research and development (R&D). These include whether the company is undertaking R&D from which a qualifying trade will be derived or has met the knowledge-intensive test requirement by virtue of their R&D. HMRC’s lack of depth of knowledge regarding R&D is increasingly frustrating strong EIS applications. 

We are also seeing an enhanced level of diligence from HMRC concerning the receipt of funds and the issue of the shares. Examples of areas attracting HMRC’s attention when an EIS1 is submitted include the following: 

• Checking that cash received for new shares was received into a company bank account rather than the personal bank account of one of the founders. This is a particular problem where embryonic start-ups are urgently raising funds and have not yet been able to formalise banking arrangements.

• Reviewing company bank statements to ensure cash was received prior to the shares being issued.

• Reviewing legal documentation to ensure the date of issue given on the EIS1 corresponds to the legal documents prepared.

• Reviewing filed accounts to focus on how fundraising rounds have been accounted for where cash has been received before the balance sheet date and the shares issued in the subsequent accounting period.

It may be no surprise that upon occasion paperwork is not entirely consistent, particularly where company directors have attempted to do much of the work in-house. This is leading to increasingly difficult conversations with HMRC and a lack of certainty around the qualifying status of individual share issues. 

Lessons from case law 

There is a healthy dose of case law when it comes to the EIS. 

HMRC v Alan Blackburn Sports Ltd & Anor (2008) EWCA Civ 1454 is an excellent starting point, covering a range of problems which might arise when issuing EIS shares, which then may create issues at a later point when submitting a compliance statement. However the point with Blackburn, as the Court of Appeal judge noted, is that if HMRC was correct about all the technical positions it took, no share issue could ever qualify for EIS – a position which clearly did not reflect the intention of Parliament. 

A case often cited by HMRC is Martin Ashley v HMRC (2008) SpC 633, where the company issued EIS3 certificates using the wrong date, and the judge found that this meant the taxpayer was unable to claim EIS at all. Notwithstanding the outcome, the judge did describe this decision as being one even he found “harsh and unmeritorious”, suggesting that HMRC reconsider its policy in such situations in a clear nod to HMRC using its discretion in similar cases. 

In the more recent case of Fashion on the Block Ltd v HMRC (2021) UKFTT 0306 TC), while acknowledging that the First-tier Tribunal cannot direct HMRC to use its discretion, the judge ordered HMRC to remedy the error through rectification of the relevant forms and highlighted that HMRC should be slightly more focused on using a purposive approach in its work.

In other areas of tax, there are cases which refer to HMRC using its power to apply discretion. For example, in GB Housley Ltd v HMRC (2016) EWCA Civ 1299, the Court of Appeal confirmed that HMRC had failed to correctly exercise its discretion in relation to a VAT matter. Another case of interest is that of Joost Lobler v HMRC (2015) UKUT 0152, where the taxpayer ticked the wrong box on a pension-related tax form, creating a tax outcome that he clearly had not intended. The Upper Tribunal allowed this mistake to be rectified. 

While most practitioners advising in the EIS field accept that it is complicated, and the rules slightly prescriptive at times, equally HMRC should accept that minor errors in the paperwork should not always be fatal, and rectification of paperwork should be preferred over the outright refusal of what would otherwise be a perfectly acceptable qualifying EIS investment on all-fours with the intention of Parliament. More often than not there should be plenty of scope within the body of case law referred to above for HMRC to reach commonsense conclusions in line with the intention of Parliament. 

Practical impact of HMRC’s approach

The real-world impact of HMRC’s tighter approach to venture capital compliance is starting to become clear. For those who are seeking to raise seed EIS (SEIS) shares with no immediate plans to raise EIS money, the cost of seeking appropriate tax and legal advice may well consume 5% of the initial funding round. If less than the maximum £250k is being sought, that percentage goes up. Lawyers and tax advisers are now highly cognisant of the fact that the risks in this area are increasing, and more time needs to be spent checking the company’s bank accounts and legal documentation before the SEIS1s or EIS1s are submitted. Similarly, greater scrutiny of the company accounts may be necessary. This all takes time and results in materially increased fees where EIS work is concerned. 

For many entrepreneurs, the cost of that advice will increasingly appear to be excessive. A view may be taken that they can forgo the advice and the further assistance with execution and completion of the SEIS1 or EIS1 forms, preferring to undertake these steps themselves with limited or no professional support. This will mean that many start-ups will enter into fundraising rounds anticipating SEIS/EIS qualification, but then become mired in deeply frustrating and technical correspondence with HMRC, and potentially will not qualify for the SEIS/EIS status originally promised to investors. 

It is also possible that competent EIS advisers will consciously price themselves out of fundraises below a certain level (ie, those that cannot bear a reasonable cost for professional support) with the possible result that the number of SEIS and EIS fundraises may decline, particularly at the lower end of the spectrum. In other words, EIS may begin to fail to achieve the policy objective set by the government as outlined above. 

Words of warning

Some start-ups may understandably decide to avoid EIS for their earlier smaller rounds, preferring to consider it for later more substantial fundraising rounds. However, because of the way in which EIS works this may not always be possible, and those investors who participated in early rounds would then not be eligible for later rounds, even if the company qualified and other new investors also qualified. 

The real danger here is that SEIS and EIS may become viewed as an expensive luxury which is too difficult to access. As the government has committed to retaining the EIS until 2035, it could usefully consult on changes that would simplify the rules and ensure that attracting investment to drive growth remains affordable. 

Stuart Rogers, Partner, and Kate Culley, Senior Manager, PKF Francis Clark.