Finance Act 2018 introduces a new Risk to Capital condition for companies raising funds via Enterprise Investment Scheme (EIS), Seed Enterprise Investment Scheme (SEIS) and Venture Capital Trust (VCT) arrangements.

It applies from Royal Assent on 15 March 2018, however, since 4 December 2017 HMRC have refused to provide advance assurance if it does not appear that the risk to capital condition is met.

The risk to capital test has two legs, applied when the shares are issued, if it “would be reasonable to conclude”:

  • The issuing company intends to grow and develop its trade in the long term; and
  • There is a 'significant risk' of a capital loss exceeding the “net investment return”.

The latter condition is to be considered for investors generally, rather than any specific investor.

This measure is intended to exclude artificial investments that have no real prospect of risk from benefiting from the tax advantages of the VC reliefs: it is not designed to affect genuinely entrepreneurial start-ups.

“Significant risk” is not defined and will be a question of fact on a case by case basis.

'Net Investment Return' includes:

  • Income tax relief on the investment
  • Distributions of income from the company
  • Capital growth on the shares

In order to assess the tests, regard must be had to all circumstances but the legislation particularly references:

  • Company’s intent to increase its number of employees, turnover or customer base
  • Nature of the sources of income, including risk of not receiving it
  • Extent to which the company has assets that could be used to secure financing
  • Extent to which activities are subcontracted to unconnected parties
  • The ownership structure
  • How the investment is marketed
  • The extent to which the investment is marketed with or linked to other investments.

Where there are one or more indicators that capital is not being risked this will not automatically mean that the condition is not met; all factors need to be considered together on a case by case basis.

HMRC (in its draft internal guidance VCM8550) indicate that they will carry out post-investment checks on companies to see if the risk to capital condition was met, as well as reviewing if the money raised has been used in accordance with the information provided in their compliance statement.

Following these checks, HMRC are able to withdraw relief if the conditions are not met and advance assurance cannot be relied upon if full facts were not provided to HMRC.

HMRC’s examples are not numeric so contain no calculations showing the second leg of the test.

HMRC Example 1:

A company is set up by postgraduate students to exploit their research, which they expect will eventually have wide commercial value. They have been using the university facilities but they now need their own laboratory. The directors prepare a business plan but, as their plans are high risk and long term and the company has no track record, the company is unable to attract investment from the market. The company secures initial investment under the EIS from members of an angel syndicate, and a fund manager acting as nominee for a number of individual investors. A schedule of follow-up funding is agreed for the next five years. The directors retain a majority interest in the company. The company uses the money to set up and equip a small laboratory on the university grounds and employ a technician. It expects to expand the laboratory, and employ more technical and administrative staff, over the next five years. 

  • Taking all the information above into account, the company will meet the risk-to-capital condition, provided that all other eligibility requirements are met.
  • The directors of the company are entrepreneurs who have set up their own company to carry on their own business. The angel syndicate, fund managers and other promoters have not been involved in setting up the company; they have been approached by the entrepreneurs to consider investing as independent minority investors.
  • The company intends to increase its employee numbers and eventually launch a product on the market, which will be the company’s main trade. This suggests long-term plans to grow and develop its business.
  • There is significant risk for the EIS investors in the company as there is no certainty at the time of their investment that a commercial product can be developed or will be successful.
  • When making a decision on whether the investment meets the risk-to-capital condition, other relevant factors will be considered along with those above, and all the relevant facts of the individual case will be taken into account.

HMRC Example 3:

A film production company is seeking investment for a new film. It sets up a special purpose vehicle (SPV) through which to produce the film, in line with usual industry practice. The company has agreed some pre-sales for the film and has also applied, or intends to apply for Film Tax Relief in respect of the planned investment. The pre-sales and tax relief provide security for a proportion of the overall investment; the remainder of the investment is not secured. The film production company subcontracts elements of the film for which it does not have the expertise in-house, such as set design and visual effects, to different freelancers and companies, but retains overall control of the project and of the decision-making in relation to production activities. The company intends to carry on developing content, such as screenplays, and making films in the future, and intends to reinvest most of the profits from making this film to help it grow and develop as a company.

  • Investment in the SPV would not qualify for the relief, as the SPV will not grow and develop. However, investment in the film production company as the parent company of the SPV would be likely to qualify, as long as it intends to grow and develop as a company and provided other conditions are met.
  • It is normal commercial practice in the film industry to secure pre-agreed income (for example pre-sales or eligibility for other support, such as Film Tax Relief). To meet the risk-to-capital condition, the investment must be genuinely at risk. Therefore, only investment in film that is not covered or protected by pre-agreed income or support (referred to in the media industry as the ‘gap’) will be likely to qualify for tax relief, provided other conditions are met.
  • Though the film company contracts out elements of the film production, this is standard industry practice and the company maintains control over end-to-end production of the film. It intends to reinvest profits from making the film into future projects. As such, subcontracting in this situation does not necessarily indicate a capital preservation investment.
  • When making a decision on whether the investment meets the risk-to-capital condition, other relevant factors will be considered along with those above, and all the facts of the individual case will be taken into account.

Links:

Enterprise Investment Scheme

Seed Enterprise Investment Scheme

External:

HMRC’s draft internal guidance (VCM 8500 onwards)

HMRC’s examples (VCM 8560)