A return to the true spirit of EIS…a summary of market developments

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Date05 Apr 2018
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Key outcomes/What happened?

The objective of the budget changes is outlined in the consultation document “Financing growth in innovative firms” which was published in August last year.  The objective of the review was to stimulate investment in patient capital defined as “long-term investment in innovative firms led by ambitious entrepreneurs who want to build large-scale businesses”.  It has been identified that there is a serious gap in the funding market for small to medium sized businesses and venture capital funding in the UK has been in decline since about 1987 when pensions funds and other institutional investors started to divest from venture in pursuit of the globalization story.

The unsung part of the change in the Budget was that the Government introduced a £20b package of stimuli to encourage Institutional investors back in the venture sector. This will have a hugely positive impact on EIS and VCT investors as it should develop the exit market for these investments, improving returns and reducing timeframes.

The Venture capital schemes regime has been incredibly successful at attracting funds to SMEs however, of late there has been an increasing focus on tax planning using capital preservation structures.

The Chancellor took action in the budget to divert these funds into genuine investments by introducing a principles based test (see below).  Basically the test looks at investments and makes a subjective decision as to whether they are genuine Patient Capital Investments.  If HMRC judges that they fail the principles based test they will not offer advanced assurance which means that investors have to take a chance over securing their tax relief.

  • Enhancement to EIS Tax Relief – doubled for knowledge intensive companies (KIC) – That’s an overwhelming vote of confidence for this method of financing. Doubling of the annual investment limits for KICs, from the £5m that all EIS companies can raise to £10m. Individual investors can currently invest up to £1m a year in EIS companies. From April 2018, they will be able to invest £2m, of which at least £1m must be with KICs.

Equally significant is the extension of the period in which KICs can remain within the EIS. This has been  raised to ten years. Importantly the clock will not start ticking on that ten years until revenue exceeds £200,000. Currently countdown begins when the first commercial trade takes place. This has been a beef ever since legislation in 2015 restricted to seven years the age of EIS-qualifying companies. It was felt it denied tax-efficient investment to businesses at just the time they would be looking to scale up.

To qualify as a KIC, a business needs to:

  • carry out significant research and development during the three years before investment.
  • have created, or be creating intellectual property (i.e. something unique),
  • or to have 20% of the employees educated to Master’s degree level or higher and be working on research and development.
  • Principles based test introduce. This will be aimed at detecting those investments whose structure/return may not be in the spirit of EIS. This will play an important part attaining Advanced Assurance. Critical to the test is the ‘risk to capital condition’ – this is to identify those investments where the tax relief forms a substantial part of the return, these investments will not eligible. In addition the investee company must have objectives to grow and develop over the long term and the investment must carry a significant risk that investors will lose more capital than they gain as a return (including any tax relief).

So this will exclude companies with sub-contractor operating models and EIS where 50% of risk covered by assets and Income tax relief. Specifically:

  • The company should be proposing to trade on an ongoing basis, not just to carry out one project.
  • The company should have the objective of growing and developing over the long term.
  • An investment in the company must carry the risk that an investor will lose an amount greater than the net return.
  • The company should not have assured or highly predictable income streams.
  • The company should not own an asset held mainly with a view to its disposal.
  • The company should not sub-contract all or most of its activities to others. The company should not effectively be controlled by the promoter.
  • The company should not be one of a number of identical companies all carrying out the same activity – this is referred to as “fragmentation”.

Such a test will also have positive impact on Advanced Assurance turnaround times – Target 14 days by 04/18

Start-up companies, businesses founded by entrepreneurs with a vision to grow, “KICs” i.e. companies established off the back of research and development or intellectual property – these are all the types of businesses which will qualify going forward.

  • £20bn to invested to stimulate scale up companies ie Patient Capital and backing for 1st time & emerging fund managers through £1.5bn of new investment

This represents the “Patient Capital Stimulus”, a reference to the Patient Capital Review commissioned by the Chancellor in Autumn 2016. This Patient Capital Stimulus is important for EIS and VCT investors because it will drive exits and valuations.

What does it all mean?

EIS are seen as inherently risk and there is potential for this view to be exacerbated as capital preservation structures are being withdrawn. Nonetheless the hunt for alpha does mean that there continues to be increasing interest alternative investments to which end EIS can form part of a wider portfolio.

Diversification is the way forward and whilst acknowledging that EIS has some inherent risk it may be mitigated through a diversified approach which takes into consideration different sectors, funding stages, providers/managers and vintage.

So following the Budget the future for EIS is bright with a renewed importance on the underlying investments, yet still offering even more enviable tax benefits. That said it is clear that diversification remains the most effective risk management tool.

EISA, have produced a guide EIS: new landscape, new opportunities,  which further explains the new world order.

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