EIS - FTT considers risk to capital condition
Newsletter issue - December 2021.
The enterprise investment scheme (EIS) is a collection of tax incentives aimed at encouraging private investment into younger trading companies. EIS is well established; however, the rules have been subject to various changes and additions over the years.
In summary, the reliefs available on a qualifying investment are:
- income tax relief of 30%;
- capital gains tax reinvestment relief;
- capital gains tax exemption for the EIS shares themselves;
- automatic share loss relief against income (subject to adjustment for income tax relief given).
Of course, as the reliefs are very generous there are myriad conditions to be met before HMRC will approve an investment as qualifying. Some of these relate to the underlying company, some to the investor, and some to the mechanics of the investment itself.
The nature of the various reliefs has seen EIS become a target for promoters designing investment opportunities into companies which just about meet the qualifying conditions but, in reality, are aimed at capital preservation, i.e. securing the relief with a high probability of returning the capital to the investors after the minimum holding period ends. HMRC were concerned that the scheme was not operating as intended and was, for example, allowing projects where the money raised was being used to buy property.
To combat this, a "risk to capital" condition was introduced in 2017. All prospective investments must meet this condition before HMRC will issue a positive advance assurance opinion, or a EIS3 form.
The condition has two legs, both of which must be met.
The first leg is that the company must have objectives to grow and develop in the long term, and that the prospective investment will assist with this. Neither the term "grow and develop" or "long term" are defined statutorily, and so are open to interpretation.
The second leg is that there must be a significant risk that investors will lose money by making the investment. Any arrangements which are aimed at reducing risk, or at capital preservation, will fall foul of this.
Taking both legs together, the risk to capital condition is considerably more subjective than other conditions for EIS relief. It is therefore inevitable that case law will eventually be required to examine the two legs.
The First-tier Tribunal in CHF PIP! PLC v HMRC looked at the first leg of the test. In this case, the issuing company had acquired intellectual property rights relating to animated programs and merchandise. This IP was exploited by outsourcing the production and licensing to companies under common control with CHF PIP! PLC.
A number of shares were issued in tranches in 2018, and the company submitted a compliance statement under the EIS provisions. HMRC refused relief on the basis that, in their view, the company was not carrying on a qualifying trade, and in any case did not meet the risk to capital condition.
In order for the issuing company to meet the condition relating to carrying on a qualifying trade, it must be undertaking activities which are not excluded under the legislation, and this must be done on a commercial basis with a view to realising profits. In the first instance the tribunal looked at whether the receipt of royalties and licence fees was an excluded activity. However, this was not the case because there is an exception from being excluded if this type of receipt relates to exploitation of relevant intangible assets.
The tribunal considered that the issuing company was indeed trading, despite the outsourced activity. However, in part due to steadily decreasing turnover and losses made for six successive years, the tribunal decided that the trade was not being undertaken on a commercial basis with a view to a realistic profit at the time the shares were issued - despite the fact that a new steering committee had been appointed. In particular, the tribunal pointed to the fact that the appetite for content of the sort the company produced was significantly declining.
Failing the qualifying trade test was enough to ensure that no EIS relief could apply. However, as HMRC had raised the question of the risk to capital condition as part of its argument, the tribunal went on to consider the first leg, i.e. whether the company had objectives to grow and develop in the long term.
The commentary extends to just a single paragraph:
"Secondly, as regards the risk to capital condition, I find that at the relevant time it is not reasonable to conclude that Pip had objectives to grow and develop its trade in the long-term. I say this for the same reasons as I have given for coming to the conclusion that Pip was not trading on a commercial basis with a view to profit. The risk to capital condition has an objective element and it is my objective view that Pip did not have the objectives of growing and developing its trade in the long-term. The aspirations of the steering group which Miss Brown has given as evidence of that long-term objective are wholly unrealistic when tested against the trading history and financial performance of Pip between 2011 and 2018."
Possibly the most interesting part of this appears to be the judge's willingness to look back in order to look forward, i.e. to look at the recent trading history to determine whether long-term growth and development was a realistic objective. Whilst the decision may be appealed, it appears to indicate that merely having an intention for growth and development will not be enough - that intention needs to be realistic and realisable as well.