There must be risk!

Following the Budget at the end of November and the subsequent draft guidance paper published on 4 December titled Introduction to the Risk-to-Capital Condition, the dust is now beginning to settle and it’s clear we are in for a major sea change in the EIS market.

What are the new rules and how are they going to work?

From now on, HMRC will be applying a ‘principles-based test’ in assessing whether applications for Advance Assurance fulfil the ‘risk-to-capital condition’. Instead of disqualifying certain trades, as they have done in the past, or certain types of asset (viz. freehold property based businesses) they will look at applications “in the round” to assess whether they qualify. A bit like a points based system but more discretionary.

So, what will qualify and what won’t?

The following are a number of key points HMRC will consider:

  • 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”.

It is clear from this that HMRC are determined to disqualify no-risk or low-risk schemes which are marketed as such and are set up primarily to obtain the benefit of the tax relief, often with an early exit arrangement.

Start-up companies, businesses founded by entrepreneurs with a vision to grow, “Knowledge Intensive Companies” (already abbreviated to 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. Single asset businesses, construction businesses, media companies which rely on pre-sales and production credits, businesses with highly predictable income streams and/or a large degree of out-sourcing – these are all the types of businesses which will NOT qualify going forward.

So, when will the new rules come into force?

Companies which already have an Advance Assurance should be able to continue to issue shares up to the date of Royal Assent to the Finance Bill, which is expected in March 2018. Companies which do NOT have an Advance Assurance can now only apply to HMRC on the basis of the new rules. Companies which had already applied before the date of the Budget but not had a response are in a grey area but likely to be subject to the new regime, i.e. there is little chance of you now getting an Advance Assurance on the basis of the current/old rules.

What effect will this have on the overall market?

The jury is out on this, but our house view is that the new rules will in the short term reduce both demand and supply. The tail end of 2017-2018 will obviously be affected, as we have seen above, but the overall funds raised numbers are likely to be high for 2017-2018, since so much of the investment has been “pulled forward” to before the Budget because of rumours there would be major changes. 2018-2019 is likely to see a dip, as investors and providers get used to working with the new regime. A sharp drop in demand from advisers and investors solely interested in low-risk schemes is likely over time be offset by a long-term increase in demand from investors looking for pension alternatives and CGT shelters.

Many of us in the EIS industry welcome the changes, as they are likely to re-position the rules to fall squarely into the spirit of the law, and disqualify the many low-risk schemes which have done so much to discredit the industry. We are particularly indebted to the EIS Association, which played a key role in consulting and negotiating with HM Treasury, to help find a fair and equitable way of adjusting the rules.

Martin Sherwood
Partner, Enterprise Investment Partners
T: 020 7843 0472

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