21 MARCH 2000 BUDGET-IMPROVEMENTS TO EIS & VCTS

Summary of measures

Changes to the Enterprise Investment Scheme (EIS) and Venture Capital Trust (VCT) scheme were announced today to improve the way they work, make the schemes more attractive to investors and benefit small higher risk companies seeking funding.

The changes will
– reduce from 5 years to 3 years the minimum period for which investments must be held if they are to qualify for income tax relief under the schemes;
– make it easier for EIS investors to invest alongside venture capital funds;
– prevent tax reliefs under both the EIS and VCT scheme being put at risk if the company in which an investment has been made goes into receivership;
– safeguard VCT investors’ reliefs where a company in which the VCT has invested is sold, merges, or undergoes a capital reconstruction, and the VCT receives shares rather than cash.

Further Details

Minimum holding period

1. Under the EIS and VCT schemes, shares for which income tax relief is obtained must be held for at least 5 years if the relief is not to be withdrawn or reduced. For shares issued on or after 6 April 2000 the minimum holding period will be 3 years for VCT shares and for shares in EIS companies which are carrying on a qualifying trade at the time of issue. For EIS companies which are preparing to trade at the time of issue, the minimum holding period will end when the company has been carrying on its qualifying trade for 3 years.

EIS – Facilitating co-investment

2. An investment in a company does not qualify for EIS purposes if the company is controlled by another company at any time during the relevant period beginning when the investment is made. This ensures, for example, that the EIS cannot be used to subsidise investment in subsidiaries of larger companies. However, the way “control” is defined means that, in some circumstances, a venture capital fund which has a minority stake in a company may be treated as controlling that company. This is because the definition of control focuses on factors such as entitlement to distributed profits, and venture capital funds commonly invest in preference shares which give preferential rights to profits. If this happens, the EIS investors’ tax reliefs may be put in jeopardy.

3. The proposal is to change the definition of control to one which focuses on the power of a person to control the affairs of a company through the holding of shares, voting rights or other powers. A venture capital fund which has minority investments in a company will generally not be treated as controlling it under this new test and, as a result, co-investment by individuals under the EIS and venture capital funds will be easier.

4. This change will come into effect for shares issued on or after Budget Day. For shares issued before that date, it will take effect in relation to that part of the relevant period which has not yet expired.

Receiverships

5. Any company which uses money raised under the EIS must, throughout the relevant period, exist for the purpose of carrying on a qualifying trade. A company which goes into receivership may fail to meet this requirement and therefore put its EIS investors’ tax reliefs at risk. The EIS already provides for a company not to fail this requirement in the case of a bona fide liquidation, but there is no corresponding provision for receiverships. The proposal provides for the company to continue to qualify under the EIS if it would have qualified but for the actions of the receiver.

6. This change will come into effect for shares issued on or after Budget Day. For shares issued before that date, it will take effect in relation to that part of the relevant period which has not yet expired

7. VCTs must invest at least 70 per cent of the funds they raise in qualifying holdings in the small higher risk trading companies the scheme is designed to benefit. Currently, if a company in which a VCT has invested goes into receivership, the investment may cease to be a qualifying holding. If as a result the 70 per cent test were not met this could cause the VCT to lose Inland Revenue approval.

8. The VCT rules already provide for a company not to fail this requirement in the case of a bona fide liquidation. This proposal will ensure that the investment also continues to be a qualifying holding if it would have continued to do so other than for the actions of the receiver, and so will help to safeguard the approved status of the VCT and the tax relief of the investors.

9. This change will apply to determine whether an investment held by a VCT is a qualifying holding on or after Budget Day.

Disposals for shares rather than cash

10. A similar problem can arise where companies in which VCTs have invested are sold, merge or undergo a capital reconstruction.

11. Where the VCT receives shares or securities rather than cash in consideration for its interest in the company the new shares or securities will not be qualifying holdings for the purposes of the 70 per cent test.

12. The proposal is to treat the new shares and securities as qualifying holdings for the purpose of the scheme subject to certain conditions, the detail of which will be set out in regulations. Broadly the intention is to allow VCTs
– to retain new shares and securities as qualifying holdings where they would have qualified but for the transfer; and
– a period of grace in which to dispose of others during which they will be treated as qualifying holdings under the scheme.

13. The new rules will take effect for transfers taking place on or after Budget Day.

Licence Fees and Royalties

14. Companies which obtain a substantial amount of their income from licence fees and royalties are excluded from the schemes, except in limited circumstances where the fees or royalties arise from films or from research and development. This provision is being extended in line with the proposals under the Corporate Venturing Scheme to cover licence fees and royalties which arise from an intangible asset, the greater part of which has been created by the small company (see REVBN1C) of today’s date on the Corporate Venturing Scheme). This change will take effect for shares issued on or after 6 April 2000.

15. All the proposals set out above respond to representations for changes in the schemes. In addition, the definition of research and development used for both Schemes is to be changed to align it with the definition used for the Corporate Venturing Scheme and for Research and Development Tax Credits.

Background Notes

The Enterprise Investment Scheme

1. The EIS is designed to help small higher risk, unquoted trading companies raise start-up and expansion finance by issuing full risk ordinary shares. Individuals who are previously unconnected with companies in which they invest may obtain various income tax and capital gains tax reliefs, in particular:
– income tax relief (at 20 per cent) on the amount invested (on investments of up to 150,000 pounds per tax year) and relief from capital gains tax on disposal of the shares, provided they are held for at least 5 years;
– relief for any allowable losses on the shares against either income or chargeable gains; and
– deferral of capital gains tax on a chargeable gain from the disposal of any asset where the gain is reinvested in the shares.

Deferral relief can also be obtained by individuals who have a prior connection with the company, and by the trustees of certain trusts.

2. The EIS currently uses the definition of “control” set out at section 416 of the Income and Corporation Taxes Act (ICTA) 1988 to determine whether one company controls another. It is proposed to replace this with the definition at section 840 ICTA 1988, which is concerned with the power to secure that the company’s affairs are conducted in the way that the person controlling the company wishes.

Venture Capital Trusts

3. VCTs are companies listed on the Stock Exchange which specialise in investing in small higher risk unquoted trading companies of the same kind as those which qualify under the EIS. By investing in a VCT, individuals are able to spread the risk over a number of such qualifying companies. The investor is entitled to various income tax and capital gains tax reliefs, including:
– income tax relief (at 20 per cent) on the amount invested in new ordinary shares up to an annual limit of 100,000 pounds provided they are retained for at least 5 years;
– deferral of capital gains tax on a chargeable gain from the disposal of any asset where the gain is invested in shares for which income tax relief is obtained;
– exemption from capital gains tax on the disposal of any ordinary shares;
– exemption from income tax on dividends on ordinary shares.

Exchequer Costs

4. The reduction in the minimum holding period is estimated to cost 5m pounds/15m pounds/25m pounds in 2000/01 to 2002/03 and to have a full year cost of 30m pounds. The other changes are estimated to have a negligible cost.

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