Venture Capital Schemes – The Risk-to-Capital Condition

Posted by on Jun 30, 2018 in News Alerts, Newsletters | No Comments

For companies looking to raise funds based by a venture capital scheme and for investors looking to benefit from the tax relief, HMRC have introduced a key new condition – the risk-to-capital.

This condition is being applied to the Seed Enterprise Investment Scheme (SEIS), the Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCT).

The Risk-to-Capital Condition is made up of two components both of which must be met:

  • the intention for the company to grow and develop; and
  • the risk to the investor of losing their capital.

Under the first part of the condition, HMRC will be considering whether the company in its business plan has the clear ambition grow and develop its trade over the long term.

HMRC will look at some general indicators, such as increasing revenue, customer base and employees, together with those specific to the applicant’s business plan.

Essentially, HMRC are looking for evidence that investment is both planned to be and, in reality, is employed to support the company to grow and develop.

Under the second part of the condition, HMRC will be considering whether, at the time the investment is made, a given investment presents a significant risk of a loss of capital to the investor of an amount greater than the net return.

Essentially, HMRC will be evaluating the commercial risk of the company failing in the market.

The central issue with the Risk-to-Capital Condition is, as HMRC concedes in their internal manual, that there are no prescribed definitions of ‘growth and development’, ‘long term’ or ‘significant risk’.

As a result, this makes this a subjective decision based on interpretation. As HMRC stated on a recent webinar, “Each inspector will look at an application and view it on its merits. Each inspector obviously can interpret things in a different way……”

Venture Capital Schemes have been designed to encourage the patient capital investor. In this light, HMRC would be expecting the investor to hold their shares for longer than the three-year minimum requirement.

In addition, any indication that the future operation of the company could be compromised to enable investors to exit their investment would be seen as contrary to the objective to grow and develop in the long term.

Broadly speaking, a company that is created solely to deliver a project or a series of projects would not be considered to have objectives for long-term expansion.

This type of company, often referred to as a Special Purpose Vehicle, that would generate a certain amount of money once the project is complete, either through a steady income stream or gains on disposal of the asset created, would not be eligible for the tax reliefs under Venture Capital Schemes.

In evaluating the net investment return from a risk perspective, HMRC will include any income, such as dividends, interest payments or other fees, as well as capital growth and, potentially, the amount of upfront Income Tax relief the investors would be eligible to claim.

If the investment is in any way protected, for example by assured future income streams or capital repayment, the investment is unlikely to meet the risk condition.

However, the potential future return to an investor from the genuine growth the company expects to realise should the company be successful is not considered. As long as there is a significant risk at the time of the investment, the prospect of potential large returns in the future is not compromised by the risk condition.

It is important to remember that HMRC has the right to clawback the tax reliefs granted under Venture Capital Schemes either to the company or an individual shareholder if all the conditions are not met throughout the relevant period. In broad terms, the relevant period is three years from the investment.

As a result, it is not simply a matter of presenting a qualifying case at the time of applying for the initial tax relief, it is also about delivering on the plans and strategies through the relevant period.

If you have any questions or concerns on the Risk-to-Capital condition or Venture Capital Schemes in general, please email us at tax@cooperfaure.co.uk.