There have been rule changes to how EIS and VCT structures work. This article explains the new market.

Enterprise Investment Schemes and Venture Capital Trusts are ways in which people can secure considerable tax breaks by putting money to work in start-ups, early-stage and specialist companies in the UK. It may come as a surprise to realise that they have been around for more than 20 years and have survived – despite the odd worry – Conservative, Conservative/Liberal Democrat and Labour administrations. Politicians like to boast (not always very convincingly) of their support for small business, but the reality is that as other forms of tax incentives have been eroded in some ways (such as for lifetime pension saving tax-free limits), structures such as the EIS have drawn new followers. This article is by John Glencross, chief executive of Calculus). He talks about recent rule changes, how they affect investors, and future points to consider. The editors of this publication are grateful to Calculus Capital for sharing these insights. As ever, they do not necessarily share all the opinions expressed and invite readers to react.

The Finance Act that came into law last November brought with it changes to the rules governing EIS and VCT vehicles. These changes relate mainly to the criteria used to determine companies’ funding eligibility and the levels of investment they can receive. They are ultimately designed to ensure that capital is targeted at the entrepreneurial growth businesses that need it most. 

While we don’t believe the new regime should materially affect the attractiveness of EIS and VCT structures to suitable investors, they do add greater complexity to the VCT and EIS rulebooks, which is something investment managers must deal with. 

In broad terms, the key changes mean that companies older than seven years will no longer will be able to receive EIS or VCT funding, nor will companies with more than 250 employees, and no single company will be able to receive more than £12 million in investment. 

Knowledge intensive company rules
But there are exceptions. So-called “knowledge intensive companies”, which generally refers to businesses with high research and developments costs and highly skilled employees, are subject to slightly different rules. They have a ten year “age limit”, £20 million funding cap and limit of 500 employees. The seven and ten year age limits do not apply where the company has received EIS or VCT funding in its first seven years, nor where the EIS or VCT investment is more than 50 per cent of the average turnover of the investee company over the past five years - provided the new funds are used for new geographies or new products.

VCT capacity may be constrained in 2016
A further and significant change that will have an immediate impact on VCTs is the prohibition on using VCT funding to finance management buyouts or buy-ins. Many VCTs do this and some are not raising new funds this tax year as a result of this new restriction affecting their investment strategy.

As far as other amendments to the rulebook go, there is a ban on so called “trade and asset” acquisitions from VCT or EIS funding. A consequence of this is that it extends to companies using VCT or EIS money to acquire intangible assets such as patents from other companies. Speaking as growth capital investors, this is an exceptionally short-sighted decision by the Treasury. The OECD has pointed out that modern companies spend more on acquiring intellectual property than they do on fixed plant and machinery. A life sciences company, for example, may need to acquire rights to use a patent held by someone else to enable them to achieve some step in their own core research more easily. Making it more difficult for a small company to acquire rights to relevant IPR suggests a Conservative government that doesn’t understand the needs of modern businesses. 

More positively, the Treasury has accepted that replacement capital - where funding is used to buy shares from existing shareholders - should be allowed within the VCT and EIS regulations. It is recognised that it is often necessary to sort out shareholding structures in SMEs prior to a venture capital investment. The details are to be confirmed but it is likely that up to 50 per cent of any investment up to £5 million ($7.25 million), i.e. £2.5 million, will be allowed in the form of replacement capital in any rolling 12-month period. Replacement capital was not allowed under the original scheme regulations but the industry took up the issue with the Treasury, pointing out that the Global Block Exemption Regulations - the overarching EU guidelines governing tax advantaged venture capital schemes in the EU - allow for replacement capital. The Treasury is therefore in discussion with the EU about allowing it for VCTs and EIS investment. The detail is yet to be settled and approval is likely to be sometime in 2016.
 

Fundamental attractions
Some people have contended the new rules could make EIS and VCT investments less attractive to some investors; viz, it could be argued that because the changes will make it more difficult for established or larger companies to obtain VCT or EIS funding, investment will instead be focused on smaller or earlier stage companies and so investment risks will increase. 

This may be true to some extent but it should not be forgotten that the fundamental purpose of VCT and EIS investment is to provide smaller and fledgling companies with funding to help them achieve their growth potential. Discounting for a moment the fact that even under the new rules, EIS and VCT-qualifying businesses may already be well-established and profitable, such companies have always carried with them a higher degree of risk than later stage or listed companies. That is why EIS and VCT investments come with such generous tax reliefs. Both provide initial tax relief of 30 per cent, while VCTs pay tax-free dividend payments, a highly valuable feature for those requiring income and profits that are free of capital gains tax, the latter also being true of EIS investments. 

EIS investments are, additionally, free of inheritance tax after two years, provide loss relief so that the maximum loss on a single investment is 38.5 pence in the pound for a taxpayer paying the top income tax rate of 45 per cent, and allow for CGT deferral.

In totality, these tax reliefs provide considerable protection against possible losses, particularly for EIS investments. Coupled with the growth potential of smaller companies, we believe VCT and EIS vehicles will continue to appeal to investors.

And the attractiveness of EISs and VCTs to wealthy investors is enhanced when considered in the context of tax reliefs being heavily reduced on pensions. The annual pension contribution limit is £40,000 today, when only a few years ago it was £255,000, and the lifetime limit for tax relieved pension contributions is shortly to fall to £1 million. Additionally, the annual allowance for anyone earning more than £150,000 a year will from April be tapered to a minimum of £10,000. In light of these circumstances, EIS and VCT vehicles are being used more and more in retirement planning strategies.

Factor in today’s environment of low yields and hard-to-come-by capital growth from mainstream investments and the high growth potential of VCTs and EISs may make them more attractive to some investors than they have ever been.  

Summary
Overall, our view is that there is now more complexity to the VCT and EIS rules, which is unhelpful for investment managers, though the appeal of EISs and VCTs to investors is fundamentally undiminished. 

Because some VCT managers will need to reconsider their investment strategies in light of the management buy-out/buy-in restriction, we are likely to see reduced capacity in the VCT sector in the short-term. This is something that investors and wealth managers will need to bear in mind if they are thinking about making VCT investments this tax year. 

The key EIS and VCT rule changes:
- The purpose of the investment must be to promote business growth and development; 
- All investors must be “independent” from the company at the time of the first share issue; 
- The EIS annual limit of £5 million is now to include investments in subsidiaries or where trades are transferred in; 
- There is a new limit of £12 million on the total lifetime investment a company may receive through EIS or VCT, with some exceptions including “knowledge-intensive” companies; 
- There is a new age limit of seven years from the first relevant commercial sale, with some exceptions including “knowledge-intensive” companies or companies that have already raised EIS or VCT funding; 
- EIS and VCT funds may not be used for the acquisition of existing companies; 
- With regards to “knowledge-intensive” companies, the lifetime investment limit is £20 million instead of £12 million and the age limit is ten years from the first commercial sale;  
- Age limits will not apply where the investment represents more than 50 per cent of turnover averaged over the preceding five years; 
- The number of employees allowed in “knowledge-intensive” companies is being raised from 250 to 500.

VCT tax reliefs:
- 30 per cent income tax relief up to a maximum investment of £200,000 per year. Shares must be held for five years or tax relief will be claimed back. Tax relief is paid in the form of a rebate and is only available on tax an individual has paid; 
- Tax-free dividends, and
- Free of capital gains tax.

EIS tax reliefs:
- 30 per cent income tax relief; 
- Free of capital gains tax; 
- Loss relief; 
- 100 per cent inheritance tax relief, and 
- CGT deferral. 

This article reflects Calculus Capital’s understanding of current (February 2016) UK legislation and practice. Bases and rates of taxation are liable to future change.