Can EIS survive another open heart surgery?
The UK Government EIS (Enterprise Investment Scheme) consultation period ends on Friday 20th June 2008 and it will report back its findings by autumn. However, will more consultations solve some of the fundamental problem surrounding EIS?
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The EIS plays a significant role in the provision of venture capital for small businesses, having helped raise over £6.1 billion, invested in over 14,000 companies. Its original aim was to incentivise investment in smaller, higher-risk companies that have growth potential but sometimes struggle to raise finance, but the total amount and the number of deals going into EIS schemes have been going down every year, plus there is the old chestnut of ‘equity gap’ that doesn’t exist in reality.
Increased EIS limits won’t do the trick
The 2008 budget announced a further increase in the annual investor limit to £500,000 (subject to state aid approval) to ensure that the scheme continues to stimulate investment. The limit was raised from £150,000 to £200,000 in 2004, and to £400,000 in 2006.
The number of deals and amount has been going down consistently from a peak of £1,061m in FY00, to £666.4 in FY02, to £585.9 in FY 04. Furthermore, deal numbers had collapsed from 2,376 in FY 00 to 1,109 in FY04 and only 634 in FY05.
Mired in red tape and lots of caveats
The EIS was introduced in January 1994 as the natural successor to the Business Expansion Scheme (BES), which operated from 1983 until the end of 1993. It is one of three tax-based venture capital schemes (the others being venture capital trusts, or VCTs, and the corporate venturing scheme, or CVS), designed to address an acknowledged capital market failure in the UK, by helping small firms (who suffer it most acutely) to obtain the finance they need in order to grow their businesses into sustainable, profitable enterprises.
Two year limit is a non-starter for tech companies
Previous EIS rules required that a company receiving EIS money must start trading within two years and that 100 percent of money raised must be spent within two years. This is a real challenge for tech companies, as building effective prototypes can take 18 months and a further one year before first customers are properly engaged.
Investors qualify for a 20 per cent income tax relief on up to £400,000 investment in any one tax year (giving up to an £80,000 reduction of income tax liabilities). Subject to state aid approval, this limit will be raised to £500,000 (giving up to a £100,000 reduction on income tax liabilities) for the tax year 2008/09 onwards. This is based on the amount invested in the company.
The relief given is 20 percent of the amount invested.
- Capital gains tax (CGT) charge can be deferred on a capital gain that is reinvested in an EIS qualifying company; and
- CGT exemption on gains arising on disposal of EIS-qualifying shares;
- Gross assets test – the gross assets of the company (or of the whole group if it is the parent of a group) cannot exceed £7 million immediately before any share issue and £8 million immediately after that issue; and
- Employees – the company (or the whole group if it is the parent of a group) must have fewer than 50 full-time employees (or their equivalents) at the time the shares are issued.
The maximum total investment in any tax year on which income tax relief can be claimed is only by individuals who are not ‘connected’ with the company.
Not for ‘connected’ parties
Neither income tax relief nor capital gains tax exemption is available to individuals who are connected with the company. An individual is considered to be connected with a company in two ways:
- Employment – someone is connected with a company if they, or an associate, are a partner, director or employee of the company.
- Financial interest – neither the investor nor an associate can have a financial interest, which includes control of the company, holding more than 30 percent of the share capital (or share and loan capital taken together), voting rights, or being entitled to more than 30 percent of the assets in the event of a winding up.
Exception for business angels
However, there is an exception for directors who are business angels. Where the investor’s only connection with the company is as a director who receives no remuneration (and is not entitled to such remuneration), and who had not previously been involved in carrying on the trade the company is carrying on, an investment may qualify for income tax relief.
Income tax relief is not withdrawn if the investor subsequently becomes a paid director. The investor can also claim income tax relief on shares subscribed for after becoming a paid director, (providing any remuneration is reasonable), and those shares are issued to him no more than three years after the original shares he subscribed for. If the company had not started to trade when the shares were issued to the investor as an unpaid director, relief can be claimed on further issues within three years of the company starting to trade.
Three year holding period
An investor is entitled to these reliefs provided that the shares are held in a company that remains an EIS-qualifying company for a period of three years after the issue (or three years after the commencement of the trade if that followed the share issue).
More consultations won’t solve the basic problem
One of the government’s priorities in promoting enterprise is to ensure deserving companies have good access to both debt and equity finance. It acknowledges that securing external funding is vital to new start-up companies, as well as to expanding companies, in order to grow, develop and become viable, sustainable, profitable enterprises. But..
Putting money where the mouth is?
Although surveys have found an improvement in the overall financing environment for small and medium-sized enterprises (SMEs) over recent years, they mask a more complex underlying picture. For a minority of SMEs, especially young or potentially risky SMEs with high growth aspirations, debt finance alone (such as bank loans) is inappropriate and risk capital in the form of equity finance is more suitable.
Old chestnut: ‘equity gap’
The existence of a UK equity gap has been known about since 1935. Equity gap is an illusion – concocted by the learned professions, who cannot see beyond their fee earning capacity, lacking in domain specific knowledge and business building skills.
When, Ram Shriram wrote his cheque for a couple of students that started Google, he wasn’t thinking of equity gap or the cost of legal bills, neither was he motivated by tax incentives, as there weren’t that many tax incentives around. It all boils down to a risk taking culture.
To its credit though, the government does admit to not knowing how to identify and target the gap.
Evidence indicates that such firms may have difficulty accessing relatively modest amounts of equity or other forms of risk capital. It remains fundamentally difficult to pin down the size or shape of the gap, so they should stop trying to change the track.
There should be a whole new risk-reward entrepreneurial culture. Competition should not continue to be distorted via subsidies, handouts and initiatives. What’s really needed is a well thought out, brand new, more stable, tax incentive programme for SME lending (both debt and equity) that is not burdened with red tape. Many people feel that EIS has it day and its time to start with something totally fresh.
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© Chilli Publishing Ltd 2008 |
18 JUN 2008 |
