Stephen Hemmings – Business Tax Partner
In recent years, successive governments have introduced or improved a number of tax incentives for early stage companies looking to scale up and grow. In an increasingly competitive international marketplace they have recognised the benefit of encouraging innovative companies to build in the UK. This has included a particular focus on the technology sector.
In this three part article we consider the tax reliefs that are available for a growing technology business over its lifecycle, how useful they are, and what businesses need to do to ensure they can maximise the incentives available.
Effective tax planning can have a massive impact on the returns generated for a technology business and its shareholders. To understand and maximise the benefits, it is important that businesses receive appropriate advice.
Initial investment stage
The Enterprise Incentive Scheme (EIS) offers significant tax advantages to investors who make qualifying investments. This can entail immediate income tax relief worth 30% of the investment made. Alternatively, under the Seed Enterprise Scheme (SEIS), designed for investment into very early stage businesses, immediate income tax relief is worth 50% of the investment.
Companies can raise up to £5 million a year under EIS or £12 million in the company’s lifetime. The first EIS or other venture capital scheme investment needs to be made within seven years of the company’s first commercial sale. These limits are relaxed further for companies which are deemed to be knowledge intensive. Conversely, the SEIS investment limit of £200,000 is much smaller and this needs to be raised within two years of the commencement of trade.
These schemes have undoubtedly played an important role in raising investment in scale up technology businesses, which commercially represent a high risk for investors. In 2017/18, £1.9 billion was raised under EIS and £20 billion in total since the scheme was first introduced.
An example EIS scenario
Let’s imagine a scenario where an individual invests £1 million in an EIS qualifying technology business and then sells their shares three years later for three times the initial investment price.
The investor could receive a £300,000 deduction against their income tax liability to use in the tax year of investment or the previous tax year and would then receive a £2 million gain tax free at the time of sale.
Even if the investment fails the tax reliefs available soften the blow. Assuming that the individual never saw their £1 million investment again they could still get income tax relief worth up to 61.5% of their original investment.
Despite its generosity the EIS regime is renowned for its complexity and HMRC is rigid in applying the rules and disqualifying the investment where the investor or company have accidentally breached them.
It is possible to gain an advance assurance from HMRC that the investment qualifies for the scheme at the time, and this is often key to attracting the initial investment. However, this is not the end of it.
Firstly, there are specific rules concerning how the share issue should be implemented, and HMRC have been known to look at this carefully. One key rule is that the investment cannot compose of a conversion of an existing loan. The company also needs to demonstrate that is has spent the funds within two years. It is recommended that separate bank accounts are maintained to evidence this. If the company becomes profitable in this time, it may otherwise be difficult to demonstrate that the EIS funds themselves have actually been spent.
The company then needs to ensure that the investment meets strict ongoing criteria, broadly for a continuous three-year period from the date of investment. This involves the monitoring of excluded activities, which include:
- the provision of financial services,
- receiving royalties,
- receiving rental income.
Where a group has raised the investment, such non-qualifying activities cannot be substantial (which HMRC deem to be 20% or more). Where the investee is a standalone company with a qualifying trade, any other activities outside of this trade cannot be more than incidental (something which HMRC have indicated in correspondence is less than 1%).
Such a breach leads to a clawback of the income tax relief claimed, which can have serious repercussions for the investor/company relationship.
During the course of this feature we’ve explored the tax reliefs and incentives available for technology businesses and their investors to benefit from during their early life. It is important that businesses are aware of them and understand the nuances of the various regimes to ensure that they achieve an optimal tax position, providing the company with a strong platform to be successful.