By Jon Dawson and Paul Twydell, Manager and Tax Director at haysmacintyre for The Fintech Times.
Some of the most revolutionary businesses in the fintech space were born in the UK and in 2017 we saw 31 companies based in London make it into the Fintech50. The continued growth of fintech start-ups in the UK has provided (and will continue to provide) vast opportunities for private investors to invest in exciting businesses. The Enterprise Investment Scheme (EIS) has meant these investments can be made in a tax efficient way and the scheme is attracting a range of investors like we haven’t seen before.
From sophisticated financiers to first-time investors who are exploring crowdfunding platforms, EIS provides benefits to the investor such as income tax relief of up to 30% of the cost of the investment, and exemption from capital gains tax (CGT) on the eventual disposal of the shares.
For investments in companies which have been carrying on their business for less than two years, the similar but separate Seed Enterprise Investment Scheme (SEIS) is available on the first £150,000 of investment, allowing income tax relief of up to 50% of the funds invested. Most of the rules for the SEIS are the same as for the EIS; this article concentrates purely on EIS for ease of reading.
Since the EIS was launched in 1993-94, over 26,000 companies have received investment and over £16 billion of funds have been raised , with the number of companies seeking investment under the scheme being at its highest level ever.
How is EIS relief obtained?
EIS relief is claimed by an investor in their personal tax return. However an investor is not able to make this claim unilaterally under self assessment and can only make this claim where a certificate of entitlement to the relief is issued by HMRC. The investee company must apply for the relief on behalf of its members and can only do so after it has been carrying on its trade, or R&D activities, for four months.
So that investors can have peace of mind that an investment should qualify under the EIS prior to making their investment, HMRC offer a non-statutory clearance, known as Advance Assurance. It is not a requirement of the scheme that Advance Assurance must be obtained in order for the reliefs to apply but we often find clients and their investors want that peace of mind.
HMRC aim to review an Advance Assurance within fifteen working days of a company making an application. However with the increased number of applications being made to the specialist department which deals with EIS, HMRC have not been able to meet this time limit and we have experienced applications taking up to fourteen weeks to be looked at – worth bearing in mind if you’re planning on raising further investment in the foreseeable future.
HMRC are looking to streamline their processes, and in order that the generous tax reliefs afforded under the scheme are targeted to companies which most need the investment and acceptance under the scheme is given in the most timely manner, HMRC have introduced some recent changes as to how the scheme is operated.
We expect that fintech companies will be amongst the biggest winners when HMRC implement their proposed changes.
New rules – risk to capital
HMRC are looking to target EIS relief to small, higher risk, early-stage trading companies that would otherwise struggle to access the funding needed to enable them to grow and develop, as they have little or no track record. However, it has been the case that the EIS scheme has been used by investment managers for capital preservation schemes investing in property backed businesses, such as pubs, crematoria and nurseries, where the income tax relief is used in part to provide the return on investment to the investors and it may not be the case that the investor is under any real risk of losing all of their investment.
The new rules will only grant EIS relief where a company can meet two conditions: firstly that there is an intention for the business to grow and develop over the long term, not just for the three year period in which an investor’s EIS relief is at risk. Such factors could be plans for increasing revenues, customer base and the number of employees. The second condition is that the investor has a real risk of losing all of their investment where there is a commercial risk of the company failing in the market.
HMRC have not suggested that these tests have set criteria to meet, but moreover that the overall business plan has, with reference to certain factors, an overall feel that there is an intention for growth and a risk of failure. HMRC have provided guidance on these factors and provided examples on their website.
In the fintech space we expect there to be many companies who will be able to demonstrate that this test is met: where the technology is new with no proven business model, or requires a certain amount of take-up from the market and a high number of users before it will turn a profit then there is unlikely to be a guaranteed return. HMRC advise that where a company uses subcontractors to perform the bulk of its work this can be an indication of a capital preservation scheme, but we have been advised that where the company lacks the skills in house and subcontracts, for example, the front-end development of their platform, this fact is unlikely to breach the test on its own.
HMRC have advised that as the Advance Assurance is not a statutory clearance they do not have to confirm that EIS relief is or is not available in advance of an investment. Accordingly they will not answer any Advance Assurance application where there is a risk that the risk-to-capital conditions could be breached. That is not to say that a company cannot apply for EIS relief after the investment has been made, where the eligibility of the EIS claim can be reviewed in relation to the facts at that time.
Whilst it may appear that this new rule will affect firms seeking investment in a negative way, for firms in the fintech sector this may actually have a positive result. Firstly, HMRC estimate that 60% of the applications they were dealing with previously will now fail the risk-to-capital condition, which should speed up fintech firms obtaining a timely response from HMRC as to whether their business will qualify under the schemes. Secondly, whilst this rule change will not result in investment managers who are seeking low risk returns for their investors suddenly switching to investing in high-risk startups, it may be that certain individual investors seeking relief under the EIS may now be more interested in putting their money into non-property backed investments.
New rules – information needed for a request for Advance Assurance
Another factor which has led to HMRC taking so long to review applications is that applications are dealt with on a purely first in, first out basis. More than a third of Advance Assurance Applications provided by HMRC to date have not resulted in an investment and have either been purely speculative in nature, or been requested so far in advance of the company being in a position to raise funds from the market that the assurance received becomes obsolete (e.g. where the company pivots its trade).
To remedy this, HMRC have advised that they will only process an Advance Assurance claim where all of the following information is provided by the company:
- a copy of the latest available accounts of the company (and its subsidiaries if applicable). If the company has not yet drawn up a set of accounts, HMRC does not expect it to do so for this purpose;
- the company’s business plan including financial forecasts;
- details of all trading or other activities to be carried on by the company and any subsidiary, and a note of which company or companies will use the money raised, and how;
- a schedule of all previous EIS funding or other risk-capital state aid raised;
- details of the amount the company hopes to raise, and a schedule of the activities, and amounts, on which it (or its subsidiary) intends to use the money; the amount does not need to be precise but should be close to the actual amount needed and not state rough figures such as ‘up to £5 million’
- an up-to-date copy of the Memorandum and Articles of Association of the company and of any subsidiary, and details of any changes to be made
- a copy of the register of members at the date of submission of the Advance Assurance application
- details of any subscription agreement or other side agreement to be entered into by the shareholders
- confirmation that the company expects to be able to complete the declaration on form EIS1 in due course
- details of the potential investors* or, if the company is using an intermediary to provide investors, details of the fund managers or other business promoters who are expected to provide these investors.
- the latest draft of any prospectus, information memorandum, pitch deck, brochure or similar document relating to the relevant fund raising or offer to be issued to potential investors.
- any other relevant information, for example documents to support a company’s view that it is a knowledge-intensive company, and group structure diagram.
The general rule is that if a document is to be provided to investors or is publicly available so as to be used by a proposed investor in order to make a decision as to whether to invest, this should be sent to HMRC with the application.
*Most contentious of the above points is to provide a list of proposed investors. Where investors would not be willing to invest without Assurance being granted, it may be the case of the ‘chicken coming before the egg’ for the company to provide this information where its investors are not yet committed. HMRC have advised that they are looking for some evidence that the company has potential investors, to make sure the company has a prospect of getting an investment if it receives an Advance Assurance. That would mean that an investor, fund manager or crowdfunding platform is engaging with the company. It is unlikely that HMRC would consider merely being on a crowdfunding platform to be evidence of a proposed investment; the company would need to evidence some traction on that platform.
Is EIS investment the right sort of funding for all fintech companies?
In more general terms, we have had several discussions with our clients as to whether investors seeking EIS relief are suitable for some fintech companies in view of the potential markets and products which those companies may be interested in both at the time of the investment and in the future.
In order for EIS relief to be given to an investor it must be the case that the company does, or intends to carry on a qualifying trade which does not consist, to a substantial extent, of non-qualifying activities. The ‘tech’ part of fintech would normally be a qualifying trade where the company developed the bulk of its intellectual property itself. However companies undertaking financial activities (or the ‘Fin’ part) are excluded from raising EIS monies should they be undertaking activities which are normally provided by a bank, acting as agent on behalf of a bank, or bearing their customer’s financial risk. ‘Substantial’ in this circumstance would mean that more than 20% of the company’s activities breach the EIS rules, for which there are several methods by which a company can define how its activities are undertaken, for example with reference to turnover, employee time or how profits are generated.
For some fintech companies it will be clear from the off that they are not going to qualify under the EIS and these companies are happy to seek non-EIS funding. With others the position is not so clear cut. The company may be a purely softwarebased concern at the time of its funding offering, but in time may seek to obtain a banking licence or FCA Approval to enter certain markets which would render it non-qualifying, or its non-qualifying income may creep over the 20% test naturally within the three year period. As the company must meet the EIS guidelines for its qualifying activity from the time of its investment to a period ending three years afterwards, there could be a risk that investors could obtain the tax relief in the beginning, but subsequently the tax relief is withdrawn. The consequences of which are the investors being faced with an unexpected tax bill and the directors faced with an angry group of shareholders. Clear communication to investors with regard to the future intentions of the business and the risks of losing qualifying investment status are key here.
What may not be appropriate in certain circumstances would be for the directors to restrict what the company does solely to maintain EIS relief for a group of investors. Under company law the directors must work to promote the best interests of the company and protect the shareholders as a whole. Should a company delay its entry into new finance-based markets purely to protect the investors’ tax relief, or restrict certain non-qualifying income streams for the same reason, this could be seen as a dereliction of directors’ duties and legal advice would need to be taken by the board.
It is also important when making an Advance Assurance application that the company makes full disclosure to HMRC as to what it intends to do in the three years following investment, to the best of its knowledge at the time, in order that HMRC would be bound by any Assurance given. If incorrect, incomplete or misleading information is provided when the Assurance Application is made then the Assurance may not be worth the paper it is printed on and the investor’s tax relief is at risk.
The team at haysmacintyre have a wealth of experience in advising companies on EIS matters including assisting with structuring business operations in advance of raising finance, outlining the risks of losing EIS status to our clients and preparing Advance Assurance Applications for EIS and SEIS. When making an Advance Assurance Application we aim to provide the most comprehensive explanation of the company’s intentions for the trade and use of funds and endeavour to outline where the company is likely to meet each individual piece of legislation governing the EIS scheme so as to streamline a response from HMRC. By taking this line we have, in many cases, obtained Assurance from HMRC first time without any subsequent queries raised by the Inspector. If you or your company would like any assistance in these matters please contact [email protected] for further enquiries.