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18 April 2018

Government consultation on new fund for knowledge-intensive companies

Tax analysis: Robert Birchall discusses the government’s enterprise investment scheme (EIS) consultation which explores possible options for an EIS fund structure aimed specifically at investment in knowledge-intensive companies.

The government has announced a consultation on the creation of a fund structure within the EIS that invests in knowledge-intensive companies. The consultation closes on 11 May 2018.

What is the background to the consultation?

In response to the patient capital review consultation carried out last summer, the government announced in the Autumn Budget 2017 that it intended to consult on the introduction of a new EISfund structure. This announcement formed part of a package of measures intended to address thefunding gap identified for capital-intensive and R&D-intensive companies that generally fall within thedefinition of ‘knowledge-intensive company’ for EIS purposes. The other measures announced in theAutumn Budget 2017 have since been enacted in the Finance Act 2018 and have increased thevarious EIS investment and time limits applicable to knowledge-intensive companies.

Responses to the consultation are invited by 11 May 2018.

The consultation seeks responses in two main areas:

  • the reasons why some knowledge-intensive companies are unable to obtain the funding required, and how best to encourage that funding, including through funds targeted at such companies
  • the options for an EIS fund structure aimed specifically at investment in knowledgeintensive companies

The government is conscious of the need for both investors and companies to have as much stabilityas possible, and therefore intends to continue to utilise the existing definition of ‘knowledge-intensivecompany’ for the purposes of the new fund structure. As the consultation may lead to changesbefore the UK leaves the European Union, any suggestions must also be in line with EU state aidrules. In this respect, the government notes that the tax reliefs attaching to EIS, the seed enterpriseinvestment scheme (SEIS) and venture capital trusts (VCTs) are among the most generous of theirkind in the EU, and so it does not intend to raise the income tax relief for these schemes.

The intention is for any EIS fund structure to be built on the existing EIS rules, without changing themain requirements that the underlying investments must remain in ordinary shares, or that a threeyearholding period applies.

In order to achieve the policy goal, any proposed fund structure would need to focus on investmentsin knowledge-intensive companies, although the government acknowledges that a small proportion of the investments - ‘possibly 10- 20%’- could be in non-knowledge intensive companies.

Any new fund would also need to obtain HMRC approval, and there is expected to be regularreporting obligations on the fund managers to ensure that HMRC has adequate oversight of thefund.

In line with the government’s stated intention to simplify the tax system, the introduction of the newfund rules would coincide with the removal of the existing EIS ‘approved’ fund regime.

What tax incentives is the government considering for the new EIS knowledge-intensive fund?

The government’s aim is to create additional tax reliefs through the new fund structure to:

  • incentivise investment into high-risk, knowledge-intensive companies
  • ensure those investments are made for the long term

The government suggests four possible reliefs that could achieve these goals, though cautions that they will not all be introduced:

  • dividend tax exemption: investors would not pay tax on any dividends paid by the knowledge-intensive investee companies after a fixed holding period of ‘say five or seven years’. The government acknowledges that there may be a question regarding how much of an incentive such a relief would be, given that stakeholders refer to the potential for a capital gain, rather than an income stream, being the primary economic driver for a number of investors in this area
  • capital gains tax relief: investors will be able to write off, rather than defer, gains to the extent they are reinvested in the fund. This would operate in a similar manner to the existing relief available for investors in SEIS companies, but at a lower rate. The government notes that evidence will be required to demonstrate that such a relief would provide substantial additional capital to knowledge-intensive companies
  • extended carry-back of income tax or CGT deferral: EIS currently enables investors to carry-back the income tax relief arising on investment against the tax year prior to the year of investment. The government suggests that investors in EIS funds could carryback the relief even further, although it does not suggest a timescale. It is suggested that such a relief could be an alternative to providing income tax relief at the time of contributing capital to the fund, which the government sees as fraught with potential issues
  • up-front tax relief: investors would receive up-front income tax and CGT deferral relief on investment into the fund, provided the capital is invested by the fund within a specified time window, such as two years. This contrasts with the current position for unapproved EIS funds, where reliefs only arise when an investment is made into an underlying investee company. However, the government considers that this option would be the most complex of the reliefs to implement. New rules would need to be introduced to govern, for example, what the funds can do with the cash before it is invested in eligible companies, as well as new compliance procedures that could lead to the withdrawal of the relief if the fund ceases to be eligible

Which of the options do you think will be best received?

As the latter three options outlined above involve an initial tax relief in some form, they are likely to be the best received by investors.

However, investors and in particular, investment managers are unlikely to welcome the fourth option if, as indicated, the government requires that it is accompanied by significant additional restrictions and compliance burdens.

As the government acknowledges, the dividend exemption is likely to be the least attractive to investors as knowledge-intensive companies are rarely in a position to pay dividends for a significant period of time and, as a result, investors are rarely motivated by the prospect of any income yield and are instead primarily motivated by capital returns.

Do you foresee any issues with the proposed removal of the existing fund arrangements?

Following changes made to the EIS rules a number of years ago, there are currently minimal benefits for investors associated with investing in an ‘approved’ EIS fund, and yet the restrictions on ‘approved’ funds remain in place.As a result, and as the government recognises in the consultation, there has been minimal take-up in the market. It is therefore unlikely that there will be many issues associated with the removal of the regime, particularly as any removal would presumably include some form of ‘grandfathering’ provision for existing approved funds to ensure they are not prejudiced as a result.

Do you think the proposals will succeed in closing the patient capital funding gap for knowledge-intensive companies?

A new EIS fund structure that is not overly complex and can deliver a tax benefit that is currently unavailable to ‘unapproved’ funds should help create a more attractive investment environment for knowledge-intensive companies. This is even more likely to be the case when combined with the recent loosening of the knowledge-intensive company EIS restrictions.

Ultimately, it will be necessary to wait and see what form any new EIS fund structure takes but the overall ‘direction of travel’ suggested in the consultation appears positive.

Robert Birchall was interviewed by Susan Ghaiwal. This interview was first published through LexisNexis.