MALCOLM GUNN FTII, TEP examines the changes to the enterprise investment scheme in this year's Finance Act.
I WAS RECENTLY asked a very simple question by someone who had invested in an enterprise investment scheme company in 1999. What he wanted to know was when will he be finally out of the dreaded value received rules in relation to his share subscription. I am not going to admit here how long I spent looking up the answer, at least not without having a considerable volume of wine poured down my throat beforehand.
MALCOLM GUNN FTII, TEP examines the changes to the enterprise investment scheme in this year's Finance Act.
I WAS RECENTLY asked a very simple question by someone who had invested in an enterprise investment scheme company in 1999. What he wanted to know was when will he be finally out of the dreaded value received rules in relation to his share subscription. I am not going to admit here how long I spent looking up the answer, at least not without having a considerable volume of wine poured down my throat beforehand.
Of course, for those who do not wish to flog through the detailed Finance Act amendments to sub-subparagraph (ii) of subparagraph (c) insofar as it relates to the application of subparagraph 2(d) but for the application of subparagraph 3(f), and all such things, the easy place to look is the Budget day press release. This stated that the value received rules would be changed 'to reduce from two years to one year the period prior to the issue of shares during which receipts of value can lead to loss of relief'. Apparently no other change was proposed.
The next port of call might be the Notes on Clauses issued by H M Treasury. These also confirm that, amongst the 'main changes' is a reduction of one year in the period affected by the value received rules, this being relevant to the period before the issue of shares; previously one applied the rules for the two years prior to the date of issue of the shares, whereas now this is reduced to one year only.
On this basis, it would seem that the status quo prevails. The Finance Act 2000 had changed the seven-year period (two years before and five years after the date of issue) during which the value received rules apply but only with effect for shares issued after 5 April 2000. Accordingly, the seven year rule still applied for shares issued before that date.
Shares issued after that date enjoyed a new 'termination date' which was three years after the date of issue or, if later, three years from when the company concerned began to trade. The value received rules applied from two years prior to the date of issue and up to the termination date. After that, the shareholder was out of the woods.
As I read the Finance Act 2001, the old seven-year period had now been firmly consigned to the dustbin. Paragraph 40 of Schedule 15 to the Act quite clearly applies all the amendments to the value received rules to all enterprise investment scheme shares issued after 31 December 1993 and to which relief under the scheme was still attributable on Budget day 2001. In this area, we no longer talk about a 'seven-year period', nor a 'designated period', as previous Finance Acts would have had it, but we now talk about a 'period of restriction'. This starts one year before the date on which the shares are issued and ends three years after that date, or three years after the company starts to trade if that is later. That sounds to me like a major and unannounced change for those with shares issued before 5 April 2000.
This left me wondering whether it was me, or whether it was the Revenue and the Treasury which had lost the plot. I then noticed that a repayment supplement provision in the enterprise investment scheme legislation has been amended, but before the amendment it referred to 'the twelve months mentioned in two subsections of section 824, Taxes Act 1988'; but neither of those subsections mentions anything about twelve months at all.
Also, when looking at the latest set of changes, there is a new rule which broadly says that it no longer matters if a company becomes quoted after the issue of the shares; so why is there another new rule stating that it does not matter either if the shares are listed on an unrecognised exchange which later becomes a recognised exchange? If they only have to be unquoted at the time of issue, why is anybody bothered what happens to stock exchanges later on?
So I am still left in some considerable doubt about which of us has lost the plot, but what I do know is that, however welcome the changes are to the over stringent rules for the scheme, the constant detailed tinkering with little rules, sometimes backdating them and sometimes not, seems to be confusing everybody, even those producing the changes. In the meantime, I am standing by my advice that, for shares issued on 1 June 1999 by an established company, the value received rules now cease to apply on 31 May 2002, instead of 31 May 2004 as it was before this year's Finance Act. If anybody thinks otherwise, because I have overlooked section 72(BA)(12)(c)(iii) or the like, I would be delighted to hear about it.
Insignificant value
One of the major difficulties with the enterprise investment scheme related to the harshness of the value received rules. Although the income tax relief allowed for a withdrawal of relief on a pound for pound basis where there was an impermissible return of value to the investor, the capital gains tax deferral relief had a rule which was very much more harsh. One pound of returned value could forfeit hundreds of thousands of pounds of deferral relief and there was nothing to help the transgressor. Given that the return of value might be no more than a small debt of a few pounds left owing to the company for a short period of time by a relative, one can see how this rule could give acute problems. Those advising enterprise investment scheme companies will know that, in the real world, any thriving business would have huge problems in identifying tiny infringements of the rules.
Fortunately, the Finance Act 2001 has come to our assistance. In both the income tax and the capital gains tax provisions relating to the scheme, there is now a new provision that amounts of 'insignificant value' may be disregarded so that they will not lead to withdrawal of relief. You may wonder, as did the Finance Bill Standing Committee, what falls within the definition of 'insignificant'. Unfortunately the Economic Secretary to the Treasury simply said that a similar provision is in the corporate venturing scheme 'and nobody has yet had any difficulty with it'. There are of course 58 million people in Britain and speaking for them all would be difficult, so presumably she meant to say that nobody has yet complained about this nebulous term. The Standing Committee tried to insert a test of 5 per cent of the amount of the share subscription into the Bill but failed in the attempt; the Economic Secretary clearly thought that 5 per cent was far too high: 'That would mean that someone investing £100,000 for example would be able to get a return of £5,000 without losing any relief'. Clearly, she was aware that the Revenue would never stand for that.
The best guidance we get is in the Revenue's Company Taxation Manual which has the following to say at paragraph 4897:
'Our view is that for the purpose of the second category above "insignificant" must be given its normal dictionary meaning of trifling or completely unimportant. Thus in most cases it is very unlikely to cover any amount in excess of £1,000.'
Following the Finance Act 2001, up to £1,000 in returned value is acceptable for any investor, even though this might be pretty sizeable as compared with the amount of the investment. It seems odd therefore that, for someone who has invested a very much more substantial sum of money, the Revenue is still not really prepared to go much above £1,000.
New provisions are inserted to define what exactly the amount of returned value is in all the various circumstances already listed in the legislation. So, for example, if it is the incurring of indebtedness to the company, then the return of value is the amount of the indebtedness less any repayment made before the issue of shares. The new rules in this area all seem to be fair enough.
Cumulative receipts
The legislation now recognises that those who transgress the return of value rule in some minor way may well do so more than once. Each individual occasion may be within the £1,000, but it will clearly not be right if all the amounts concerned came to much more than £1,000 in total without affecting the tax relief given. There is therefore a provision for adding together all returns of value during the period of restriction relating to enterprise investment scheme shares. If the total remains under the statutory limit, then the relief remains safe, but once it goes over, there will be a withdrawal of relief by reference to the total amount.
Where there is more than one issue of qualifying shares to a shareholder in a company within the scheme, then the return of value is attributed to all the shareholdings in proportion to the amounts subscribed for them. If there are some shareholdings which did not qualify for enterprise investment scheme relief, or in relation to which the relief was not claimed, then unfortunately it is not possible to apportion any return of value to those shareholdings in order to minimise withdrawal of relief. Nor can one apportion return of value to shares which did qualify for relief but which are now out of their period of restriction.
The apportionment provision is not applied for the purposes of the capital gains tax deferral relief. This is because the deferral relief is still all or nothing as regards return of value. Any unacceptable return of value forfeits all the capital gains tax relief given on a shareholding and so there is no need to make any apportionments. The test for 'insignificant value' is, however, the same as for the income tax relief and there is provision for cumulation of separate amounts during the period of restriction for any enterprise investment scheme shares.
Prior arrangements
The new insignificant value provision cannot be applied where there were any arrangements in existence in the one year prior to the issue of any shares for a return of value to the prospective shareholder. This applies to any amount, however small, and so it is vital that prospective shareholders do not have any arrangements whatsoever about any value being returned to them in due course.
Replacement value
Once a shareholder has received value back from the company, and assuming that the insignificant value rule does not assist, is that 'curtains' for the tax relief given? The answer prior to the Finance Act 2001 was 'yes'. There was no scope for sinners to repent.
The Finance Act 2001 has come to the rescue. It is now possible for an enterprise investment scheme investor who falls foul of the return of value rule to pay the money back to the company or to compensate it in some other way in full and still to retain the relief given. Unfortunately, the new provision does nothing to help the past as it only applies to shares issued on or after 7 March 2001 and to value received and repayments made after that date in relation to previous share issues. All the same, this new rule is very welcome indeed.
There is no limit on the level of unacceptable value received. All that matters is that the investor makes sufficient payment back to the company in order to reinstate it for the sum which should not have been passed out to the shareholder in the first place. The payment back can either be in cash or it can be by other means, such as transferring a different asset of sufficient market value into the company's name.
Where the return of value was the release of a liability owing to the company or the payment of the shareholder's liability owing to a third person, this can now be rectified by a transaction which reverses the effect of the previous offending transaction. This is not explained any further in the legislation, but for example, if the company has paid the shareholder's debt owing to a third party, this could be reversed by the shareholder also paying the sum due to that third party so that it could refund the company.
Another return of value rule applies where a director or employee of the enterprise investment scheme company (or a 51 per cent subsidiary of it) purchases shares from the qualifying investor. Obviously, the shares would not be those qualifying for relief under the scheme, but the idea must be that an existing shareholder could effectively get enterprise investment scheme relief for the existing shares by subscribing for new ones and selling off the old ones. This is covered under the return of value provisions, and where the rule has not been complied with, the enterprise investment scheme investor can put things right by repurchasing the shares which he originally sold to the director or employee provided that the consideration is not less than the amount of the original value.
Matters excluded
There are some limitations on the scope of the replacement value relief. First and foremost, the new rule cannot help those who have been caught out by the company repaying a debt to the investor which was outstanding when the shares were subscribed for. The mischief here is that individuals cannot convert debt into equity and collect enterprise investment scheme relief on the way. The rule is not quite as stringent as it may appear at first sight, because it only applies to debt which is repaid as part of arrangements for the acquisition of shares, and so although the new replacement value rule is excluded from providing any help in this situation, it may still be possible to show that the repayment of debt was nothing to do with any share acquisition.
It will also not help to trawl through the past, before the qualifying shares were subscribed for, in order to see if some replacement value can be found from history. The value must have been put back into the company after the subscription for enterprise scheme shares. Apart from this, it does not matter whether the replacement value was before or after the offending event.
However, if the return of value is after the offending event, then it had better not be too much later. The legislation requires that it be made 'as soon as is reasonably practicable in the circumstances' where an appeal has been made against the withdrawal of relief by reason of return of value, there is a sixty-day time limit for reinstating value to the company, this counting from the time when the appeal is finally determined. This gives one the idea that sixty days might also be regarded as a reasonable time-lag where there is no appeal but anything much longer than that might perhaps be asking for trouble. However, we shall have to see what Revenue guidance materialises in due course. Nothing relevant was said during the Standing Committee debate.
There are also extensive rules preventing normal commercial arrangements from being regarded as return of value.
Purchase of own shares
Those familiar with the enterprise investment scheme will know that a purchase of own shares by the scheme company is a forbidden fruit during an extended period whilst there are scheme shares at risk. One tiny bite of the apple by any shareholder who does not have shares qualifying under the scheme, and a massive amount of enterprise investment scheme relief could suddenly collapse instantly. Under the income tax relief provision there is withdrawal of relief apportioned over the qualifying shares still at risk when the purchase of own shares takes place. Under the capital gains tax deferral relief provision there is no apportionment and all qualifying investors suddenly find their deferral relief withdrawn.
The Finance Act 2001 makes some steps towards correcting this unbelievable injustice.
First, as from 7 March 2001 the risk period for purchases of own shares runs from one year before the qualifying shares are issued and ends on the termination date for those shares, which is normally three years after the issue date, but up to two years longer if the company starts trading after the shares are issued. This is rather better than the pre-Finance Act 2001 rule when the period ran from two years before the issue date and ended between three and five years after it, and even better than the pre-Finance Act 2000 rule which was a seven year period starting two years prior to the issue of shares. (This potted history alone is an indication of the confusion sown by the annual tinkering with the relevant provisions.)
Last year's Finance Act already introduced a small measure of relief from this harsh rule by reference to the corporate venturing scheme. If the share repayment caused a loss of relief for corporate investors under that scheme, then a formula could be applied to see whether any balance of tax relief to be withdrawn was under a de minimis limit of £1,000.
The Finance Act 2001 now introduces further relief effective from 7 March 2001. Any repayment of shares can be disregarded if both the market value of the shares repurchased and the amount received by the shareholder in respect of those shares is 'insignificant in relation to the market value of the remaining issued share capital of the company'. This therefore will help out where just a few shares are repurchased from someone who is not an enterprise investment scheme investor. The rule is not, however, permitted to apply if arrangements were already in hand for the share buyback in the period of one year before the qualifying enterprise scheme shares were issued.
Other minor changes
Use of money raised
With effect from 7 March 2001, the funds raised by a share subscription under the enterprise investment scheme must be used for a qualifying business activity within two years. 80 per cent of the money must be applied in the first year, and the balance in the second. Previously, all the money raised had to be applied within twelve months.
Repayment supplements
Prior to the Finance Act 2001 there was a special régime for calculating repayment supplements attributable to enterprise investment scheme relief. As far as I can see, the relevant legislation had in any event fallen into disrepair as it rather looked as though it did not take into account the revisions to repayment supplement introduced under self assessment. Whatever the correct position is, those wanting to know what the Revenue's interpretation of the rules used to be should look in the Inspector's Manual at paragraph 3047, where there is a worked example.
The Finance Act 2001 abolishes any special rules for repayment supplement and the normal provisions for interest on tax under self assessment now apply.
Oil
Oil exploration is now no longer a qualifying business activity within the scheme. This applies with effect from 7 March 2001 for both new shares and existing shares to which enterprise investment scheme relief still attaches. One might think that this repeal has suddenly pulled the plug on some existing investors' reliefs but, according to the Budget day press release, this is unlikely. It was said in that press release that trading companies will still be able to carry on oil and gas exploration in most cases and in future will also be able to engage solely in oil and gas extraction. Hopefully, therefore, there are no dire consequences for any existing investors.
Is that better then?
The complexity of the enterprise investment scheme has long been subject to criticism although, to be fair to the Revenue, the complexity is no more than a reaction to the way in which the business expansion scheme became highjacked by the tax planning industry. The latest changes undoubtedly bring some improvement, but many rough edges continue. Although it is now possible to restore value to a company if the 'value received' rules are infringed at any stage, there is still a worry as to the fairly strict time limit for this – 'as soon after that time as is reasonably practicable in the circumstances'. Any offending return of value may not be uncovered until some considerable time after the transaction concerned and even if it is then rectified immediately, there remains the danger that the Revenue will say that the clients should have had their eye on the ball and the delay in restoring funds is outside the stringent Finance Act time limit. Alternatively, the problem may come up during the annual audit, and even then the problem might be one year old; will this satisfy the Finance Act 'as soon as possible' test? Remember too that return of value can apply to loan repayments made to certain relatives out of their own wholly owned companies; the tentacles of the detailed rules stretch out far and wide and only those well versed in the scheme will be alert to all the danger areas. This is in no way to sound ungrateful for the concessions introduced in the Finance Act, but it does need to be recognised that the journey's end has not yet been reached.
