How To Turn IDIOTS Into INVESTORS -- I

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JOHN BARNETT offers readers a practical guide to the enterprise investment scheme.

THE PURPOSE OF the enterprise investment scheme is to help certain types of small higher-risk unquoted trading companies to raise capital. It does so by providing a range of tax reliefs for investors in qualifying shares in these companies. At least this is what is said in IR137, the Inland Revenue's guide to the enterprise investment scheme.

However, anyone who has had the misfortune to be involved in applications for enterprise investment scheme reliefs will know that only the first of those two sentences is necessarily true. The prospect of enterprise investment scheme relief often does help certain companies to raise capital, yes, but far less frequently are those reliefs actually granted. Perhaps too often, the enterprise investment scheme lures individuals into investment in small companies with the promise of significant tax relief, only to dash that promise at one of the innumerable hurdles the legislation puts in their way.

This is the first in a series of three articles looking at the enterprise investment scheme from a practical perspective. The main thrust of these articles is the income tax relief and capital gains tax exemption under the scheme; the rules for the capital gains tax deferral relief are less harsh in certain respects. The IDIOTS of the title is an acronym borrowed from Kevin Slevin (Born Again EIS – I, 20 August 1998 at pages 548 to 550): Investors Deciding to Invest in Ordinary shares for Tax Saving. The meaning of INVESTORS will have to wait until the end of the three articles.

In this article, I will look at why enterprise investment scheme applications so often fail. The next article will look at how the relief should be properly handled from the outset. The final article will then look at the three years following the enterprise investment scheme subscription and at how faulty applications can be rectified.

Why do applications fail?

In my experience, there are two broad reasons why enterprise investment scheme applications fail: the attitude of clients, and the attitude of the Inland Revenue.

Clients

Groucho Marx once said that he would not want to join any club which would have him as a member. The same, it appears, is often true of the enterprise investment scheme club where the rules for membership are not really designed for the sort of members that the club wants to attract.

Small start-up companies are usually cash-strapped, often making them unwilling to pay for proper advice until they get their enterprise investment scheme money banked. Unfortunately this is often fatal.

Similarly, investors in those companies are usually dynamic entrepreneurial types. They want to pay their money and get on with building the value of the business. They are not necessarily so bothered with the nuances of the legislation which can be vital to a successful application.

Inland Revenue

If the attitude of clients is the main factor in failed applications for enterprise investment scheme relief, the attitude of the Revenue must surely run a close second.

This is not intended as a criticism of the Revenue. Rather it is to make the point that a body whose mandate is to collect as much tax as possible, is not best placed also to administer a valuable tax relief.

Matters have perhaps improved somewhat now that enterprise investment scheme applications are dealt with centrally by the small companies enterprise centres. On the other hand, this centralisation of functions could just as easily mean that best practice concerning how to frustrate taxpayers is also centralised.

The Revenue would argue that the fault is not with it, but with the legislation. There is something in this. But one might ask why the legislation is drafted in this way in the first place. In my view, a more lenient attitude is called for, allowing the Revenue to overlook minor technical defects in applications. If that leniency needs to be embodied into the statute, then so be it.

Specific reasons for failure

Turning to some more specific issues, Box 1 attempts to summarise the main conditions which need to apply for enterprise investment scheme relief to be granted. This is not an exhaustive checklist, but looks at some of the main areas where applications for relief can fall down. The highlighted terms will be examined in more detail.

Eligible shares

The two main requirements here are that the shares are 'new' and that they are 'ordinary' shares. In practice, the first requirement often causes more problems than the second, and clients need reminding that enterprise investment scheme relief is not available when buying out an existing shareholder. Ordinary shares, however, are fairly widely defined (sections 312(1) and 832(1), Taxes Act 1988). So long as the shares do not carry preferential rights they are likely to be 'ordinary' shares, even if not described as such. The Revenue may need reminding that a 'deferred' share is nonetheless eligible for relief.

Qualifying company

Clients usually tend to be aware that the company must be unquoted (which includes Alternative Investment Market companies). The £15 million gross assets test also rarely poses problems in practice. The main difficulty here is usually with subsidiary companies. The percentage holding in the subsidiary is crucial:

• 90 per cent or more subsidiary – fine;
• 75 per cent or more subsidiary – fine but the money raised cannot be used for the subsidiary's trade;
• 51 per cent to 74.9 per cent – any subsidiaries in this range will be fatal to the application (section 293(3A)(b), Taxes Act 1988);
• 50 per cent or less – shareholdings in this range count as investments rather than as subsidiaries, and so may be acceptable. However, a significant investment in other companies may cause the parent company no longer to be a trading company in its own right.

Subscribed

Subscribe is not defined in the legislation but is generally taken to mean a formal application for shares to be issued (see Government Stock and other Securities Investment Co v Christopher [1956] 1 WLR 237, Waterford, Wexford, Wicklow and Dublin Rly Co v Pidcock [1853] 8 Exch 279, and Arnison v Smith [1889] 41 ChD 348). Consequently, it is invariably necessary to prepare a proper application letter. The Revenue will usually ask to see the subscription agreement and any formal prospectus.

Cash

The Revenue agrees that cash, for these purposes, includes a cheque. It also appears to include foreign currency (section 738, Companies Act 1985). However, a large number of applications founder because assets are transferred directly in exchange for shares. If assets are to be transferred, this can be achieved by borrowing the cash to be subscribed and then using this to purchase the assets (as long as the borrowing is on commercial terms, section 299A, Taxes Act 1988 should not cause problems).

Issued

It is a truism to say that enterprise investment scheme shares must be issued, but too many clients seem to expect relief simply by sending a cheque to the company. The issue of shares also needs to be distinguished from their allotment. The latter is the time when the company unconditionally agrees to grant the shares to the investors. But issue does not take place until pen hits paper on the register of members or, if earlier, the date a share certificate is provided to the individual (see National Westminster Bank v Commissioners of Inland Revenue [1994] STC 580. The Revenue does not appear always to take this last point. The final article in this series will look at how this point can sometimes work to the taxpayer's advantage.

Qualifying person

The key condition here is that the individual is not connected with the company. The main danger points are for employees, directors and shareholders with an interest of more than 30 per cent in the company. Great care must be taken with timing, as shown by Examples 1 and 2. The position of associates must also be watched.

Fully paid up

It is not uncommon to find shares which, for reasons best known to the company secretary, have been issued partly paid. If the money is to be paid in tranches, then a separate issue of shares should be made for each tranche (but watch the timing issues raised in Example 1).

Same issue

All the shares issued on the same day must be issued in order to raise money (section 312(4A), Taxes Act 1988). The legislation for capital gains tax deferral relief is slightly different, but I have had correspondence with the Revenue in which it takes the view that the same point applies. See Example 3 for an illustration of how things can go wrong in this area.

To raise money

The Revenue is known to refuse relief where an existing loan account is capitalised by the issue of shares. It argues that no new money is being raised by the issue. Even where cash is subscribed, there is a danger of this being treated as a loan unless the issue of shares takes place contemporaneously.

Employed

Advisers will be aware that trading must commence within two years of the issue of shares. Eighty per cent of the money must be employed within the following 12 months and the remainder in the 12 months after that. Employed for these purposes means something like 'irrevocably designated for business purposes'. This is not the same as 'spent'. The Revenue may need reminding of this, but it will want to see proper business plans and board minutes regarding the future use of the money.

Active company

The active company is the company in whose business the money will be employed. This could be the parent company or a subsidiary. Where the parent company uses the money to buy shares in another company, the Revenue argues that the trade must be hived-up to the top company. This is because the second company will not be a subsidiary throughout the relevant period. In this situation only the parent company can be the active company.

Exists

A company can exist for the purposes of carrying on a trade without actually carrying it on, so long as its raison d'être is to carry on such a trade (see Lord v Tustain [1993] STC 755). This can sometimes be a useful point with which to confront the Revenue.

Qualifying trades

Fortunately most clients do comply with these rules. However, it is worth checking what the client wants to do in some depth, as the Revenue will ask detailed questions to establish whether there are any non-qualifying activities.

Procedural issues

Even if the company manages to comply with the technicalities of the legislation, a number of enterprise investment scheme applications will founder at the next hurdle: namely ensuring that relief is properly applied for. The following issues may arise.

Form EIS 1

A significant practical problem for many investors is actually persuading the company to complete form EIS 1 and send this to the Revenue. Unless they are properly advised, investors will often not know of the need for this form until, having sent in their tax return, their local Inspector informs them that the company needs first to make an application. By this time, the company, which has by now probably spent its money and has no further incentive to help its investors, may be reluctant to do so.

Form EIS 3

It is not unheard of for companies to issue form EIS 3 to their investors without first sending the EIS 1 to the Revenue, despite this being an offence carrying a penalty of up to £3,000.

Four months trading

Enterprise investment scheme relief cannot be granted until a company has been trading for four months (see section 289B(6), Taxes Act 1988). The Revenue interprets this (wrongly in my view) as meaning that a form EIS 1 cannot be submitted until four months trading have taken place. As the company has up to two years to commence trading, this may mean that it is up to three years before relief is actually granted.

Tax returns

For capital gains tax deferral relief, enterprise investment scheme investment can be made up to three years after the gain has accrued. However, the EIS 1 to 3 procedure has to be completed before a tax return can be submitted. As seen above, this can take anything up to a further three years. Clients therefore need to be aware that they may well have to pay their capital gains tax upfront only later to reclaim it. This makes capital gains tax deferral relief significantly less attractive than it might otherwise seem.

Two-year and five-year time limits

A company cannot submit an EIS 1 more than two years after the year of assessment in which shares are issued/trading commenced. Again, where proper advice is not taken at the outset, it is not uncommon to find situations where this time limit is breached.

Individuals must make their applications within five years and ten months of the end of the tax year after issue/commencement of trading. Although this is a long time limit, by this stage many investors may well have given up. The five-year time limit is sometimes relevant to capital gains tax exemption claims. Capital gains tax exemption is only given where income tax relief was both due and claimed. It is not unknown for an investor to realise that he could have claimed enterprise investment scheme relief on a small subscription he made five or so years ago. He did not bother at the time because the income tax relief was only minimal. But now the shares stand at a significant capital gain. This gain would have been exempt had he made the original application in time.

Minimum subscriptions

The minimum subscription of £500 in a year is easy to overlook. Although the income tax saving is only small, the ultimate capital gains tax exemption hinges on income tax relief having been given.

Conclusion

This article has concentrated on what can go wrong with enterprise investment scheme relief. If any of the examples seem theoretical, I can say that they all come from real-life experiences that I have had during the past six years. I should add, however, that in none of the situations which have gone wrong was I involved at the outset!

John Barnett MA(Oxon), ATII, solicitor is an associate at Burges Salmon. He can be contacted on 0117 902 2753 or e-mail: john.barnett@burges-salmon.com.

Issue: 3837 / Categories: Comment & Analysis