Tax benefits for AIM quoted and PLUS quoted companies

We are planning to go plublic in AIM or PLUS. Which are the Venture Capital Schemes (specifically, EIS) tax benefits in the UK?

Venture Capital Schemes

The venture capital schemes have always been focused on smaller, higher risk businesses, in order to target support for investment at those businesses that find it most difficult to raise money. The new definition is proposed as a means of preventing larger businesses benefiting from the schemes and from investment that might otherwise go to those intended to benefit from the reliefs.

The Enterprise Investment Scheme (EIS)
The Enterprise Investment Scheme aims to help unquoted companies attract equity investment by offering investors a range of tax incentives. AIM quoted and PLUS quoted companies qualify as well.

The EIS was introduced in 1994 to encourage individuals to invest in unquoted trading companies by offering tax reliefs. The EIS allows a company (a ‘qualifying company’) that meets certain conditions to raise funds by issuing full-risk ordinary shares to the individual investors previously unconnected with the company. It is particularly suitable where the investment project is risky, as the maximum a higher-rate taxpayer can lose is 48% of their investment. It also allows individuals to be paid directors in the companies in which they invest and yet retain the tax reliefs, provided certain conditions are met.

For all its advantages, the EIS has one major flaw – it is a highly complex set of tax laws.

EIS qualifying companies must:

• Be unquoted – although AIM and PLUS Quoted companies do qualify
• Be independent
• Have gross assets of less than £7m before the EIS share issue, and £8m afterwards
• Be trading companies – though certain types of trade are prohibited. See excluded companies below for details
• Have less than 50 employees
• Raise no more than £2m per year from a combination of the EIS, venture Capital Trusts and the Corporate Venturing Scheme

Tax International and Braxton can help your company attract equity investment by guiding you through the minefield of tax legislation, helping you obtain Advance Approval from HM Revenue & Customs and dealing with the compliance side of the process.

Enterprise Investment Scheme Tax Relieves

Income Tax relief

An investor who subscribes in cash for ordinary shares in an EIS qualifying company can obtain income tax relief of up to 20 per cent of the subscription. For the full EIS reliefs, the maximum subscription for each tax year is £500,000, so a husband and wife could claim relief on subscriptions totalling £1m.

CGT deferral relief
In addition, a UK resident investor who makes a capital gain from the disposal of any asset can defer that gain to the extent of the EIS investment, thereby increasing the effective relief on £500,000 to 60 per cent. Gains can also be deferred where income tax relief is not available.

Exemption from Capital Gains Tax
If an investor holds EIS shares for at least three years, any capital gain realised on the disposal of the shares will be both income tax and capital gains tax free, provided income tax relief has been given and has not been withdrawn.

Loss relief
If a loss is made on the disposal of the EIS shares at any time, that loss may be offset against either the investor’s income or capital gains in the year of disposal. In computing a loss on EIS shares, the sale proceeds, if any, are reduced by the net acquisition cost, which is the amount subscribed, reduced by the income tax relief attributable to the shares.

Inheritance Tax
Provided a shareholder has owned shares in a qualifying unquoted trading company for at least two years and certain conditions are met at the time of transfer, inheritance tax business property relief of 100 per cent is available, which reduces the inheritance tax liability on the transfer to nil.

Excluded companies

Companies whose trades consist substantially (more than 20%) of the following activities are excluded from the Enterprise Investment Scheme

• Dealing in land, in commodities or futures, or in shares, securities or other financial instruments;
• Dealing in goods otherwise than in the course of an ordinary trade of wholesale or retail distribution;
• Banking, insurance, money-lending, debt-factoring, hire-purchase financing or other financial activities;
• Leasing (including letting ships on charter or other assets on hire), or receiving royalties or licence fees. Exceptions are made for intangible assets created by the issuing company or its subsidiaries;
• Providing legal or accountancy services;
• Farming and market gardening, woodlands and timber production;
• Property development;
• Operating and managing hotels and nursing homes;
• Coal production
• Steel production
• Shipbuilding
• Providing services to a connected person conducting one of the above trades

State Aid approval of the Venture Capital schemes
The EIS and VCT received approval from the EC as State Aids on 29 April 2009. That approval was subject to a number of changes being made. The draft legislation included in this Note makes those changes.

In particular, it:

• applies a new requirement that to qualify under either scheme, a company must not be in difficulty;
• replaces the requirement that to qualify under either scheme a company must carry on its qualifying trade wholly or mainly in the UK, with one that the company must have a permanent establishment in the UK;
• removes the requirement that a VCT’s shares must be included in the official UK List, replacing it with one that their shares must be traded on an EU regulated market; and
• changes the rules governing the amount of a VCT’s investment that must be held as equity.

Partnerships
HMRC has setting out its current view that companies carrying on their qualifying activity in partnership do not qualify under the EIS.

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Usually there are at least two sets of lawyers involved in the private equity process; one representing the
management team and one representing the private equity firm. Other parties, such as bankers and other private
equity firms, if acting as a syndicate, will each want their own lawyer involved.

The private equity firm’s lawyer
The lawyer is mainly concerned with ensuring that the private equity firm’s investment is adequately protected from
a legal standpoint. The lawyer will draw up the various investment agreements, usually including the following:

Warranties and indemnities
Documents that confirm specific information provided by the directors and/or shareholders to the private equity firm. If this information turns out later to be inaccurate, the private equity firm can claim against the providers of the information for any resulting loss incurred. An indemnity is as a promise to indemnify, ie. to reimburse the investors in respect of a designated type of liability if it arises.

Shareholders’ or subscription agreements
Documents detailing the terms of the investment, including any continuing obligations of management required by the private equity firm, the warranties and indemnities given by the existing shareholders, penalty clauses and the definition of shareholder rights.

Debenture agreements
A statement of the terms under which these forms of finance are provided.

Disclosure letter
Contains all the key information disclosed to the private equity firm on which the investment decision has been
based. It is essential that the directors do not omit anything that could have an impact on that decision. The
disclosure letter serves to limit the warranties and indemnities.

The management team’s lawyer
The management team’s lawyer will review the Offer Letter (the heads of agreement or Term Sheet) from the private equity firm and, together with your financial adviser, will help you to negotiate acceptable terms. The management team’s lawyer will also, in due course, negotiate the investment agreements with the private equity firm’s lawyer and produce the disclosure letter, as well as negotiating any loan documents with the banker’s lawyer.

If you need to find a lawyer experienced in these areas, Braxton can help.

You may also consider a lawyer who is specialiced in private equity tax issues. The tax adviser will also help to ensure that, where possible:

• Capital gains tax is deferred on the sale of equity.
• Exposure to Inheritance Tax is minimised.
• Tax indemnities provided by the company directors and shareholders to the private equity firm are reviewed.
• Tax relief is available for interest paid on personal borrowings to finance management’s equity investment.
• Potential gains on the sale of equity are taxed as a capital gain and not treated as earned income.
• Tax relief on professional costs in connection with an MBO, flotation or other exit is maximised.
• Share option plans are properly set up.

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A VCT is a company, broadly similar to an investment trust, which has been approved by HMRC and which subscribes for shares in, or lends money to, small unquoted companies. Under the VCT scheme, VCTs and their investors enjoy certain tax reliefs (see below).

The VCT scheme is designed to encourage investment in small unquoted companies. Individuals invest by holding shares in a VCT. The VCT invests in a spread of small unquoted companies, enabling investors to spread their risk, just as they do by holding shares in an ordinary investment trust company.

The Venture Capital Trust (VCT) scheme in the UK, introduced in 1995, is one of the three tax-based Venture Capital Schemes. The scheme is designed to encourage individuals to invest indirectly in a range of unquoted smaller, higher-risk trading companies, by investing through VCTs.

VCTs are similar to investment trusts, and are managed by fund managers who are usually members of larger investment groups. Investors subscribe for shares in a VCT, which then onward invests in trading companies, providing them with funds to help them develop and grow.

The main features of the VCT scheme are that:
• VCTs must be listed on a UK recognised Stock Exchange.
• VCTs can invest up to £1 million per year in each qualifying company.
• VCTs are exempt from corporation tax on any capital gains arising on disposal of their investments.
• Qualifying companies are limited to companies carrying in a qualifying trade with a maximum of 50 full time equivalent employees at the time shares are issued, and maximum gross assets of £7 million before investment and £8m immediately after investment.

Qualifying holdings
In order to obtain and retain approval as a VCT, traditionally the company must continuously have at least 70% of its investments in qualifying holdings. For this purpose a ‘holding’ in a particular company is the sum of the shares and securities which it holds in that company.

In certain circumstances in which a holding would not qualify as a whole, it is to be treated as comprising two separate holdings, the division being made in such a way that one of them qualifies.

Reliefs to Shareholders
The tax reliefs available to investors are:
• Income Tax Relief – shareholders can claim income tax relief at the rate of 30% of up to £200,000 annual investment, provided their shares are held for at least five years. Income tax reliefs are available to individuals aged 18 years or over and not to trustees, companies or others who invest in VCTs.
• Dividends – no income tax is payable on dividends from ordinary shares in VCTs.
• Capital Gains Tax (CGT) – No CGT is payable on disposals by individuals of ordinary shares in VCTs.

Key policy changes
There have been some policy changes to the scheme since its inception that could be reflected in the statistics. The last key changes affected from 6 April 2007. With this change, VCT qualifying holdings are limited to companies with a maximum of 50 full time equivalent employees at the time shares are issued. This restriction also applies to companies seeking funding through the Enterprise Investment Scheme and the Corporate Venturing Scheme. From 19 July 2007, companies must have raised no more than £2 million under any or all of the tax-based venture capital schemes (Venture Capital Trusts, Enterprise Investment Scheme and Corporate Venturing Scheme).

Period for which return is required
A company which is or has been a VCT must make a return to the Small Company Enterprise Centre dealing with its accounts of all its investments for each accounting period for which it was approved as a VCT. If it was approved as a VCT only for part of an accounting period, it must make a return for that part of the accounting period.

Time limit for making a return
Returns must be made within 12 months of the end of a VCT’s accounting period or, where approval has been withdrawn, the VCT ceasing to be approved, whichever is sooner.

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Expanding your business to take advantage of international opportunities requires proper planning on many fronts. To navigate the complex tax implications of active participation in the global marketplace, you need an experienced international tax advisor to steer you in the right direction.

International tax of property transactions

Undertaking property transactions in a tax-efficient way continues to be a challenge for the international real estate sector but there are many opportunities to save tax when structuring deals. Tax International (www.tax-international.com) maintain a forward thinking and innovative approach towards tax planning, and actively encourage the development of new products and processes to meet changing client needs.

Tax International´ specialist team has extensive experience advising property owners on how to structure their transactions most tax effectively. Key areas include:

• maximising tax allowances on the purchase, refurbishment, construction or re-construction of a property
• tax-efficient finance arrangements
• determining the most appropriate framework for property ownership – including the use of local and overseas entities
• minimising any non-recoverable VAT

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The schemes which we refer to as the venture capital schemes are:

• the Enterprise Investment Scheme (EIS),
• the Venture Capital Trust scheme (VCT scheme),
• the Corporate Venturing Scheme (CVS),
• relief for capital losses (VC loss relief).

These schemes can be grouped together because they have similar aims and have certain legislative features in common.

The central aim of the venture capital schemes is to encourage investment in small unquoted trading companies. Small businesses generally, while often able to obtain modest loans or overdraft facilities, find larger amounts of capital difficult to raise – except for the largest and most solid undertakings. The exact range of this ‘equity gap’, as it is known, is open to dispute, but the existence of a funding gap of some kind is commonly agreed.

The EIS aims to attract investment from individuals (and, in the case of deferral relief under the scheme, from certain trustees), while the CVS aims to promote investment by companies and thereby to encourage corporate venturing relationships. The VCT scheme encourages indirect investment by individuals, through the medium of a corporate vehicle similar to an investment trust.

In the case of EIS, VC loss relief and the CVS, reliefs are available only for investment in shares which meet certain requirements (broadly ordinary shares) in such companies. Under the VCT scheme reliefs are available for investment in similarly qualifying shares of the VCT, while the VCT can make its own investments partly in shares other than eligible shares or loan stock or loans.

In the case of EIS and the VCT scheme reliefs are available to individuals – and, as respects EIS deferral relief only, certain trustees. In the case of CVS, reliefs are available only to companies.

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Since September 2000 all new cases of issues of shares under the EIS and of investments made by VCTs have been dealt with at a special HMRC office called the Small Company Enterprise Centre (SCEC). As from April 2002 this office deals also with all cases of issues of shares under the CVS. The SCEC operates from sites at Maidstone and Cardiff, with a central customer service point and support team at Cardiff.

SCEC also deals with companies granting options under Enterprise Management Incentives (EMI).

The Small Company Enterprise Centre (SCEC) deals with:

• enquiries from companies about the conditions of the EIS, the CVS and the VCT scheme,
• requests from companies for informal advance clearance that they will meet the requirements of any of the three schemes,
• the CT liability of companies using any of the three schemes for the period during which the requirements of the scheme in question have to be met.

The SCEC does not deal with claims to relief under any of the three schemes, and claims to VC loss relief – these are dealt with by the tax office dealing with the claimant.

The following abbreviations about the Venture Capital Schemes in the UK are used:

CG/CGT Capital Gains/Capital Gains Tax
CT Corporation Tax
CVS Corporate Venturing Scheme
EIS Enterprise Investment Scheme
ESC Extra Statutory Concession
FA Finance Act
ICTA Income & Corporation Taxes Act 1988
ITA Income Tax Act 2007
SA Self-assessment
SP Statement of Practice
TB Tax Bulletin
TCGA Taxation of Chargeable Gains Act
TMA Taxes Management Act
UK United Kingdom
VC/VCT Venture Capital/Venture Capital Trust

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Example of a typical management buyout.
(a) A company is available to be purchased for £40m. The senior managers of the company obtain the backing of a VC to buy it in a management buyout. A new company (“Newco”) is formed as the vehicle to acquire it. Newco is to be funded by the management team, the VC and banks.
(b) The managers and VC determine that the company needs £8m of expansion capital to develop its business, and that transaction costs (loan arrangement fees, professional fees, stamp duty, etc) will be £2m. Total funding of £50m is therefore needed.
(c) A bank offers to lend £25m as a senior secured loan, with an interest cost of 7%.
(d) A mezzanine lender (or possibly the mezzanine division of the same bank) offers a £5m mezzanine loan, unsecured but ranking ahead of the VC’s and management team’s capital. The mezzanine interest rate is 10%, and the mezzanine lender is granted warrants to subscribe at par value for 3% of Newco’s ordinary share capital.
(e) The remaining £20m needs to be invested by the VC and the management team.
(f) The £20m capital is structured as £10m preference shares and £8m subordinated debt, all invested by the VC, and £2m ordinary shares subscribed 85% by the VC and 15% by the managers. The preference shares have a cumulating dividend of 8% p.a. and the subordinated debt has a coupon of 11% p.a. The managers invest (between them) £300,000 of their own money for 15% of the ordinary shares and the VC invests £1.7m for the other 85%. There are no ratchet arrangements.
(g) Customary leaver provisions are included in the relevant contracts whereby managers are required to sell their shares – possibly for less than full market value – to the other investors (including other managers) if they cease to be employed in the business. These leaver provisions do not apply to the shares held by the VC. Customary drag-along and tag-along provisions are also included.
5.2 The shares held by the managers are therefore “restricted securities”, and are also “employment-related securities”, within ITEPA 2003.
5.3 The IUMV of the Managers’ Shares is determined as follows, applying Section 3 above:
(a) the coupon (11% p.a. on the debt, and after adjusting for tax as provided in paragraph 4.2(c) above, 11.4% p.a. on the preference shares) on the VC’s Preferred Capital that is leveraging the ordinary shares is not less than the coupon on the most expensive third party debt (being the 10% on the mezzanine loan); and
(b) the managers paid the same price per share (“DA”, for the purposes of section 428 ITEPA 2003) for their ordinary shares as did the VC.

In this example borrowings from an unconnected bank were used to fund the investment and the coupon on these formed the benchmark “most expensive financing” mentioned in paragraph 4.1(b) above. If there were no other finance provided by an unconnected investor, so that all finance was provided by parties who hold Ordinary Capital, (which is a somewhat common feature of venture or development capital investments) then there would be no benchmark rate. In such a case, in order for the tax treatment in Section 3 to apply, the question of whether the condition in the first sentence of paragraph 4.1(b) is satisfied would need to be determined some other way. This might be done by comparing the expected rate of return on the Preferred Capital with the returns on similar investments in the market, or by comparing the capital structure with the structures in similar transactions, or by some other commercial analysis or comparison.

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The examples and explanations we offer here deals with certain tax issues for managers of a company that is financed by a venture capital/private equity provider (“VC”).

If the Managers’ Shares are subject to “ratchet arrangements” which conform to 6.2(a) below, the Inland Revenue accepts that the ratchet arrangements should be dealt with by being taken into account in determining the unrestricted market value (assuming the shares are restricted, otherwise market value) of the Managers’ Shares when they are acquired by the managers, and either Part 2 (general earnings) or Chapter 2 Part 7 ITEPA 2003 will apply if that value exceeds the amount paid for the shares. However, if the ratchet arrangements conform to all the conditions in 6.2 below, the Inland Revenue accepts that the ratchet arrangements will not of themselves result in any charge under Chapters 1 to 5 Part 7 ITEPA 2003 and accordingly, if all the conditions in paragraph 4.1 (apart from 4.1(c) and 4.1(e), which are replaced by the conditions in 6.2 below) are also satisfied then the Inland Revenue accepts that the price paid by the managers to acquire their Managers’ Shares will not be less than IUMV.
 The conditions referred to  above are:
(a) The ratchet arrangements are arrangements under which the participation of different holders of Ordinary Capital in the profits and assets of the company might vary according to the performance of the company or the VC’s return on its investment in the company (but not according to the personal individual performance of any particular holder).
(b) The ratchet arrangements are in existence at the time the VC acquires its Ordinary Capital.
BVCA / Inland Revenue Memorandum of Agreement July 2003
(c) The managers pay a price for their shares in the Ordinary Capital that, at the time of acquisition, reflects their maximum economic entitlement. (This condition is to be interpreted in a manner consistent with the principles outlined in paragraphs 6.3 to 6.5 below.)

Where the managers pay a price per share that is equal to (but not more than) the price paid by the VC for its Ordinary Capital Shares, the condition in paragraph 6.2(c) will be satisfied where the ratchet arrangements are structured so that they can only have a negative or dilutive effect on the Managers’ Shares. By way of illustration, arrangements comparable to those in the following Examples (i) and (ii) would be taken as satisfying this condition, whereas arrangements comparable to those in Example (iii) would not. In all these (hypothetical) examples the overall transaction structure is that a company is established into which a team of managers and a VC invest. The Ordinary Capital of the company is to be £1,000,000. The commercial terms agreed are that the managers will have a basic entitlement to 12% of the Ordinary Capital, but if the VC realises a return of at least 25% IRR on its (the VC’s) investment at the time the investment is sold or realised, the managers will then become entitled to 15% of the Ordinary Capital. The A shares and B shares in these examples all count as Ordinary Capital as defined above, and each A share participates in the same proportion of the company’s assets and profits as each B share.

Example (i)
Managers subscribe £150,000 for 150,000 A ordinary shares, VC subscribes £850,000 for 850,000 B ordinary shares. A term in the share rights requires that 34,091 of the A shares automatically convert (at the time when the investment is realised, in the future) into worthless deferred shares in the event the VC’s investment returns less than 25% IRR. After this conversion, the division of the Ordinary Shares will be 115,909 A shares:850,000 B shares, which is 12:88.

Example (ii)
Managers subscribe £150,000 for 150,000 A ordinary shares, VC subscribes £850,000 for 850,000 B ordinary shares. The terms of the B shares give the holders the right to subscribe at nominal value for a further 250,000 A shares (or additional rights equivalent to a further 250,000 A shares) in the future, in the event the VC’s investment returns less than 25% IRR. On the operation of the ratchet, the division of the Ordinary Shares will be 150,000 A shares:1,100,000 B shares, which is 12:88.

Example (iii)
Managers subscribe £120,000 for 120,000 A ordinary shares, VC subscribes £880,000 for 880,000 B ordinary shares. A term in the share rights requires that 200,000 of the B shares automatically convert into worthless deferred shares in the future, in the event the VC’s investment returns more than 25% IRR. After this conversion, the division of the Ordinary Shares will be 120,000 A shares: 680,000 B shares, which is 15:85.
The distinction here is that in Examples (i) and (ii) the managers have paid the price for their A shares that they would have paid if the condition above were being observed and if hypothetically it were known at the start that the contingencies upon which the ratchet depends (in this case, the 25% IRR for the VC) were going to be satisfied. In contrast, in Example (iii) under the same hypothesis, the managers have not paid as much as the VC for their relative holding of Ordinary Shares. Thus, Examples (i) and (ii) would be taken to comply with the condition in paragraph 6.2(c) above but Example (iii) would not.
Based upon this distinction:
(a) The condition above will also be taken to be satisfied if, in a case where the ratchet arrangements are structured so that they have a negative or dilutive effect on the Ordinary Shares other than the Managers’ Shares, the managers subscribe for or acquire their Managers’ Shares at a price which includes a premium (relative to the price paid by other investors for the other Ordinary Shares) attributable to the fact that the Managers’ Shares cannot suffer dilution under the ratchet whereas the other Ordinary Shares can. The Revenue will accept that this premium has been paid if the principles illustrated in the following further Example (iv) are applied. This further example is based on the same assumed facts as the examples above.

Example (iv)
Managers subscribe £150,000 for 120,000 A ordinary shares, VC subscribes £850,000 for 880,000 B ordinary shares. A term in the share rights requires that 200,000 of the B shares automatically convert into worthless deferred shares in the event the VC’s investment returns more than 25% IRR. After this conversion, the division of the Ordinary Shares will be 120,000 A shares: 680,000 B shares, which is 15:85. This is the same structure as in Example (iii) above, except the managers pay a further premium for their A shares of £30,000. The effect of this is that the managers have paid in 15% of the total money subscribed for Ordinary Capital, not 12% as in Example (iii).

(b) In the event the ratchet arrangements are structured so that they have a negative or dilutive effect on the Ordinary Shares other than the Managers’ Shares, but no premium as mentioned  above is paid, the Revenue considers that the Managers’ Shares may have been acquired for a price lower than their IUMV. In such a case, and assuming the other relevant conditions in paragraphs 4.1 and 6.2 above are met, the Revenue accepts that the maximum difference between the price paid by the managers for their Managers’ Shares and the IUMV of those shares will be an amount corresponding to the £30,000 premium calculated in Example (v) above. This will be the maximum “IUMV-DA” for the purposes of section 428 ITEPA 2003. It will be the maximum IUMV-DA because it will generally be appropriate to discount this maximum by reference to the likelihood of the ratchet being triggered or not. The actual IUMV-DA in these cases will thus be a matter for the taxpayers concerned to determine and agree with Inland Revenue as appropriate, and the only confirmation given in this memorandum is that the answer is somewhere in the range zero to whatever figure corresponds to the £30,000 premium in the above Example (iv).

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©2010 Braxton Consulting. All Rights Reserved.