Advisers must ensure the EIS investment they choose for clients do not fall foul of HMRC’s rules, says Ian Warwick, Managing Partner at Deepbridge Capital.
Investing via EIS is increasingly accessible, offers many options for investors but has can also be confusing for investors.
In the early years of the EIS, companies could not raise large sums each year and therefore investments were ‘relatively small amounts,’ as Michael Portillo, then Chief Secretary to the Treasury, stated as the intention in 1994.
Fast forward several years and the government wanted to encourage investment in to renewable energy projects as they prioritised their targets to hit EU renewable energy targets. With the EIS also being expanded to allow up to £5 million per year to be invested in to a company, this is when the EIS market really took off.
In 2010/11 HM Revenue & Customs (HMRC) stated that £549 million of funding was raised via EIS but by the 2014/15 tax year this figure had increased to £1.8 billion. During a short period, EIS investing had grown exponentially with investors attracted to propositions with asset-backed renewable energy projects benefitting from long-term government subsidies.
What was not to like; tax reliefs on the way in, subsidies guaranteeing income for the lifetime of the investment and a likely exit to an organisation seeking predictable income?
Investment in to other EIS opportunities, such as technology and other innovations, was also growing as a result of legislative changes and the market became a competitive landscape.
Sea-change in approach
With the removal of energy production focused products, in 2014 and 2015, came a sea-change in the way that investors and, in particular, providers approached EIS. There were suddenly those providers who sought-out propositions that could perhaps replicate the renewable energy EIS model and there were those who sought-out investment opportunities that they felt would generate real returns for investors and adhere to ‘the spirit of EIS.’
When the EIS was originally launched, Michael Portillo stated: ‘The purpose of Enterprise Investment Schemes is to recognise that unquoted trading companies can often face considerable difficulties in realising relatively small amounts of share capital. The new scheme is intended to provide a well-targeted means for some of those problems to be overcome.’
EIS was created to support UK businesses seeking to grow and has always been intended to be ‘well-targeted,’ a policy which George Osborne as Chancellor continued. When requesting HMRC ‘advance assurance’ it is noticeable how HMRC are increasingly keen to understand the growth objectives of investee companies before they agree to EIS qualification.
Investing in an EIS proposition always carries the risk that tax reliefs could be challenged by HMRC or withdrawn. Even if HMRC has provided advance assurance to a company, this can be revoked or challenged subsequently by HMRC if there is a change to legislation or a perceived change to the business model of the company.
Words to watch
I therefore suggest that certain key words and phrases should set alarm bells ringing when considering an EIS proposition. If an investment opportunity talks about ‘capital preservation’ then I would suspect that HMRC will be looking at the underlying investments and considering whether they really are adhering to objectives of the EIS.
As the government, predominantly under George Osborne’s stewardship at Chancellor, amended qualification criteria and limits, there was a constant recognition that if investors are receiving significant tax-reliefs then there should be an expectation that the investor is taking appropriate risk with their investment.
If any EIS claims to be anything other than ‘high risk’ then questions should be asked. Financial advisers do not need me to tell them that investing in unquoted stocks of small, relatively early stage companies should always be considered at the higher end of the risk scale. Therefore, if investing in a high risk product does it not make sense to target real returns?
I was also intrigued to see a presentation from another provider last year who opened their presentation by stating (I paraphrase): ‘We have scoured the EIS legislation and found this one area where we believe we can provide an asset-backed EIS.’
My concern with this would be that if they have identified this area as a ‘loop-hole’ then HMRC will have done so as well.
So what is the ‘spirit of EIS’ and why is it important?
The companies that we are led to believe that the government, and therefore HMRC, wants EIS funding to support are those which are creating innovation or jobs. They want companies to be of benefit to the UK economy:
- developing innovations that can be exported and drive income to the UK
- developing innovations that can provide cost/efficiency savings within the UK economy
- businesses with growth plans that will create jobs.
The UK has always been an innovative country, and a Japanese report in 2014 apparently claimed 55% of ‘significant’ inventions since the Second World War were created by the British, compared to 6% by the Japanese themselves and 21% by Americans. With this innovation focused mentality in the UK, there are plenty of opportunities for investors to back exciting new technologies.
Keeping the balance
An EIS provider’s job is to ensure a constant balance between providing adequate capacity to meet investor demand but to also ensure that investee companies receive the funding they need, as an underfunded company could be detrimental to investors’ interests. It is therefore the EIS providers with a focus on companies within this ‘spirit of EIS’ that usually have a flow of investee companies ready to come in to a portfolio and therefore do not have capacity issues.
For example, in our tech and life sciences focused EIS propositions, we always have at least two companies in the deal flow pipeline at any time to ensure that as we complete funding rounds we can easily replace companies within the portfolio.
Investing in innovation, whether that is technology, life sciences or whatever else, is not only appealing to investors due to the potential tax-reliefs but we find that investors are often also excited by knowing about the innovations they are invested in. The potential growth returns are also appealing.
Post-Brexit investment in UK innovation will likely be even more important as the UK government seeks to replace funding previously available via the EU.
A sector to have already received a pledge of support from the UK Government is the life sciences sector, with Chancellor Philip Hammond announcing in October 2016 that funding currently provided by the EU would be continued post-Brexit by the UK. It is highly likely that the likes of EIS will be pivotal for supporting such funding.
My tips to anybody considering investing via the EIS would be to consider whether the underlying investments are really where the government intended EIS money to go and assess whether the investment provider really knows that market. My team, for example, only invests in sectors they are experienced in and know well. This approach allows the Deepbridge team to work proactively with investee companies to ensure they are commercialising as planned, and thereby mitigating some investment risk.
Our position regarding the importance of the spirit of EIS is not a lonely voice and I was delighted recently to speak with our friends at Symvan Capital who echoed our sentiment. Kealan Doyle CEO at Symvan, commented;
‘Anybody considering an EIS proposition should understand where their investment is going and be reassured if the underlying investee company is genuinely innovative or seeking to create jobs. EIS qualification rules will undoubtedly be amended in the future and HMRC will increasingly scrutinise EIS qualifying companies. The best and most effective way to mitigate this ‘HMRC risk’ is to invest in companies which adhere to ‘the spirit of EIS’ and focus on innovation. EIS funds which specialise in disruptive technology companies will almost certainly be the beneficiary of the changing landscape of tax-efficient investing.’
