The Venture Capital Schemes — Are the tax breaks worth the risk?

This article was published at Tax Notes can be downloaded in pdf format at Academia.edu.

In this article we take a look at the Venture Capital Schemes and ask whether the risks involved are really worth it. In particular we see there are two types of risk — investment risk and tax risk. Investment risk can lose you money, but losing the tax reliefs is not necessarily fatal.

The Venture Capital Schemes — what are they?

The purpose of the Venture Capital Schemes is to provide funding for companies that are in the relatively early stage of the business cycle. At the time of writing, there are four separate schemes in the UK, each one offering generous tax breaks to investors as a reward for taking on the risks associated with this type of investment.

The different levels of risk are reflected in the type of investment:

• The Seed Enterprise Investment Scheme (“SEIS”) — is at the highest rung of the risk ladder. The word “seed” gives a clue — these are for companies still in the incubation stage. It can be thought of as a mini version of the next scheme which is:
• The Enterprise Investment Scheme (“EIS”) — still risky, but lower down the ladder from SEIS;
• The Social Enterprise Investment Scheme (“SITR”) — this is a version of the EIS Scheme that has been adapted to investments in social enterprises. The abbreviation “SITR” stands for Social Investment Tax Relief — guess why we don’t use the abbreviation SEIS?

In all of the above three schemes — which we shall call the Enterprise Schemes — investors subscribe for securities in a company in return for the tax breaks. One can invest in more than one company, subject to the annual limits. However, the following scheme provides a more efficient way of spreading risk:

• Venture Capital Trusts (“VCTs”) — a VCT is a corporate vehicle that invests in other growth companies. It can be thought of as an EIS fund in the sense that the companies making up the portfolio are of a similar type to those seeking EIS funding. Investors access these companies indirectly by buying shares in the VCT. VCTs are relatively more liquid as their shares can be bought and sold on the London Stock Exchange;

And finally:

• Social Venture Capital Trusts (“Social VCTs”) — this hasn’t yet arrived on the scene. Social VCTs are intended to the equivalent of a VCT which invests solely in social enterprises. What the VCT is to the EIS Scheme, so will the Social VCT be to the SITR Scheme.

So what are the tax breaks available?

A table showing a summary of the tax breaks can be downloaded from this link. The main tax breaks are:

• Income tax relief (“upfront relief”) — whereby either 30% or 50% of the amount invested can be set against your income tax bill. For the Enterprise Schemes, this is a key relief. Most of the other reliefs can only be accessed if income tax relief is claimed at the very outset of making the investment;
• CGT exemption — whereby any capital gains incurred on realising your investment are tax free. For the Enterprise Schemes, capital losses are also available to set against capital gains — this is a departure from the usual tax rules that if gains are exempt, losses are unallowable;
• Share loss relief against income — the Enterprise Schemes have a further advantage in that capital losses can be set against income;
• Inheritance tax relief — Shares held in the Enterprise Schemes may also benefit from an inheritance tax exemption provided they are held for at least two years;
• CGT reinvestment relief — whereby capital gains incurred on other assets can be sheltered by reinvesting the gains in a venture capital investment. Only the Enterprise Schemes have this facility — VCTs used to have it, but it was abolished for the tax years 2004/05 onwards;
• Dividend exemption — (VCTs only) — investors receive their dividends tax free. This has proved very popular with higher rate taxpayers, given the various hikes in the income tax rates over the last few years.

In order to benefit from these tax breaks there are certain conditions. Actually there are lots and lots of conditions, all very complicated! It is important to bear in mind that the reliefs can be withdrawn if the conditions are broken.

The amount of relief is normally limited by reference to the annual investment limits for the particular tax year. There is also a “lock-in” period that normally applies before the relief can be granted. For example, investors who sell their shares during this period are denied the capital gains exemption and also face the prospect of paying back any upfront relief that they claimed when they first made their investment.

But the Venture Capital Schemes are risky

This is the catch. As most commentators in the financial press will tell you, the tax breaks come at a cost. The type of companies that require venture capital funding are at the early stage of the business cycle — investors must take on risk in order to benefit from the tax breaks.

However, the position is a bit more subtle than that. There are in fact two types of risk involved:

• Firstly, there is investment risk, as we’ve just noted. The Government can afford to give away the tax breaks — it won’t hurt the Treasury because the chances of investors making substantial gains aren’t that great anyway;
• Secondly, there is tax risk. The rules are so complicated that it’s very easy to fall foul of them. So there’s a good chance that investors will never be able to claim the tax breaks after all!

Here is an example of how it can all go horribly wrong.

A group of four entrepreneurs Bill, Steve, Jeff and Mark wish to set up a company to carry out their new business. They are all keen to take advantage of the tax breaks afforded by the Enterprise Investment Scheme, so they all subscribe for equal shares in the company. Bill is the first to jump in, subscribing for his shares on Day One, with Steve, Jeff and Mark following suite on Day Two.

By investing separately from his buddies, Bill is disqualified from income tax relief. According to the rules, no investor can hold more than 30% of the company’s share capital. This shouldn’t be an issue with four people all subscribing equally. But for one day — just one single day — Bill controlled the whole company. It is because of that one single day he loses not only his entitlement to upfront relief but also the capital gains exemption when he eventually sells his shares.

There are lots and lots of other ways of falling foul of the rules. But…

It isn’t the end of the world if you lose your tax breaks

This sounds like an incredibly surprising statement coming from a tax professional. But it really isn’t the end of the world.

For it is investment risk that one needs to be most wary of — the prospect of losing your money if the venture fails. For if the money’s lost it can never be recovered.

On the other hand the loss of the tax reliefs doesn’t necessarily mean that your investment has gone bad. It is of course a painful prospect for investors to repay any tax relief that they’ve already claimed — but if the company is still surviving and it still has good prospects, something at least can be salvaged from the wreckage. In short, there is still a chance of making a return on your investment.

I encountered such a situation when I was a junior tax lawyer in private practice. We were acting for an entrepreneur whose company designed mobile phone technology. The company needed short term bridging finance to tide it over till such time that venture capital funding became available. A willing partner was found in the form of a University Fund set up to finance start-up technologies, and everything was going swimmingly well until they realised that the cost of receiving the funds was the possible loss of the company’s EIS status.

Oh dear. Urgent meeting with corporate colleagues (Tax Partner: “You never told us before about EIS,”; Corporate Partner: “You never asked!”). After a lot of head scratching, the Tax Partner suddenly said:

“What’s more important to the client? Does he want to raise money so that he can develop the business? Or does he just want to hold on to the tax breaks?”

The point being that the tax breaks were nice to have, but if the business didn’t grow, they wouldn’t be much use. There’s no point in having a capital gains tax exemption if ultimately, there isn’t going to be much of a gain to exempt.

In the end, the client accepted the loss of the tax reliefs with good grace (guess whose job it was to tell him the bad news?) He didn’t sack us either, and in fact a few months later, my corporate colleague told me that he was doing well and had successfully obtained the venture capital funding that he needed to develop the business.

So are the tax breaks worth the risk?

Upon reflection, perhaps this is not the question that investors should be asking themselves.

The key question is whether the investment is worth the risk? The tax breaks are nice to have, but surely, it is the underlying business that matters — what are its prospects, is it in good financial health, can you trust the managers not to fritter away your hard earned money?

An investment that is inherently bad will lose you money, irrespective of whether there are any tax breaks on offer. In fact, the availability of the tax breaks has no bearing on whether a business has the potential to do well, and the loss of such incentives isn’t necessarily fatal to the well being of the enterprise.

This is not to say that the tax breaks aren’t important — they clearly are, as businesses do use them to attract funding. But they aren’t the “be all and end all”. The first question you should ask as an investor is: “What’s the business case for this investment?” Then, and only then should you consider the tax breaks. For what use are tax breaks if you end up losing all your money?

Satwaki Chanda is a UK Tax Lawyer and is the Editor of Tax Notes, where you can find a more detailed overview of the Venture Capital Schemes.

Photo credit: Flickr: Black faced bunting with acorn by conifer. The photo illustrates that not all acorns grow into oaks — they are liable to many perils on the road to success.

Link: The following news story illustrates the point that these investments are high risk and you should take great care in making a decision to invest: Octopus losses are a ‘wake-up call’ for EIS industry.

I am grateful to journalist Tanzeel Akhtar for bringing this article to my attention.

Originally published at taxnotes.co.uk on July 2, 2015.