Clampdown on EIS tax break knocks £200 million off amount raised in 2018/19

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Tax-efficient Enterprise Investment Scheme (EIS) companies raised almost £200 million less in 2019/20 due to stricter rules on venture capital investing.

In the 2018-19 tax year, £1.8 billion was invested into 3,905 companies, down from £2 billion the previous year, according to figures released by HM Revenue & Customs. Investment via the Seed Investment Enterprise Scheme (SEIS) has also fallen. In 2018-19, 1,985 companies raised a total of £163 million of funds under the SEIS scheme. This is a decrease from 2017-18 when 2,430 companies raised £195 million.

EIS investors receive 30 per cent income tax relief on investments of up to £1m in return for investing in some of the UK’s most high-risk start-ups, and can invest up to £2m in so-called “knowledge-intensive companies”.

According to accountants Price Bailey, the ‘risk to capital ’ rules, introduced on 1 December 2017, mean that entrepreneurs must demonstrate to HMRC that there is a “significant risk” of a capital loss on their shares exceeding the “net investment return”. This is leading to nearly 1 in 10 applications for Enterprise Investment Schemes (EIS) being rejected or withdrawn.

Further, it is clear that London still dominates the funding market as 49% of all EIS funding is flowing to companies in the capital. Technology companies also look to be holding strong, attracting 30% of total funding. However, it has been concerning to see a 54% reduction in deals worth £4m or more.

Chand Chudasama, Partner at Price Bailey, comments: “The dramatic erosion of pension tax relief allowances, and historically low interest rates, boosted investment into companies qualifying for EIS/SEIS. The new risk to capital rules are having a significant chilling effect on the market and are pushing up the cost of raising venture capital via EIS/SEIS by well over a half in order to access meaningful levels of investment for growth.”

“Deals of £4 million or more are an important barometer as this funding typically flows to true scale up businesses who are then able to make some real inroads into a marketplace. This dramatic reduction will no doubt harm many good companies’ ability to take the risks that entrepreneurs need to take in order to grow their businesses.”

He adds: “We are expecting to see an increase in rights issues as a consequence of the economic fallout from COVID-19, many of which could qualify for EIS relief. Businesses are likely to assume that because their initial share offers qualified, secondary offers will too. HMRC could decide that the new shares do not qualify for EIS relief under the new rules, or if business plans have significantly changed since the initial share issue. Businesses should allow themselves plenty of time for the approval process or risk missing out on investment.”

Price Bailey says that the recent rule changes have marked a very clear shift towards growth, and away from capital preservation strategies. This means that in many cases businesses using EIS/SEIS to raise money represent higher risk investments.

Chand Chudasama, Partner at Price Bailey, comments “The data suggests it is getting harder to raise capital from new investors. This means that rights issues will likely increase and investors will need to be ready to put their hands in their pocket to support portfolio companies. EIS should be an attractive way to achieve this, especially given the limited value of the Future Fund to investors with cash; investors we are speaking to are generally preferring to invest more and get EIS relief over and above trying to apply for matched convertible loan money from the Future Fund that doesn’t provide any wider benefits.”

However, “The change to “risk to capital” rules mean that investments should carry a real risk that investors will lose more capital than they are likely to gain. HMRC decides whether investors’ capital is at risk by looking at a businesses’ financial position. The problem is that the rules are often misunderstood by entrepreneurs.”

“Investors will need to consider how much they are prepared to lose. One way to manage the increased risk is by investing across a number of different businesses or EIS funds. There is now much greater onus on investors to learn about the fund managers and their track records, the quality of the deals pipeline and seek to understand the investee companies that will sit within any given portfolio. Given the heightened risk posed by EIS and SEIS investments, investors may want to revise their diversification strategies accordingly.”