Venture Capital Schemes and the Risk-To-Capital Condition
HMRC recently issued guidance on new rules relating to the Enterprise Investment Scheme (EIS), the Seed Enterprise Investment Scheme (SEIS), and Venture Capital Trusts (VCTs).
In particular, HMRC's manual provides guidance on the new 'risk-to-capital' condition for eligibility of these schemes, introduced by Section 14 of the Finance Act 2018.
Venture Capital Schemes
The various venture capital schemes identified above are schemes developed to encourage individuals to invest in certain small, higher risk, early-stage trading companies that may not be able to access funding via other methods. These schemes offer tax relief benefits to an investor as an incentive.
The government's perception is that the availability of this relief has resulted in the creation of tax-motivated, low-risk investment opportunities, referred to as 'capital preservation' arrangements, which allow the investor to take advantage of the tax reliefs at minimal risk to their capital. Such arrangements are contrary to the intended purpose of the schemes and it is for this reason that the government has implemented the risk-to-capital condition.
What is the risk-to-capital condition?
The risk-to-capital condition is intended to prevent capital preservation arrangements by requiring an investment in the schemes to meet both of the following conditions:
1. the company in which the investment is made must have objectives to grow and develop over the long term; and
2. the investment must carry a significant risk that the investor will lose more capital than they gain as a return (including any tax relief).
The risk-to-capital condition and the Film and TV sector
The HMRC guidance is accompanied by a number of examples, one of which sheds light on the intended application of this new condition to film and TV financing. The example and the wider guidance provide some encouragement that the specific attributes of film and TV financing have been considered, but there are still a number of areas where there is cause for concern.
Among the welcome considerations is the acknowledgement that it is standard industry practice to use special purpose vehicles for particular production projects and that such a fact does not automatically preclude the use of the tax relief schemes. However, it's important to note that the investment must be in the parent company and not a direct investment in the SPV, as it’s the parent company itself which intends to grow, develop and reinvest profits in future projects, not the SPV.
The industry will also welcome HMRC's recognition that production companies will often outsource a number of elements of the production to specialist providers as standard practice. Subcontracting is one of a number of factors addressed in the guidance which indicates that a company will only fall foul in respect of subcontracting when the company is subcontracting "all or most of its activities" to others.
The proclivity for outsourcing specialist elements of a film or TV production will also have an effect on the type of growth of the company. The guidance does not clearly define "objectives to grow and develop over the long term" but identifies an increase in the number of employees as a relevant factor. The ambitions of production companies will be to produce larger and more frequent productions, and the growth will not necessarily include much increase in headcount, because of the ability to utilise freelancers and outsource specific functions. This context will need to be considered when applying the risk-to-capital condition, in order to avoid film and TV production activity being squeezed out of eligibility for these tax relief schemes.
Unfortunately, there are additional intricacies within the film and TV industry which may not have been considered. Another of the factors identified by the guidance is 'fragmentation'. This refers to a tactic adopted by capital preservation schemes in which the activity that qualifies for tax relief under the various schemes is fragmented between a number of companies. The investors seeking to utilise the capital preservation scheme can then invest the maximum amount allowed under a scheme within each company, therefore reaping greater tax relief benefits than they would have been able to by investing in just one company. Those working in the creative industries will know that fragmentation can occur for a variety of reasons. A number of different companies are often set up by the same individual or entity in order to deal with different partners, financial arrangements or elements of intellectual property. Again, such context will have to be considered when applying this factor.
Despite these concerns, it appears that HMRC have taken into consideration views from the film and TV industry. On 31 January 2018, the British Screen Advisory Council ("BSAC") provided its comments on the guidance, where one of its particular concerns surrounded the interpretation of the second arm of the condition. It requires that the investment must carry a significant risk that the investor will lose more capital than they gain as a return. The guidance contained in Example 3 previously stated that "only investment in film that is not covered or protected by pre-agreed income or support (referred to in the industry as the 'gap') will be likely to qualify for tax relief". BSAC's view was that this inconsistency with the legislation itself might lead to an interpretation that all of the investor's investment must be entirely at risk, in contrast to the general principle of the legislation that the risk must be to a significant portion of the investment. The latest version of the guidance appears to rectify this ambiguity by stating that investments covered by pre-agreed income or support will be unlikely to qualify for tax relief, "unless the amount of protected investment is insignificant and the overall risk of loss of capital remains significant". Still, what will amount to 'significant' remains unclear.
To be continued…
Whilst it is clearly not the objective of the legislation to prevent film and TV production companies from utilising schemes such as EIS, SEIS, and VCTs, it remains a concern that unless the specific intricacies of the film and TV sector are considered and understood, this may be the effect.
It is hoped that the guidance is reviewed after six months, with industry input, to ensure that the film and TV industry continues to enjoy the incentives offered by these schemes.
The risk-to-capital condition applies to investments in EIS, SEIS and VCT schemes made on or after 15 March 2018.