The ill-fated business start-up scheme introduced in 1981 can be seen as the beginning of government's 'love affair' with the use of tax-based incentives to encourage 'risk' investment in small businesses. Once some empirical evidence had been collected over time, such reliefs were targeted more carefully. The enterprise investment scheme (EIS), which started life in 1994, is the current mainstream version. The EIS provides income tax relief for equity investment by individuals in eligible unlisted companies, as well as providing a number of CGT benefits. Income tax relief at the rate of 20% of the investment is available (up to a monetary investment limit of £150,000 a year).
The Finance Act 2000 introduced the corporate venturing scheme (CVS), which applies from 1 April 2000 (until 31 March 2010), and gives companies their own system of tax breaks for new share investment in qualifying companies. Its basic objectives are to attract new equity investment in small higher-risk trading companies and to encourage 'mutually beneficial corporate venturing relationships' between the two companies. The basic CVS qualifying conditions thus closely resemble those built into the existing EIS and venture capital trust (VCT) regimes for individual taxpayers. However, in contrast to the EIS and VCT regimes, the CVS does not involve any monetary restriction on the amount that can be invested (subject to the qualifying company that issues the CVS shares satisfying the 'gross assets' test - see below).
Under the CVS, the investing company can enjoy three different types of relief:
Investment relief - this is the principal relief, which provides a maximum reduction in the investing company's corporation tax liability of 20% of the amount subscribed for shares in a qualifying CVS company ('Qualco').
Loss relief, enabling any capital loss on the disposal of 'CVS' shares to be written off against the investing company's corporation tax 'income' profits.
Deferral relief, which confers the ability to defer any capital gain arising on the sale of CVS shares by further reinvestment under the CVS in one or more other Qualco(s).
The various CVS reliefs can be forfeited if certain 'disqualifying' events take place within the relevant three-year 'qualification period' - broadly three years after the CVS share sub-scription or, if later, when the issuing Qualco starts trading using the CVS share monies.Investing company conditions
A qualifying investing company must subscribe for ordinary shares wholly in cash (fully paid up) in a Qualco. A purchase of existing shares or shares issued in exchange for services rendered by the investor will not therefore attract CVS relief.
The CVS share investment in the Qualco must be held as a chargeable asset for CGT purposes (as opposed to a trading asset), and there must be no pre-arranged 'exit' route. The CVS shares cannot contain any preferential rights to dividends or assets on a winding up. Similarly, the shares must not contain any preferred rights of redemption (para 35; unless stated otherwise, all statutory references are to Sch 15, Finance Act 2000).
The investing company is prohibited from entering into any reciprocal arrangements under which another person would subscribe for shares in another company in which the investing company has a 'material interest' (para 6). The CVS investment must be made for commercial reasons and must not be part of a tax avoidance scheme.
A number of important conditions must be satisfied by the investing company both when it makes its CVS investment (or, if later, when it or one of its qualifying subsidiaries starts to trade) and throughout the following 'three-year' qualification period. Broadly, these require that the investing company must be a trading company or part of a trading group that does not: control or have a 'material interest' in the issuing Qualco or any 51% subsidiary, ie, broadly it must not hold more than 30% of Qualco's ordinary share capital (including loans convertible into shares) or voting power (paras 5 and 7); carry on a financial trade, at least to any substantial extent. (An investing company substantially engaged in banking, lending, finance leasing, insurance, dealing in shares, etc, will not therefore qualify (paras 10-12)).
For the purpose of determining whether the investing company has 'control', the s 416, Income and Corporation Taxes Act 1988 test is used, subject to certain modifications. Shares held by Qualco's connected companies, Qualco's directors and their relatives will also be attributed to Qualco for these purposes, but any relevant preference shares and loan creditor rights held are ignored (paras 8-10).Shareholders' taper relief
A CVS investment may potentially affect the investing company's taper relief status. The shareholders of an unquoted trading company or holding company of a trading group will normally attract the very attractive business taper reduction against their capital gains on a subsequent sale of their shares.
If the investing company loses its 'business asset' status for taper relief purposes, its shareholders' future taper relief reductions will be diluted. There is no special concession that treats CVS investments as trading activities for taper relief, although non-trading activities (such as investments) may be ignored if they broadly represent under 20% of the investing company or group's total activities. The special 'let-out' rule that treats equity investments in qualifying joint ventures as trading activities for taper relief purposes will not assist here. This is because the rule in para 23, Sch 1A, Taxation of Chargeable Gains Act 1992 requires the investing company to hold more than 30% of the 'joint-venture' company.Issuing Qualco conditions
The issuing Qualco must apply at least 80% of its (CVS) share subscription proceeds wholly for the purposes of a relevant trade within 12 months of the share issue or commencement of trade by the Qualco or its qualifying subsidiary. The balance of the share monies must be used for trading purposes within the following 12 months (para 36). For pre-7 March 2001 CVS share issues, the legislation required all the share subscription monies to be used for trading purposes within the first 12 months of issue/when trading began.
At the time the relevant CVS shares are issued, the issuing Qualco must be unquoted or listed on the Alternative Investment Market (para 16). However, if at the time of a CVS issue the issuer has no arrangements in place for a future listing, etc, the CVS relief will not be 'clawed back' if it becomes listed during the relevant 'three-year' period.
CVS relief is targeted towards investment in 'smaller' companies. Hence, relief is only available if the issuer's balance sheet value of 'gross assets' (before any reduction for liabilities) is no more than £15m immediately before the share issue and no more than £16m afterwards (para 22). The balance sheet must be drawn up in accordance with GAAP and be updated to reflect the current position at the share issue date (SP2/00).
The issuing Qualco must satisfy further conditions throughout the 'three-year' qualifying period.
a) It must be independent, ie, it cannot be a 51% subsidiary or under the control of any other company, and there must be no arrangements for it to become so (para 17).
b) At least 20% of the issuing Qualco's shares must be held by 'independent' individuals - this excludes any director or employee of the investing company or 'connected' company (including their relatives) (para 18).
c) If the issuing Qualco is a parent company, all its subsidiaries must be 'qualifying subsidiaries' (ie, those in which it holds at least a 75% economic interest).Qualifying trades
A (singleton) Qualco must carry on a qualifying trade (or be preparing to do so) on a commercial basis wholly or mainly in the UK. All trades qualify except those that are 'excluded activities' (as defined in paras 26-33) (see Panel 1 for main types of 'excluded activity').
A parent Qualco will not qualify if the group's business activities (taken as a whole and ignoring certain intra-group transactions, such as letting property to a fellow group member) are wholly or substantially non-qualifying, although at least one group member must be carrying on a qualifying trade.
The 'qualifying trade' test will still be met provided any 'excluded activities' only form an insubstantial (ie, under 20%) part of the company's or the group's total business. The issuing company will not cease to meet the 'trading activities' test if it subsequently goes into liquidation or receivership (para 24).
SP 3/00 states that in determining whether the trade is carried on wholly or mainly in the UK, the Inland Revenue will look at the totality of Qualco's trading activities. While no single factor will be decisive, the Revenue will consider where Qualco's capital assets are based, where any purchasing, processing, manufacturing or selling is carried out, and the location of the employees, etc, engaged in its trading operations. The export of goods and services, as well as the procurement of goods from abroad or their storage overseas, will not count as an overseas trading activity for this purpose.Advance clearance procedure
A Qualco can obtain advance clearance from the Revenue to confirm that its prospective CVS share issue will qualify for relief. The Revenue is likely to require:
• general details concerning the issuing Qualco and its tax reference;
• the latest available statutory accounts and other relevant financial information (eg, any prospectus or other document to be issued to investors, even if it is in draft form) and details of material changes or transactions since the last balance sheet date;
• relevant details to establish that the Qualco satisfies the 'unquoted' and 'independent' status tests, enough information to show that the £15m gross assets threshold will not be exceeded, and details of the Qualco's expected ownership after the CVS share issue;
• share issue and money raised - details of the anticipated number of shares to be issued to investors and the planned application of the share issue proceeds. Confirmation that each trade or activity will be carried on wholly or mainly in the UK is required;
• various undertakings are required to indicate that the Qualco intends to apply the share issue proceeds within the relevant time limits, that the shares will not be issued until the subscription monies have been wholly paid in cash, and the issue is for genuine commercial reasons.
If there are plans to make a concurrent EIS share issue to individuals, an informal request for clearance should be sent with the CVS application. The CVS clearance application should be sent to the Corporate Venturing Unit, Somerset House, Strand, London WC2R 1LB. The Revenue must reply within 30 days, but it may request further details before providing the appropriate clearance (see SP1/00).CVS investment relief
An investing company may claim relief for its CVS share subscription in a Qualco against its corporation tax liability. CVS investment relief at the rate of 20% of the amount invested is given for the corporation tax accounting period in which the shares are issued, restricted to the company's residual tax liability, if this is lower (para 39) (see example in Panel 2). Tax cannot be postponed on the basis that a CVS claim will be made in the near future.
The CVS claim can be made if the relevant conditions for relief are currently being satisfied, but, in the case of a new trade, relief is not given until the Qualco has traded for at least four months (para 40).
The Qualco must issue a 'compliance certificate' in respect of the CVS share issue after the Revenue has authorised it. The inspector of taxes should give authorisation after the company has submitted a compliance statement.Clawback or restriction of CVS relief
CVS investment relief is withdrawn completely if the investor sells its CVS shares to a connected person in the 'three-year' qualification period.
Relief will also be withdrawn or restricted where other capital gains disposals occur within the three-year period. This will be the case where the relevant CVS shares are subject to an arm's-length sale (for full consideration), a capital distribution is made in a winding-up, or if the shares are subject to a deemed 'negligible value' disposal or final disposal on becoming extinguished or cancelled.
Broadly, if the shares are sold at a gain, the CVS relief is completely withdrawn. If the shares are sold at a loss, the CVS relief is withdrawn at the rate of 20% of the consideration received (para 46). The mechanics of the restriction of CVS relief are shown in Panel 3.
CVS relief is also withdrawn or restricted (under para 47) if the investing company receives value (other than insignificant amounts) from the Qualco at any time within the year before the share issue or within the following three years (para 49). The investing company is treated as receiving value if, for example, the issuing Qualco repays a loan due to the investing company (that was outstanding before the CVS share issue) under arrangements relating to the CVS share issue. Similarly, the investor is deemed to have received value if the Qualco transfers an asset to it at an under-value, or the Qualco provides services, etc, to the investor or its directors for less than full consideration (para 56). The original CVS relief is reduced by 20% of the 'value received' up to the amount of the initial relief.CVS loss relief
If the investing company incurs a capital loss on an arm's length sale of its CVS investment, then it can make a claim to deduct the loss against its taxable 'income' profits (for corporation tax purposes). The loss is relieved against the investor's income (before deducting any other relief) for
• the accounting period in which the capital loss arises; and
• if required, the accounting period(s) covering the previous 12 months.
In computing the allowable loss, the CVS relief that remains attributable to the shares is deducted from the base cost of the share sub-scription. The loss relief claim is dependent on the original CVS relief not being totally withdrawn, and must be made within two years of the end of the period in which the loss is incurred.
Such claims are particularly useful if the investor has no other capital gains against which the capital loss could be immediately relieved. Losses arising on negligible value claims, capital distributions, etc, are also eligible for 'income' loss relief.CVS capital gains deferral relief
Where the investing company makes a gain on disposing of its CVS shares, it can defer the tax liability on them by making a CVS deferral claim. This requires the investing company to 'reinvest' its gain against other qualifying CVS share investments within the relevant 'four-year' reinvestment period (ie, one year before and three years after the original gain arises). The investing company has considerable flexibility in that it can specify the amount of the original gain that it wishes to defer up to the amount of the qualifying CVS investment in one or more Qualcos. The deferred gain is offset against the original gain, leaving any residual gain as taxable.
A deferred gain is carried forward and only becomes taxable when:
• the reinvestment CVS shares are sold; or
• the original CVS relief on those shares is subsequently restricted or withdrawn because the investing company has 'received value' (under para 47).
The deferred gain is taxed in the accounting period in which the relevant 'trigger event' occurs, although it may be subject to a further CVS deferral claim.The incentive effect
It remains to be seen whether CVS relief will provide a sufficient incentive to increase the flow of risk capital into small businesses. In my experience, proprietors of potential investee companies normally rely on bank lending facilities before conceding any sizeable equity stake in their companies. Where a corporate investor is bringing special commercial benefits (such as intellectual property) to the investee company, then it may seek a slice of the equity. Clearly, any investment decision will be made on the basis of the potential return, and CVS relief may help in marginal cases. The investor's lack of any significant influence over CVS-based investments may prove to be an obstacle where a significant investment is sought.
Peter Rayney FCA, FTII, TEP, is a tax partner with BDO Stoy Hayward's West Midlands practice, where he provides a tax consultancy service to accountants, lawyers and owner-managed businesses. He is the author of the loose-leaf work, The Practical Corporation Tax Manual, published by ABG Professional Information.1: Excluded activities include the following:
• Dealing in land, shares and financial instruments, etc.
• Banking, money-lending, debt factoring, insurance, etc.
• Leasing, receiving royalties and licence fees (unless relating to the exploitation of an intangible asset [including intellectual property] created by the company).
• Property development.
• Operating or managing hotels, nursing homes or residential care homes (provided the company has an interest in or occupies the property).
• The provision of services or facilities to a commonly controlled company carrying on 'excluded activities'.2: Calculation of CVS invesment relief
Dennis Ltd subscribed £50,000 for an issue of 50,000 £1 ordinary shares in Paddocks Golfing Supplies Ltd ('Paddocks') in March 2001 under the CVS. Paddocks sells golfing and other sports equipment through several retail shops, and is a Qualco for CVS purposes.
Dennis Ltd claimed CVS relief of £10,000 against its corporation tax liability for the year ending 30 June 2001, as follows:
Corporation tax on taxable profits
Less: CVS relief: £ 50,000 share subscription @ 20%
Based on the example in Panel 2, if Dennis sells its shareholding (on an arm's length basis) in Paddocks in (say) February 2003, this would trigger a clawback of the original CVS relief. The amount of relief clawed back effectively depends on whether the CVS shares are sold at a profit or loss.
Shares sold at a profit - the CVS relief of £10,000 given in the year ending 30 June 2001 is entirely withdrawn.
Shares sold at a loss - the CVS relief (in the year ending 30 June 2001) is reduced by 20% of the actual sale proceeds received. Thus, if the sale proceeds were £30,000, the clawback of CVS relief would be £6,000 (ie, £30,000 x 20%). The relief is therefore revised to 20% of the overall net cost of the share investment, ie, £4,000 (being 20% of [£50,000 less £30,000]).