Lifecycle of a Business - Fundraising in a Tax Effective Manner
Setting up and running your own business is an amazing achievement. It requires vision, creativity, motivation and stamina. On occasion, it can even bring you fame, riches and fortune. But it can also result in reams of paperwork and cause sleepless nights. And as someone once said to me about children “It doesn’t get easier, it just changes”, so the same can be said for your business throughout its lifecycle. From setting up to exit, it will force you to consider issues that you might not previously have known anything about and it will need you to make many decisions, sometimes very quickly. What it certainly is not is mundane.
With this in mind, the corporate team at Forsters, together with some of our specialist colleagues, has written a series of articles about the various issues and some of the key points that it may help you to know about at each stage of a business’s life. Not all of these will be relevant to you or your business endeavours, but we hope that you will find at least some of these guides interesting and useful, whether you just have the glimmer of an idea, are a start-up, a well-established enterprise or are considering your exit options. Do feel free to drop us a line or pick up the phone if you would like to discuss any of the issues raised further.
So far, we’ve covered “First Things First” and “Directors: Lights, Camera, Action!” But now, let’s consider financing your business – “Show Me The Money”.
Fundraising in a Tax Effective Manner
Last week, we discussed some of the fundraising options for a company. While the considerations set out in that article are important, fundraising decisions are often tax-driven and no discussion would be complete without considering these tax consequences.
The general picture
Traditional investing by a UK tax resident in the shares of a UK company comes with an income tax charge on any dividend for investors, along with a capital gains tax (CGT) charge on the gain they make when they come to sell. Shares are generally acquired out of post-tax income and any capital losses may typically only be set against capital gains.
Issues for start-ups
Investors will want a return on their capital: either reliable dividend income or long-term capital growth or, ideally, both. However, many start-ups simply do not envisage profits for many years, and when they do start to generate profits, paying out dividends may not be a priority; often, they will need to plough the profits back into the business instead. Coupled with higher risks of failure (and so capital losses for investors), the tax system recognises that investors need to be enticed into investing into start-ups and other early-stage businesses.
Investment schemes
To give smaller and newer companies a level playing field there are a number of investment schemes that give investors enhanced tax breaks when they introduce new capital into the business by subscribing for shares. The Enterprise Investment Scheme (EIS), Seed Enterprise Investment Scheme (SEIS) and Venture Capital Trust Scheme (VCT) each encourage investors to finance smaller companies.
- EIS was created to give direct tax relief to investors who subscribe for shares in small companies
- VCT was designed to spread investment risk over a number of companies; investors invest in the venture capital trust, which will then buy shares in a number of qualifying companies
- SEIS was designed to help new companies and start-ups
Tax breaks
These schemes give investors a varying number of tax breaks, which can include:
- Deferral of capital gains on assets sold to finance an acquisition of qualifying shares – meaning more money can be spent acquiring more shares and a tax bill delayed
- Income tax deduction on a percentage of the value of the investment in the year that it is made
- CGT relief on the gain made in the qualifying shares
- Ability to set any losses against income
This makes investing in eligible companies much more attractive, as investors can benefit significantly if values rise, but also have valuable tax benefits if the companies fail. This attempts to make higher risk small companies that need funding to grow, succeed and thrive a more enticing prospect compared to safer, more reliable, established companies.
Investee company conditions
Following perceived abuse of the schemes, new rules were introduced in 2018. These put in place a two-part condition, which requires the investee company to:
- Intend to grow and develop over the long-term (e.g have plans in place to increase revenue, customer base and number of employees (i.e. an SPV for a specific project would not meet this test)); and
- Not have a significant risk of loss of capital to the investor greater than the net return (risk here is the commercial risk of the company failing in the market), i.e. the company must be highly unlikely not to deliver a return).
In addition, there are a number of other conditions which the investee company must meet to enable investors to benefit:
| SEIS | EIS | VCT | |
| Type of company | Unquoted (can be listed on AIM) | Unquoted (can be listed on AIM) |
The VCT itself must be listed on the London Stock Exchange or on any other EU regulated Market, i.e. not on AIM. At least 70% of the VCT’s investments must be in unquoted companies (can be listed on AIM) |
| Ownership / subsidiaries | The company must not be controlled by another company and must not have any subsidiaries that are not 51% or more subsidiaries | The company must not be a 51% or more subsidiary of any other company and must not have any subsidiaries that are not 51% or more subsidiaries | The VCT itself must not be a close company. Broadly this means that the VCT company must not be controlled by five or fewer shareholders or any number of directors |
| Assets | The company must have no more than £350,000 in gross assets | The company must have gross assets of less than £15 million before the EIS share issue and less than £16 million afterwards | The companies that the VCT invests in must have gross assets of less than £15 million before the VCT share issue and less than £16 million afterwards |
| Employees | The company must have less than 25 employees | The company must have less than 250 employees (500 if the company is “knowledge intensive”) |
Each company that the VCT invests in must have less than 250 employees (500 if the company is “knowledge intensive”) |
| Time limits / restrictions | No previous EIS or VCT investments can have been made. The company must be less than three years old | EIS cannot apply if it has been more than seven years since the company’s first commercial sale (ten years if the company is “knowledge intensive”) | Subject to some exceptions for “follow up investments”, VCTs cannot invest if it has been more than seven years since the target company’s first commercial sale (ten years if the company is “knowledge intensive”) |
| Trade | The company must be trading, not have previously carried out another trade and must not carry out an excluded trade* | The company must be a trading company but must not carry out an excluded trade* | The VCT’s income must derive wholly or mainly from shares or securities. The VCT must distribute by way of dividend at least 85% of its income from shares. No more than 15% of the value of a VCT’s total investments can be in any one company. At least 70% of the companies invested in must be trading companies but must not carry out an excluded trade* |
| Limits | No more than £250,000 per group can be raised in any three-year period (for SEIS to apply as mentioned above the company must not have any subsidiaries that it owns less than 51% of the shares in – this is the group for these purposes) | No more than £5 million per year can be raised from any combination of SEIS, EIS and VCT. No more than a total of £12 million (£20 million if the company is “knowledge intensive”) per group can be raised from any combination of EIS, SEIS and VCT | No more than £5 million per year can be raised from any combination of SEIS, EIS and VCT. No more than a total of £12 million (£20 million if the company is “knowledge intensive”) per group ca be raised from any combination of EIS, SEIS and VCT |
| Location | Must be a UK resident company carrying on a trade in the UK or an overseas company with a UK permanent establishment carrying on a trade | Must be a UK resident company carrying on a trade in the UK or an overseas company with a UK permanent establishment carrying on a trade |
*Carrying out an excluded trade means that more than 20% of the company’s business and excluded trades include:
- dealing in land, commodities, futures, shares, securities or other financial instruments
- dealing in goods other than in the course of an ordinary wholesale or retail distribution trade
- financial activities, such as banking or insurance
- leasing assets for hire
- receiving royalties or licence fees (save for intangible assets)
- legal or accountancy services
- farming / woodlands and timber production
- property development
- nursing home or hotel management or operation
- producing coal or steel
- shipbuilding
- energy generation or supplying or creating fuel
- providing services to a connected person conducting an above trade
Investor conditions
There are also conditions for the investor themselves to meet:
| SEIS | EIS | VCT | |
| Type of shares acquired | Newly issued ordinary shares | Newly issued ordinary shares | Shares in the VCT can be bought on the open market, however second-hand shares will not entitle you to up front income tax relief |
| Payment for shares | Cash only | Cash only | Cash only |
| Tax avoidance | The subscription for the shares of the company must not form part of a scheme or arrangement the main purpose, or one of the main purposes, of which is the avoidance of tax | The subscription for the shares of the company must not form part of a scheme or arrangement the main purpose, or one of the main purposes, of which is the avoidance of tax | |
| Period of ownership to qualify for CGT relief on sale | Three years minimum | Three years minimum | Five years minimum |
| Connection | The investor cannot be an employee of the company or any qualifying subsidiary during the period of three years commencing with the date the shares are issued (a director position is acceptable but compensation must not be excessive). The investor must not have a substantial interest in the company | The investor must not be connected to the company (i.e. either alone or with associates owning or entitled to acquire more than 30% of the share capital, voting power or assets or any subsidiary on a winding up OR being an employee of the company or its group (can be a director but must not receive excessive compensation)) | VCT cannot have more than 15% of its total investments in any one company |
Investor benefits
Provided that these conditions are met, the investor can receive the following benefits:
| SEIS | EIS | VCT | |
| Annual investment upon which investor can obtain tax relief | £200,000 |
£1 million (£2 million if at least £1 million is invested in knowledge intensive companies) |
£200,000 |
| Percentage of investment on which income tax relief can be claimed | 50% | 30% | 30% |
| Income tax relief on dividends? | No | No | Yes |
| CGT relief on initial investment | 50% capped at £100,000 | 100% | N/A |
| Type of CGT relief on initial investment | Deferral | Deferral | N/A |
| Gains exempt from capital gains when investment sold? | Yes, if income tax relief was received | Yes, if income tax relief was received | Yes. The VCT itself is also exempt from corporation tax on chargeable gains |
| Relief for capital losses against income | Yes | Yes | No |
| Inheritance tax (IHT) | Any investment made in a SEIS-qualifying company held at the time of death is exempt from IHT after it has been held for two years | Any investment made in an EIS-qualifying company held at the time of death is exempt from IHT after it has been held for two years | No relief from IHT as holding shares in an investment company |
The capital gains deferral for EIS and SEIS allows an investor to defer their gain from the sale of any asset by spending the proceeds on EIS or SEIS shares. You must make the investment between one calendar year before and three calendar years after you sell the asset.
A bit of maths
An investor sells an unrelated capital asset for £140,000, making £100,000 of profit. Usually, this £100,000 would be subject to CGT. However, he invests the full £100,000 of profit into a company that qualifies for EIS. His CGT on the £100,000 is therefore deferred.
In that year he obtains £30,000 worth of income tax relief. His net investment cost is therefore, £70,000.
If you have any questions around any of the above or wish to discuss your options further, please contact our Tax team who would be delighted to assist.
Disclaimer
This note reflects the law as at 6 November 2023. The circumstances of each case vary and this note should not be relied upon in place of specific legal advice.