Tax incentive schemes to help your business grow and raise capital finance

It could be argued that, in the Autumn of 2023 trying to raise capital to finance emerging companies has never been more challenging. A combination of high interest rates, stubborn inflation, continuing supply chain issues, slow growth, understandably cautious investors and dormant capital markets provides challenges to even the most persevering and persuasive management teams.

During such times in the financial and economic cycle, and with the government’s ‘tax-take’ at historic records, it might be difficult to think of taxation as good news in providing an incentive to encourage investors by partially mitigating risks and potentially increasing the net return. However, the long standing often Venture Capital Trusts (‘VCT’) and the Enterprise Investment Scheme (‘EIS’), that trace their roots to the 1980s, can provide attractive tax incentives to UK tax payers that can make the difference between investment and growth versus stagnation and missed opportunities for many qualifying private and smaller public companies.

What is a Venture Capital Trust (VCT)?

A VCT is a publicly listed investment company that invests in small, unquoted, entrepreneurial companies and helping them grow. As such, private investors that buy shares in a VCT gain exposure to a portfolio of small companies, sometimes based on sectors and sometimes focused on smaller AIM listed companies. The tax relief for investors is attractive in terms of risk mitigation and potentially very generous in the case of significant future capital gains:

• Up to 30% tax relief – save up to £60,000 income tax when they invest in newly issued VCT shares
• Tax-free dividends – no need to declare VCT dividends on a tax return
• Tax-free growth – no Capital Gains Tax on gains
• Generous allowance – invest up to £200,000 per tax year

Funds raised by VCTs in 2022-23 was £1.08 billion, the 2nd highest on record and nearly matching the amount raised in 2021-22 of £1.1M. During 2022-23 VCTs invested £700 million in small private companies and AIM companies, providing much-needed support to the UK’s fast-growing companies.

Changes to tax rules that took effect from 6 April 2023, involving reductions in dividend and capital gains tax allowances, mean that an estimated 230,000 more people are forecast to be paying the top rate of income tax. For many investors there are limited options to invest tax efficiently. This means VCTs, although higher risk, are likely to remain popular with investors seeking exposure to smaller private companies.

What is the Enterprise Investment Scheme (EIS)?

Companies raise funds under the EIS with individual investors, typically high net worth individuals, generally sourced from networks of financial advisors. Again, the government currently offers generous tax reliefs to UK tax residents:

• Investors can reduce their income tax bills up to £300,000 per year (or £600,000 when investing in knowledge-intensive companies (‘KIC’)- broadly speaking, companies carrying out research, development or innovation at the time of the investment.
• Annual allowance of up to £1 million (or £2 million if anything above £1 million is invested in knowledge-intensive companies)
• Capital gains tax exemption on sale
• Defer capital gains from other investments – potentially indefinitely
• Offset future losses, if any, against income tax
• Pass on investment free of IHT
• The attractive nature of EIS for investors is reflected in the fact that in the 2021-22 tax year, 4,480 companies raised £2.3bn, a 39 per cent increase in funding on 2020-21. Of this, 1,755 were new companies, which raised £584mn.

Seed enterprise investment schemes, which are limited to companies with under 25 employees and £350,000 in net assets, raised £205mn, a 16 per cent increase on the previous year. 1,815 companies raised funds under the SEIS 2021-22 for the first time, representing £179mn of investment.

Qualifying companies must, in outline:

• Be unquoted, for this purpose the AIM and Aquis markets are unquoted.
• Have a UK permanent establishment, technically an overseas company with a UK branch might also qualify.
• Not be engaged in an excluded trade, which would exclude amongst others, managing or operating hotels and care homes, many financial services, property development, land trading, franchising, energy generation.
• Not be controlled by another company.
• Not have gross assets of more than £15m, and more than 250 employees.
• Not be older than 7 years, 10 years for a knowledge intensive company (‘KIC’).
• Be held as investments for more than 3 years for EIS and 5 years for VCT tax relief.

Qualifying companies can raise up to £5m under the VCT rules, £10m for KICs, and up to £12m in aggregate under the EIS.

What are the attendant risks?

While these tax reliefs are attractive, potential investors must not lose sight of the facts that:

• They are investing in high-risk businesses
• Tax relief is limited and is always subject to change, both by the investee companies failing to qualify post investment, or through a change in government policy.
• The investments may be difficult to sell
• As such, investors should invest on the back of financial analysis and commercial knowledge, with tax relief as a way to mitigate loss or enhance returns.

Capital Market Implications

The UK, and most other International capital markets have been virtually closed to new issues since November 2021, after what can now be seen as an over-buoyant IPO market in the preceding two years. As an indication, of the £1.14billion raised on AIM in the first 8 months of 2023, only £50m was raised for new issues.

The difficulty in raising finance in capital markets was reflected by the fact that while the total funds raised by VCTs was virtually unchanged in 2022-23, compared with the previous year, AIM VCTs sought only half the amount they raised in 2021/22. Amati AIM VCT did not open a share offer, while Octopus AIM VCTs, Hargreaves Hale and Unicorn raised together £85 million. More recently, Octopus Investments announced in September 2023 that it has opened a new £20 million fundraise for its two Alternative Investment Market (AIM) VCTs. Octopus AIM VCTs feature a range of AIM-listed businesses at different stages of maturity. This allows investors to participate in established portfolios of around 90 AIM-listed companies, and the team continues to add new investments to the portfolio each year.

Companies seeking IPO capital in current markets need to be able to approach as wide an audience of potential investors as possible to have any chance of a successful admission. While having VCT/EIS qualifying status does not guarantee success, it is a significant benefit in allowing an aspiring AIM or AQSE entrant to approach VCTs and HNW individuals seeking to make qualifying investments.

Conclusions

Investors will and should invest on the basis of financial and commercial fundamentals. However, if the net cost of investment can be reduced and the overall potential increased by the receipt of income tax, capital gain tax and inheritance tax benefits, the final investment decision should be weighed more in the recipient company’s favour. Achieving EIS and VCT qualifying status will not guarantee a successful fundraising, and future investment and financing decisions may result in a loss of relief. However, in these uncertain and challenging financial and economic times companies seeking new equity should explore the potential benefits that achieving EIS and VCT qualifying status could provide.

A first step in this process would be to review and assess the corporate structure, the current and planned trading activities, the use of funds, and to then seek advance assurance