It could be going, so invest in other companies while you can!
Readers will be familiar with the concept of government encouragement for individuals who invest in unquoted, risk-taking trading companies. In recent issues of Finance Confidential, we have looked at the Enterprise Investment Scheme (EIS) and at Venture Capital Trusts, both of which provide tax breaks to individuals who invest in them.
Rather less well-known is the Corporate Venturing Scheme (CVS). This scheme enables the kinds of tax reliefs available to individuals under EIS to be enjoyed by corporate investors. But with a good number of subtle differences, of course.
Two things are now happening to the CVS:
1. This year’s Finance Act includes some tinkering to the rules. And not very helpful tinkering at that – the scope for making “investments with tax relief” has now been narrowed.
2. Worse still, when CVS was first introduced at the turn of the century, it was given a finite shelf-life. It was a 10-year shelf-life to be exact which is due to expire in just over three years’ time (on 31 March 2010). And any hopes that it might be extended beyond that date now look fairly slim – for the present at least. That’s because, as we indicated at 1 above, the Government appear to be in no mood to expand the scheme. In fact, quite the opposite.
So if your company wants to take advantage of the tax breaks on offer here, now is the time to do it. They won’t be around for too much longer!
The tax breaks you can get under CVS
This month we shall look in some detail at CVS in the current, post-Finance Act 2006 climate. We shall explain how the various tax breaks might be secured – and how, once they are secured, care must be taken to avoid them being clawed back by the Revenue.
So if your company has some spare funds and is looking for a suitable investment – or simply wants to reduce its corporation tax bill – how might the Government’s CVS initiative help? There are two principal types of tax relief on offer:
1. Corporation tax relief, against your company’s profits, for certain kinds of new investments made, and
2. Looking ahead, if a capital loss is ultimately made on the investment, relief against your company’s income profits (should you so choose) for that loss.
(There’s a third strand to the relief – a deferral of the tax payable on certain capital gains which your company may have realised. But the scope of this strand is very limited, so we shall not dwell on it here.)
The purpose of our article is to show readers what their companies can – and cannot – achieve through CVS over the next three years or so. Needless to say, we shall come up with a good sprinkling of tax planning points along the way.
Here’s the first of our 20 questions. (And answers.)
Q1. What must my company do to qualify for CVS relief?
It must subscribe for ordinary shares in an unquoted trading company. And that company must carry on a “qualifying trade” . Note the phrase “must subscribe for”: the shares must be new shares issued to your company. Shares bought from another shareholder do not qualify.
Q2. How much tax relief is available?
Tax relief, known as CVS investment relief, is given at the rate of 20%. This is so, no matter what rate of corporation tax your company pays. In other words, the corporation tax liability is simply reduced by an amount equal to 20% of the subscription price for the shares. However, if this amount exceeds the corporation tax payable, the relief is restricted accordingly. The tax liability can be reduced to £nil but no more. Equally, there is no facility to carry any unused relief forward or backwards to other accounting periods.
Of course, for many companies – companies with annual profits of no more than £300,000 – profits are taxed at the small companies rate of 19%, and not at 20%. Nonetheless, as we have indicated, relief for the CVS investment will be given in full at 20%, provided this doesn’t do more than wipe out the corporation tax bill. So in practice, this 1% differential is usually of little consequence.
However, sometimes a much greater problem can arise. In order not to waste any of your company’s investment relief, it is vital that the investment is timed to take place in an accounting period which can absorb it in full. For this purpose, what counts is the date on which the shares are issued.
The problem here is that the investment often will be made before the corporation tax liability is known. Sometimes, then, it will transpire that the potential liability is insufficient to absorb all of the CVS investment relief. This results in desperate eleventhhour attempts, every now and then, by companies to increase their taxable profits for a particular year. This might be achieved, for example, by forgoing capital allowances.
Perverse.
Q3. Must the relief be claimed?
Yes. But you cannot lodge the claim until the target company (that is, the company in which your company has invested) has been trading for at least four months. Nor until you have received a certificate from that company to the effect that the investment qualifies for CVS relief. Subject to that, the claim will normally be made on your company’s annual corporation tax return.
Q4. Is there a minimum level of investment?
No. For individuals making an EIS investment, a minimum of £500 must normally be subscribed. But there is no equivalent rule for CVS investments.
Q5. Or a maximum?
Indirectly, yes. For EIS, a maximum of £400,000 is stipulated, but this limit is not carried through to the CVS regime for companies. However, there is a restriction on
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the size of the company in which your company has invested; and also on
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the proportion of its share capital; which your company can own.
For these reasons, the amount of investment which can qualify for CVS relief is not unlimited.
Q6. So, how large can the company be?
There is a ceiling on the value of the gross assets of the target company. And this is where the “unhelpful tinkering” adjustment in this year’s Finance Act bites. The gross assets must not exceed £7m immediately before the issue of the shares to your company, nor exceed £8m immediately afterwards. This represents a halving of the earlier ceiling! So perhaps “tinkering” is too mild a description.
Q7. And how much of it can my company own?
Not more than 30%. And, needless to say, when looking at the 30% limit the shareholdings of any connected parties are added in.
Q8. Any restrictions on the remaining 70%?
Yes, the 70% (or more) of the target company which will be owned by shareholders other than your company
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must not be held to the extent of more than 50% by another company (that is, the target company must not be controlled by another company); and
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must be owned, to the extent of at least 20%, by “independent” individuals.
Here, an “independent” individual is someone who is wholly unconnected with your company (for example, he/she must not be a director or employee of your company, nor a relative of any such person). The purpose of this requirement, of course, is to ensure that the investing company really is putting money into “someone else’s business”.
Q9. What sort of business must the target company carry on?
As mentioned in Q1, the company must be a trading company. (Or the holding company of a trading group.)
But that is not enough. Just like EIS, there’s a long list of activities which fail to qualify. These include, for example
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money-lending, land-dealing, farming, property development, market gardening and operating or managing hotels, guest houses or residential care (nursing) homes.
And, perhaps strangely, accountancy and legal services!
But an investment in a company which conducts a conventional kind of business in (say) manufacturing, or in retail or wholesale distribution, will normally qualify.
Q10. What if the company does some of its business abroad?
It all depends on how much. An investment qualifies for CVS relief only if the target company carries on its trade (and we quote) “wholly or mainly in the United Kingdom”. That’s too brief a definition to be much help and, happily, the Revenue have published a statement giving some hints on how this vital phrase will be interpreted in practice.
Here are some of the factors which they will take into account when seeking to identify the principal location of a company’s business. They will look at
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where the company’s employees normally carry out their duties, and
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where the company’s capital assets (buildings, machinery and the like) are located, and
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where the buying and selling is done (and, when appropriate, where the manufacturing is carried out).
After considering factors such as these, the Revenue will form an impression about the totality of the activities of the trade. And, if more than one-half of these activities takes place in the UK, then the company will be within CVS.
Q11. How long must my company hold on to its investment?
Three years. If the shares are disposed of in a shorter period, there will be a clawback of relief. But if a loss is made on the disposal, there will be only partial clawback.
Example: Your company subscribed £50,000 for 50,000 shares in the target company. CVS relief (at 20%) of £10,000 was obtained and the corporation tax bill was reduced accordingly. After two years, your company decides to dispose of its CVS shares for £30,000. So the CVS clawback will be £6,000 (20% of £30,000) not the full £10,000. Which is fair and proportionate.
Clearly, unless investment considerations dictate otherwise, your company should try to hold on to its CVS shares for another year. Once the three-year period is up, the shares can be sold free of clawback – saving, in our above example, £6,000. (But is the value of the CVS shares likely to fall by more than this amount in year 3?)
It follows that if things turn really sour, and the target company folds even before the three-year period is up, with nothing for the shareholders, then the relief secured at the outset will continue to be retained.
Q12. What if the business of the company changes?
At Q9, we explained that only certain types of business carried on by the target company qualify. It must of course carry on the kind of trade which is smiled upon at the outset, but for how much longer must it continue to do so?
Again, the answer is: three years.
There is an inherent problem here. How can you be certain that the company won’t change its activities and thus lose its CVS status within the three-year period?
You can’t, of course. You can look for statements of intent. And you can obtain assurances from the directors. Maybe even indemnities. But you can’t get an absolute guarantee that the company will retain its CVS status.
Could you perhaps limit the risk to some degree if, instead of just seeking assurances from the directors, you were to become one yourself?
Q13. Could I be a paid director?
Yes you could. There’s nothing in the legislation to prevent you becoming a director of the target company. And, provided that nothing more than a “reasonable” amount is paid for services rendered, then that’s fine too.
So, reasonable payments to your company for providing management services (including your services as a director) – or, indeed, reasonable director’s fees to you personally – are perfectly acceptable.
Q14. What if the target company becomes quoted?
We said at Q1 that the target company must be unquoted. (And here, companies on the alternative investment market – AIM – are treated favourably: they do qualify for CVS.) But what if it starts unquoted, but before three years elapse, it is floated on the stock exchange? (We explained, at Q11 and Q12, that CVS relief can often be withdrawn during the first three years.)
Fortunately, the answer here is a positive one: provided that the company is unquoted at the time the CVS shares are issued, it does not matter if things go really well and it subsequently becomes a quoted company. However, no arrangements for a floatation must exist when the shares are issued.
Q15. What if my company is quoted?
That’s fine. The investing company may be quoted or unquoted. And, unlike the target company (see Q6), it can be of any size.
However, there is one important restriction: it must not carry on a “financial trade”. This means moneylending, debt factoring, finance leasing, hire purchase financing, insurance, share dealing and the like. But, unlike the target company (see Q9), here accountancy and law are not banned!
Q16. What if, in the end, the CVS shares are sold at a loss?
We have already explained that, if your company sells its shares in the target company within three years, then there will be a clawback of CVS relief (see Q11). And we have shown how, if a loss is made, the amount of the clawback is restricted. But what of a sale at a loss after three years are up?
Clearly, in these circumstances, there will be no clawback. But what about the calculation of the capital loss?
Not surprisingly, the CVS relief received will be taken into account when working out the amount of the allowable loss.
Example (revisited): Your company subscribed £50,000 for its CVS shares and received tax relief of £10,000. After four years, your company disposes of the shares for £30,000. Accordingly, the capital loss made on the shares is (£50,000 less £30,000) £20,000. But in making the tax calculation, the cost figure (£50,000) must be reduced by the £10,000 tax relief received, to £40,000. Thus the amount of the taxallowable loss is only (£40,000 less £30,000) £10,000.
This £10,000 capital loss can, of course, be relieved in the usual way, namely against capital gains made by your company in the same year, or made in future years. But this facility may be of little value, as many companies realise capital gains only occasionally.
This is where the very useful relief mentioned earlier on page 2 (at point 2) comes into play. It is possible for the capital loss to be set against your company’s income profits for the year in which that loss is realised. And/or it can be set against your company’s income profits of the previous year.
As we said, this is a very valuable facility – especially the ability to carry back the loss for one year, so as to receive the tax relief with minimal delay.
As a rule, of course, a capital loss (treated as such) cannot be carried back: but here a capital loss, treated as income, can be. A major improvement.
Q17. And if there’s a profit?
If your company sells its CVS shares at a profit, then the gain is taxable. (This compares unfavourably with EIS regime: there, if the shares are retained for at least three years, any profit is completely tax-free.) However, to look on the bright side, in calculating the amount of the taxable gain:
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the 20% CVS relief is ignored – so, in our example at Q16, the disposal proceeds must amount to more than £50,000 (and not more than £40,000) before there is any prospect of a tax liability arising; and
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the indexation allowance, which has been abolished for individuals in favour of taper relief, is still available to companies.
So, although a complete tax exemption would of course be preferable, all in all it’s not too bad.
Q18. Are there any anti-avoidance provisions?
You bet! The headings include:
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no receipt of value
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no reciprocal agreements
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requirements regarding the use of money raised (only “insignificant” amounts may be used for nonqualifying purposes)
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no pre-arranged exits or investor protection.
To name but a few.
Q19. So, can advance clearance be obtained?
Clearly, CVS is riddled with complications and restrictions. So, a company seeking an injection of venture capital under this scheme will want to ensure that it complies with all the rules. (So will your company, as a potential investor!)
A company looking for funds can apply to the Revenue’s “Small Company Enterprise Centre” for advance confirmation that it qualifies for CVS. If satisfied, they will authorise the company to issue a “compliance certificate” to investing companies.
The advance clearance notice from the Revenue, needless to say, comes with a health warning. The notice will confirm that they:
“consider that the conditions for relief under the scheme, other than those applying to the investor (see, for example, Q15), will be met in relation to the proposed issue of shares at the time the issue is made. In the case of those conditions which have to be met throughout a qualification period (such as the threeyear period mentioned at Q12), however, there can of course be no certainty until after the end of that period that they will be met.”
So advance clearance is of considerable comfort and, in practice, is generally a prerequisite for attracting CVS funds. But, as indicated at Q12, the bottom line for an investing company is: you pay your money and you take the risk.
Q20. What about taper relief?
To bring the article to a close, we go off at something of a tangent. Here, we are not looking at the mechanics of CVS as such, but at how a CVS investment by your company could possibly impinge on you personally – and, in particular, how it might affect your personal tax liabilities at some time in the future.
Our concern here is capital gains tax (CGT) taper relief. If your company is a trading company, you will become entitled to taper relief of 75% on your shares after two years. You will not want your company’s CVS investment to prejudice that.
The Revenue have come up with some reassuring words here:
“The holding of (CVS) investments will not have any bearing on a company’s status as a trading company for taper relief purposes...”
Thank goodness for that. But wait, there’s more.
“...unless, together with other non-trading purposes, it is capable of having a substantial effect on the extent of the company’s activities.”
Not so reassuring after all. The CVS investment by your company could have the calamitous side-effect of converting your shareholding from a business asset to a non-business asset (maximum relief: 40% after 10 years, rather than 75% after two). And “substantial” here means, as readers may recall, to the extent of more than 20%.
So finally... ...
a note of caution here to would-be investing companies. Don’t overdo it. Keep well within this 20% limit. Otherwise the shareholders’ CGT bills could unnecessarily rocket when they come to sell up; the tax savings from CVS investments could be eaten up – and more – by the loss of taper relief!
Alan Rook is a chartered accountant who has been writing on tax matters for over 15 years.
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