Real Risk of a Tax Epidemic!
Get vaccinated or risk the consequences!
By Modwenna Rees-Mogg, AngelNews
Have you ever looked in detail at all the rules surrounding EIS (Enterprise Investment Scheme) investing? Just to give you a bit of a fright, try looking at the Index Venture Capital Schemes Manual on the HMRC website - You will quickly see that there are over 100 web pages devoted to the different rules and regulations. In fact there are 54 pages devoted to EIS deferral relief: shares issued on or after 6 April 1998 alone!
Understanding EIS in depth is not a job for the fainthearted. From time to time I get emails or calls from investors especially about different aspects of EIS. More often than not the best thing I can do is to refer the enquirer onto someone who knows better than I what the answer might be as I am no expert on the detail of the subject. It seems a good time to write about the issue given what I learnt from my friends at Crowe Clark Whitehill the other day.
EIS is an interesting beast. Even in the doom of 2008/9, £500m odd was invested under the Scheme and in good years this can rise to £700m+. And the number of companies backed under the Scheme each year is typically over 1,000 with 20,000-30,000 individual subscriptions being made. To my mind that is an awful lot of people who probably should, but most likely don’t, know the minutiae of the rules and the risks they are facing about their claims. Add to that the time that individuals are involved in an EIS investment. You have to hold shares under EIS for three years to guarantee that you will get the relief. That ‘s 36 months of making sure that not a single slip up is made that could cause the relief to be revoked, usually at a time when investors, at best, have little control over potential breaches and, at worst, have none at all. Let alone the poor old EIS company itself, busy succeeding commercially, only to find that it is doing so in a way that may be inadvertently causing an EIS rule to be broken!
Most investors are pretty sanguine about EIS in my experience. After all their EIS investments will make up a tiny proportion of their overall wealth and “there are so many other risks aren’t there……?”, but it still surprises me how many don’t realise that HMRC will investigate EIS claims and will challenge them. It’s by no means certain that just because you claim EIS in one year, you are on a home run.
If you are part of the management team of an EIS company, do you know the rules in detail? Even if you do, surely you want to run your business, not spend your time worrying about looking after the tax breaks your investors have won from investing in you? What entrepreneur wants to be an expert in EIS when they may only be involved in 1 or 2 EIS businesses in their lifetime? “And anyway, I’ve got the investment now, even if EIS is breached, the investors can’t take it away from me, so do I really need to worry if the Taxman wants to speak to them?”
I am sure no entrepreneur wants to be wondering if their latest bit of expansion abroad or the new office they want to fill with people will cause their investors to break the EIS rules, but it is something that should concern them. Many savvy shareholders will now put clauses in shareholder agreements that penalise the entrepreneurs if EIS is broken. The penalties can be nasty. And anyway, what individual wants to end up in a situation where what they thought was best for the business, and by default, for the investors, had led to a load of angry calls from shareholders who have just had to write a cheque back to the HMRC and, worst still, hold an awkward conversation about their own tax affairs.
The 50% income tax rate has caused a sea change in UK. I cannot think of any 50% tax payer I know who isn’t now thinking hard about how to reduce their tax bill. I am not suggesting they want to evade it, but they sure as hell want to avoid paying tax unnecessarily, if they can. As there are so few legitimate and approved ways of mitigating tax in the UK today, inevitably they are being pointed towards VCTs and EIS. After all, HMRC seems to recognise that VCTs and EIS are mainstream. I mean, there are even special boxes on the online tax return, for goodness sake!
In this context you would have thought that investing under EIS/VCTs should just be a case of filling in the forms and then going back to sleep. Sadly, this is no longer the case. The VCT industry largely looks after the tax breach issue for its shareholders. A typical VCT will have comprehensive systems of checks and balances in place to make sure they stick within the rules. They wisely employ accountants to make sure that everything is in order at all times. It is one of those small costs that is worth its weight in gold to the VCT shareholders.
In EIS land, there are all sorts of permutations of investing going on — from individual investments to various types of funds. The deals are typically small and little time and effort is often given by those responsible for making sure that the rules are adhered to. Investors often don’t fully appreciate that it is really only they who will suffer if the rules are breached. Different parties in a deal may not care as much about EIS as the EIS investors themselves. Of course this issue does not apply to the larger EIS fund managers such as Oxford Capital Partners, but for other EIS deals, especially individual investments, this lack of attention to the small print is placing many of the EIS approvals in jeopardy.
Although EIS investment has fallen considerably since the boom times of the mid noughties, this doesn’t mean that HMRC has stopped looking at it. In fact, the reverse is now true. With the Coalition Government pushing them hard to collect whatever taxes they can to repay the Deficit, rumour has it that HMRC has opened a new channel of tax investigation, namely 50% income tax payers and especially those taking advantage of EIS. And of course, we are helping them do it by laying out our investments in those annual tax returns we have to submit.
I went in to see my friends at Crowe Clark Whitehill the other day to talk to them about the issue.
Was it true? Yes, they said.
HMRC has now adopted a very active and very real policy of targeting the tax returns of 50% income tax payers to look for signs of tax evasion, as announced in Danny Alexander’s speech to the Lib Dem conference in September 2010. That, inevitably, means that their EIS applications are being scrutinised. The worry is that it may not stop there. They think that HMRC will start looking harder at whether the investee company has and still is complying with the rules. After all, what better result for a tax inspector, than to find that one company has breached the rules and then writing a letter to ALL of the investors asking for their EIS tax relief back? “And after that, surely, I can reasonably start a little investigation into each of those investors too!” an enthusiastic young tax inspector might just start thinking.
What the Crowe Clark Whitehill team told me sent shivers up my spine. I can see a world where one innocent cock-up by one EIS company could unravel into dozens and dozens of investigations, an unexpected fillip to the HM Treasury’s coffers in 2011/12 and some very unhappy investors and entrepreneurs; and woe betide the poor individual or company who sets the whole thing off.
It was good to catch up with Tim Norkett and Tom Elliott at Crowe Clark Whitehill. I used to know the firm as Horwath Clark Whitehill, but they underwent a name change late last year, to reflect their international reach. Many of you will already know Tim who is a regular in the London angel world and Tom who covers the Northern region. They are both straight-talking men who don’t try to wow you with technical mumbo jumbo. More importantly they both “get” the inter-relationship between high net worth investors and their venture investment activity, understanding that it is a lot more complex than just making financial returns. They also “get” EIS and more importantly always have an ear cocked towards HMRC’s walls. And they understand that no-one likes to have to return a cheque the Taxman has sent them, especially if it was not their fault. This visit they introduced me to their colleague Fiona Hotston Moore who is definitely cut of the same cloth, although her team focuses on advising firms that want to set up funds including EIS. With clients such as Invicta Capital and Scion Capital Partners, she and her team are known to be at the top of the league in terms of the creation of fund structures that work.
“Well, I know a bit about it because I started helping Future Capital in 2002 and have set up about 50 Collective Investment Funds Since then,” she told me, definitely underselling her expertise. That’s accountants for you! When did you last meet an accountant, especially one that works on tax mitigation, who boasted?! But Fiona is a stellar accountant — indeed she was Accountant of the Year in the Women in the City Awards 2007 and most recently listed in the Top 25 of the Financial Power List 2011. When she speaks you listen.
As I chatted to Tim, Tom and Fiona I got a real sense that they are concerned about the approach many investors take to their EIS investments. They know that no-one ever wants to pay for advice on risks that they see as minimal, but it’s clear that they think that HMRC really is going to come after the EIS market in its hunger for tax. They feel that many SMEs with EIS backing probably don’t have the EIS expertise either in-house or amongst their current auditors to deal with the challenges HMRC might throw at them; neither do their investors. They have asked me to get the message out that it is “ok” and (more importantly for some) cost effective to use a firm like theirs to do specialist EIS audits, without fear that you need to hand over everything to them. Indeed, they already get referrals from other accountancy practices which don’t have the specialist expertise themselves to do this sort of work. “Just suggest to the entrepreneurs or investors you know that they give us a quick call, so we can see if there is an obvious problem. If there is we can talk about it, but we do have a lot of expertise in this area and have a reputation for taking problems away from clients.”
Tim told me. I asked them what investors should do to protect themselves in the meantime. Tom responded, “Whether you are invested under EIS directly or via an EIS fund it would be wise to make sure you are getting up to date reports from your investee company regularly, so that you can spot if its activities are likely to cause an EIS breach. Then you have a chance to act quickly and avert a problem. “It’s also worth knowing the broad rules. And remember they can be broken for reasons completely outside your control. If you are a minority investor, changes to the shareholder base or the actions the majority shareholders take can be outside your control, but can and do affect your own EIS status. One of my “favourites” is where the timing of the receipt of funds does not precisely coincide with the issue of the EIS shares.
Funds received too early can be categorised as loans which do not qualify for the relief when capitalised into shares; funds received too late mean that the shares are not fully paid up when issued. Commercially, if the funds are received within say a week of the shares being issued, it makes no difference but the Revenue are increasingly checking the minutiae to find a reason to deny relief.” Tim chipped in. “Make sure you tell them to get all their paperwork in order; to get hold of their EIS certificates, keep them safe and have them to hand if the Taxman calls. Lots of companies are tardy about getting certificates to investors, but legally you must have them to file your return.”
Fiona also mentioned that investors need to stay closely in touch with their EIS Fund Managers. “Although I specialise in creating Funds, one of the things I notice about the Funds that investors love the most, is that they are the ones that have the best communications record. The best managers repeatedly raise new cash from existing and fresh investors, not just because they have the most cleverly structured fund from a tax point of view (though that always helps), but because they communicate most effectively with their investors. And they can’t do this if they don’t have a deep channel with the entrepreneurs they have backed.” “Funnily enough, when there is a problem with EIS, and even the best fund managers can face something unforeseen, if the communications are good, the investors tend not to mind so much. In fact, they will often roll the money back into a new deal with the fund manager to pick up the EIS relief again.”
Did the team know anything about what the Treasury are thinking of changes to the EIS rules? There are worries in the market about some people pushing the boundaries of EIS. The investments, whether made directly or via a fund are about risk capital, they told me. They think the first big attacks, if made, will be on deals or funds which fit within the letter of the rules, but are really hidden asset backed deals. “Too many of these” said Tim “and it will be like the final days of the Business Expansion Scheme, when everyone thought they could get away with just one more seat of the pants deal, only to find the Revenue closed the Scheme down.”
“It’s worth taking a look at your investments or funds in this context,” Fiona told me, “and having a word with any of us if you are worried, as it might be possible for us to do something.”
“What makes me most disappointed”, said Tom “is that in the old days you could get pick up the ‘phone and have a sensible conversation the Tax Inspector, especially for something that was a bit novel. If you inadvertently broke a rule but not the spirit, there was time for a chat. But now HMRC is totally focused on stopping you rather than enabling you and on getting its money back, if you get it wrong. This change of attitude is hardly going to be helpful to UK enterprise if it puts people off investing at a time when angels and EIS Funds are, for many, the only source of early stage capital around. “But it’s made our job quite clear. We must make sure that no entrepreneur or investor suffers at the hands of the Taxman because of EIS - either before or after the fact. And that is going to be fun!”
If you want to find out more about Crowe Clark Whitehill, or would like to talk to Tim, Tom or Fiona, please contact:
Telephone: +44 (20) 7842 7100
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