Satwaki Chanda discusses the new risk-to-capital rules introduced by Finance Act 2018.
What is the new risk-to-capital condition about?
The risk-to-capital condition (‘RTC condition’) is a new condition designed to ensure that companies raising finance under the EIS and other venture capital schemes are involved in activities which carry a genuine risk to investors. This chimes in with the general purpose of the schemes, which is to support growing businesses.
The RTC condition must be satisfied at the time the investment is made. There are two aspects to this condition:
- the company must have the objective to grow and develop its trade in the long term; and
- the investor must face a significant risk of loss to his capital.
But how does one judge whether the condition is satisfied? The legislation prescribes a number of factors to be taken into account, supplemented by HMRC guidance (currently in draft form at VCM8500 – VCM8560). The main theme running throughout the guidance is that the RTC condition is targeted at investments that provide investors a degree of protection when committing their funds.
The following factors indicate that investment risk is being mitigated:
- The company already has a source of income in place when the shares are issued
- This is standard practice in the film industry, where production companies normally secure distribution contracts before raising finance. However, HMRC do not object if a source of income is secured after the investment is made.
- The company’s business is asset-backed
- This is common in businesses such as pubs and garden centres. The premises from which the company operates may have significant value. If the business fails, investors can recoup their losses by selling the property.
- The company subcontracts its activities
- There is nothing wrong with subcontracting certain activities where a company does not have its own in-house expertise. However, certain subcontracting arrangements may indicate that the trade is really being carried on by others.
- The business is operated by a special purpose vehicle (‘SPV’)
- An SPV is normally established to deliver a set return to investors by a fixed date, after which it is wound up (see Example). However, it is acceptable to incorporate a new company within an existing group structure if this is standard practice.
The company is controlled by the promoters in charge of raising the funds
By controlling the business, the promoters may be in a position to engineer a safe return to investors within a certain date (see Example).
Example:
A company raises EIS funds which are used to construct a building from which the trade is to be carried out by subcontractors. After three years, the building is sold, the company wound up and the proceeds distributed tax-free to the shareholders.
The RTC condition is unlikely to be met:
- the trade is asset-backed – the investors’ return comes from the sale of the building;
- in substance, it is the subcontractors’ trade not the company’s. Where does the trade go when the building is sold? Do the subcontractors continue the business from other premises?
- note the use of an SPV which is wound up after the building is sold;
- the sale is timed to ensure that investors enjoy a tax-free return – EIS reliefs cannot be clawed back after three years; or
- who decided to sell up after three years? (Hint: ask the promoters!)
Where is the risk in this venture? This is in substance, a land deal, which is prohibited under EIS rules.
Practical Tip:
The RTC condition was supposed to apply from 6 April 2018 but has yet to receive clearance under EU state aid rules. However, since 4 December 2017 HMRC has refused to provide advance assurance if a fundraising is likely to fail the condition. To be on the safe side, companies raising venture capital funds should also operate on the basis that the rules already apply.
