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HMRC internal manual

Venture Capital Schemes Manual

Venture Capital Schemes: risk-to-capital condition: an overview of the risk-to-capital condition

Summary of the condition

To ensure it is clear that capital preservation activities do not attract tax relief under the venture capital schemes, a new, overarching ‘risk-to-capital’ condition has been introduced to the EIS, SEIS and VCT scheme by Finance Act 2018.

Investments in companies that are comfortably in line with the stated purpose of the venture capital schemes should meet the risk-to-capital condition.

The risk-to-capital condition is a principles-based condition that depends on taking a ‘reasonable’ view as to whether an investment has been structured to provide a low-risk return for investors. The condition is designed to deter tax planning and there are no hard rules or boundaries that would enable such planning.

A company and the investment must meet the condition before considering whether it meets any other requirement or condition to be a qualifying company under the relevant scheme. The condition works as a gateway to each scheme, to test whether the company is one that meets the underlying policy objective.

There are two parts to the condition, and an investment must meet both parts:

a)  the company in which the investment is made must have objectives to grow and develop over the long term; and

b)  the investment must carry a significant risk that the investor will lose more capital than they gain as a return (including any tax relief).

Whether an investment meets the condition will depend on the facts of each individual case; all relevant circumstances will be taken into account when a decision is made on whether the condition is met.

The new risk-to-capital condition has effect in relation to all investments made on or after 15 March 2018, the date of Royal Assent to the Finance Act 2018.

Purpose

The risk-to-capital condition will ensure that the tax-advantaged venture capital schemes are focused on investment in early-stage companies that have the intention to grow and develop in the longer term.

It will ensure that tax relief is not available for investments that are not within the spirit of the schemes; that is, those where the investee company does not have objectives to grow and develop and/or the investor’s capital is not significantly at risk.

Which investments will qualify

As explained above, investments in companies that are comfortably in line with the stated purpose of the venture capital schemes should meet the risk-to-capital condition.

The risk-to-capital condition is intended to ensure that tax-motivated investments where the tax relief provides a substantial part of the return for an investor, with limited risk to the investor’s capital, will not be eligible for relief. It is companies that offer such low-risk investment opportunities that are most likely to be affected.

How the condition will be applied

The risk-to-capital condition is applied in the same way for the EIS, SEIS and VCT schemes, subject to minor adjustments to take into account the specific scheme structures.

When considering whether both parts of the condition are met, we will look, in the round, at the company and any normal commercial practices within genuinely entrepreneurial companies, the prospective investment and any associated arrangements. We will take into account all factors and context relevant to the company at the time the investment is made; that is, when the shares (or securities, for some VCT investments) are issued.

The legislation contains a non-exhaustive list of the factors that may be considered, and these are set out in more detail further on in this guidance. The factors are not intended to work as a checklist. When determining whether the risk-to-capital condition is met, all these factors will be considered together with any other relevant factors specific to the case, to create an overall picture of the investee company’s growth ambitions and the risk that an investment poses to investors’ capital. Factors to be considered may include third party information and information not disclosed by the company.

Even if one or more indicators of potential capital preservation are present, this does not necessarily mean that the risk-to-capital condition will not be met in a particular case; a judgement about whether capital preservation activity is taking place will depend on the overall context of the investment. Likewise, even if none of the indicators listed in the legislation is present, the risk-to-capital condition may not be met if the wider circumstances of a case suggest that capital preservation is intended. Ultimately, the conclusion will depend on whether the company has genuine intent to grow and develop in the long term and the level of risk posed to investors’ capital.

The condition, and the accompanying guidance, deliberately refrain from setting out any bright lines between a qualifying and non-qualifying company, to deter gaming of the tax-advantaged venture capital schemes by tax planners. A genuinely entrepreneurial growth company and its investors who are taking a real risk in their investment will know the company meets the risk-to-capital condition, and find it straightforward to show it meets this requirement. They are not affected by the condition, whether the company goes on to make a success, or fails.

Investors and promoters actively seeking to reduce risk, for example, by:

  • creating companies themselves
  • ensuring their capital is largely preserved for exit as soon as possible under the rules or in priority to other investors
  • using arrangements to secure a preference or priority over other investors

should assume that the condition will not be met. If they wish to use the schemes in future they will need to change their investment strategies and invest in companies that meet the stated policy intention.

The guidance will be updated from time to time to reflect our experience of the way the condition works in practice.

The risk-to-capital condition sits above the other existing eligibility requirements, operating as a high level gateway to the venture capital schemes. Even if the new condition is met, the company will still need to demonstrate that all other requirements are met for an investment to be eligible for tax relief under the schemes.