Apr 222015


This article was written shortly before the Summer Budget of 2015. Since then, some of the measures have been modified and are now enacted in F(No 2)A 2015, together with the introduction of a new blanket prohibition on using the funds raised to acquire shares in another company. For VCTs this puts a damper on the practice of raising money to finance management buy-outs.

One of the announcements made during Budget 2015 was a series of measures aimed at tweaking the Venture Capital Schemes so that they are in line with EU State Aid rules.

There are four Venture Capital Schemes, though the rule changes affect just two of them, the Enterprise Investment Scheme (“EIS”), and the Venture Capital Trust Scheme (“VCT”). The other two schemes are the Seed Enterprise Investment Scheme (“SEIS”) and the Social investment Tax Relief Scheme (“SITR”) introduced last year.

All four schemes have tax incentives for investors and are also known as risk capital schemes. Why risk capital? Simple. The purpose of the schemes is to provide funding to companies that are in the early stages of the business cycle – the associated risk is the price that investors pay in return for the tax breaks on offer.

The new rules are targeted at the company that is to receive the funding – in the VCT’s case, the securities issued by this company will constitute a qualifying holding, which makes up the riskier part of the investment portfolio. The common theme around most of the changes is that there is a perceptible shift in emphasis towards new, relatively untried ventures that are involved in the fields of technological innovation

Bizarrely, while the changes are effective from 6 April 2015, the new rules aren’t actually on the statute book. There’s a good reason for this, as we shall see below.

The European angle

The reason for these changes is to ensure that both EIS and VCT schemes comply with EU State Aid rules, which have been recently amended1.

“The changes announced at Budget maintain the approach set out in the new State aid rules, requiring risk finance aid to be limited to companies that are relatively unproven by reference to the age of the company after its first commercial sale, and capping the total amount of risk finance investment a company may receive. The changes provide particular support to innovative companies that often require more finance to develop and may take more time to reach a sustainable growth path, and also smooth the interactions between the venture capital schemes.”

And indeed, this approach is reflected in the new rules.

What is peculiar in this case, is that the new rules have yet to be implemented – although they were announced during the recent Budget, they weren’t included in Finance Act 2015. But when they do come into force, they will be backdated to April 2015. The reason for this state of affairs is that the Government doesn’t want to get it wrong:

  • On the one hand, UK domestic legislation does need to be modified in line with the purpose of the new State Aid rules; however
  • Legislating now carries the risk of falling foul of the new State Aid rules. For the Government has actually gone beyond the minimum requirements set out in the new EU definition2:

“…the limits that the government has proposed are higher than the basic limits set out in the new EU risk finance framework…”

So they need to secure approval from the EU first.

What do the new rules say?

As stated previously, the shift is towards new, relatively untried ventures, with innovation being at the heart of the business3:

  • The new rules will require that all investments are made for the purpose of business growth and development;
  • The businesses receiving investment funds must be relatively new. The “newness” is determined by reference to the time of the company’s first commercial sale. This must have taken place within the previous 12 years – however, this rule does not apply in the case of a follow on investment, or where the total investment represents more than 50% of annual turnover averaged over the preceding 5 years;
  • For knowledge intensive companies the maximum number of employees is increased from 249 to 499;
  • A new lifetime cap on the total amount of funding that a company can receive from the various risk capital schemes. This is set at £15m but knowledge intensive companies are given special treatment with a cap of £20 million;
  • A removal of the requirement that if a company has received SEIS funding, at least 70% of the money must have been invested before EIS or VCT funding can be raised. This is a welcome change as it gives small businesses greater flexibility in their choice of funding;
  • For EIS only, a requirement that investors are independent from the company at the time of the first share issue (excluding founder shares).

As we all know by now, the legislation is not the simplest in the world. So for those readers curious to see where it is, the following table is available to download.

We shall now take a look at some of the points mentioned above. (Statutory references include the amendments that will be made by the draft legislation once the latter is enacted.)

Knowledge Intensive Companies (“KICs”)

Knowledge Intensive Companies – or KICs as we shall call them – are a new concept, so we might as well get used to them right now. There are two main conditions that a company must satisfy4:

  • A certain proportion of the company’s operating costs must have been devoted to R&D or innovation, during the three year period prior to receiving the EIS/VCT funding;
  • The company is either engaged in innovation – creating new intellectual property (“IP”) – or the number of skilled employees is 20% of the total number of employees.

Where the company is part of a group, these conditions extend to the whole group, treating the latter as a single economic unit.

The operating costs condition requires a minimum of 10% of the operating costs to be spent on R&D/innovation for each of the three years. If this condition cannot be achieved, it is sufficient if in at least one of those three years, the proportion was 15%5.

For the innovation condition, the IP requirement is that the company’s work involves the creation of IP rights where the end use will form the greater part of the company’s business. Furthermore, it should be reasonable to assume that the product will be commercialised within 12 years6.

If the company is not innovating, it needs to satisfy the skilled employee condition7. There are rules for taking into account whether the employees are working full time or part time. A person is skilled if he has an appropriate higher education qualification and is working on the R&D/innovative work that will one day make everyone rich beyond their wildest dreams8.

Note the other change regarding KICs and the number of employees. The maximum number is increased to 499 for KICs, so the idea is that the extra employees permitted by the legislation will enable the company to hire more boffins9.

The first commercial sale must have taken place within the last 12 years

In other words, companies that are less mature are being favoured here. The phrase “first commercial sale” has a specific meaning which is taken from the EU Guidelines on State Aid10. There are two exceptions to this rule11:

  • When the investment is a follow on investment – the original investment having been made within the relevant 12 year time period;
  • The total amount of the company’s risk capital investments within a period of 30 consecutive days, represents more than 50% of annual turnover averaged over the preceding 5 years. The 30 consecutive days means any 30 day period which includes the date of the relevant EIS/VCT funding that the company is seeking to raise.

What could the second exception possibly mean?

It is really aimed at those companies that are more mature in terms of age, but where it has been decided to start a new venture, with the original business being gradually wound down. Note that for a company with a mature business, the annual turnover test is likely to be a high barrier to surmount – it is more likely to be satisfied by those companies that, while they have been around for a while, have effectively returned to “start-up” mode.

The commercial sale rules extend to the company’s 90% subsidiaries12. This is to prevent older companies from arranging to incorporate a new parent which issues the shares and arranges to pass on the money.

First commercial sale 90 per cent subsidiaries

Investment limits – the lifetime cap

We already have in place an annual cap of £2m both for EIS and VCT schemes. When the company is raising funds, the amount is limited by the total amount of funding that it has already received from the various risk capital schemes in the previous 12 months. The £2m figure includes the funding that the company is seeking to raise by its latest share issue13.

Funding from risk capital schemes includes14:

  • Investments from VCTs;
  • SEIS/EIS funding;
  • SITR funding15;
  • Any other investment that constitutes State Aid under the “European Commission’s Guidelines on State aid to promote risk finance investment”16.

We now have a lifetime limit in addition to the annual limit.

The total amount of investments a company can raise from the various risk capital schemes must not exceed £15m or £20m, depending on whether or not the company is a KIC17. The figure also includes risk capital funding received by any subsidiary of the company – all subsidiaries, past and present18. So investors have another set of questions to ask the company before giving up their hard earned cash:

  • How much money have you raised in the past through the various risk capital schemes?
  • How much money have your subsidiaries raised?
  • What about subsidiaries past? Did they ever raise money through the risk capital schemes? Not just when they happened to be your subsidiary, but both before and afterwards? Do you still have a record of who they were?

The last question is going to lead to a lot of fun. (“I’m sorry but we no longer have a forwarding address for this company.”).

What is the position if a venture capital investment is made in a company which satisfies all the conditions, but a subsequent fundraising causes a breach of the lifetime limit? How does this impact the original investment? The original investors were well within the limit when they made their subscriptions – are they penalised for the later breach, even though it may have been caused by someone else?

This is where we see a divergence in the treatment between EIS and VCT investors. For the VCT, its holding is immediately tainted – it can no longer be a qualifying investment and therefore, the VCT will need to consider whether this impacts the balance of the qualifying holdings in its investment portfolio19. Recall that the qualifying investments must make up 70% by value of the overall portfolio20.

On the other hand, EIS investors are safe, provided that the “bad” investment is made at least three years after they subscribed for their shares – in other words, when the upfront tax relief can’t be clawed back. However, a bad investment made within the three year period does taint the EIS holding and all the reliefs that go with it21.


The Draft legislation and Explanatory Notes can be found at the GOV.UK site here.

You can also download the table that I have produced, showing a summary of changes together with the relevant legislation.

Happy reading!

A modified version of this article has been published by Which Investment Trust.


  1. Draft Legislation and Explanatory Notes, paragraph 1.9.
  2. Draft Legislation and Explanatory Notes, paragraph 1.10.
  3. Draft Legislation and Explanatory Notes paragraphs 1.5 to 1.6
  4. EIS – ITA 2007 s 252A(1); VCT – ITA 2007 s 302B(1).
  5. EIS – ITA 2007 s 252A(2), (3); VCT – ITA 2007 s 302B(2), (3).
  6. EIS – ITA 2007 s 252A(5), (6); VCT – ITA 2007 s 302B(5), (6).
  7. EIS – ITA 2007 s 252A(8); VCT – ITA 2007 s 302B(8).
  8. EIS – ITA 2007 ss 252A(10), 186A(3); VCT – ITA 2007 ss 302B(9), 297A(3).
  9. EIS – ITA 2007 ss 186A, 186A(3); VCT – ITA 2007 ss 297A, 297A(3).
  10. EIS – ITA 2007 s 183A(3); VCT – ITA 2007 s 294B(3).
  11. EIS – ITA 2007 s 183A(1); VCT – ITA 2007 s 294B(1).
  12. EIS – ITA 2007 s 175A; VCT – ITA 2007 s 294A.
  13. EIS – ITA 2007 s 173A(1); VCT –  ITA 2007 ss 280B(2), (3), 292A(1).
  14. EIS – ITA 2007 s 173A(3); VCT – ITA 2007 ss 280B(4), 292A(3).
  15. EIS – ITA 2007 s 173A(3)(ba) inserted by Schedule 1, paragraph 6(2)(a); VCT – ITA 2007 s 280B(4)(ba) inserted by Schedule 1, paragraph 2(2)(a) and ITA 2007 s 292A(3)(ba) inserted by Schedule 1, paragraph 4(2)(a).
  16. New definition of State Aid – EIS – ITA 2007 s 173A(3)(c), inserted by Schedule 1, paragraph 6(2)(b); VCT – ITA 2007 s 280B(4)(c) inserted by Schedule 1, paragraph 2(2)(c) and ITA 2007 s 292A(3)(c) inserted by Schedule 1, paragraph 4(2)(b).
  17. EIS – ITA 2007 s 173AA(1); VCT –  ITA 2007 s 292AA(1).
  18. EIS – ITA 2007 s 173AA(2); VCT –  ITA 2007 s 292AA(2).
  19. ITA 2007 s 292AB(1).
  20. ITA 2007 s 274(2).
  21. ITA 2007 ss 173AB(1), 275(1), 159(3), 256(1)(a).
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Satwaki Chanda

Satwaki Chanda

Satwaki Chanda is a tax lawyer with a First Class degree in Mathematics. Called to the Bar in 1992, he is the Editor of Tax Notes.
Satwaki Chanda

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