SUPPLIER AND TECHNOFIN®

Finance Bill 2007: The two unwelcome proposed reforms

The majority of the changes proposed in the Finance Bill for Venture Capital Trusts (VCTs) are welcome. Despite the overall positive impact of the changes, two of the proposed reforms are unwelcome.

These are the introduction of new conditions for qualifying holdings for VCT funds raised after 5 April 2007.

Specifically these are the requirements that, at the time of investment, a qualifying holding must have less than 50 employees and that it must have received less than £2million of funding from any venture capital scheme (that is, a VCT, EIS or CVS) in the preceding 12 months.

These new conditions are unfortunate as they will limit the ability of VCTs to help some small companies bridge their equity gap. It is clear that these have been required by the European Commission following the publication of its latest Guidelines on state aid to promote risk capital investments in small and medium-sized enterprises.

In light of this, the Government’s commitment to lobby the Commission to reconsider its requirement for these conditions for UK venture capital schemes is welcome.

Also restricting the new requirements only to new VCT fundraising, which preserve the investment flexibility of the existing VCT estate, is a proportionate and sensible policy settlement.

Changes related to the VCT Scheme

Six months disregard for disposals of qualifying holdings: The overall policy intent of this section is to help VCTs successfully realise their investments without compromising their tax status.

However, to ensure that the legislation fully achieves its goals a drafting amendment is required. The legislation currently requires the relevant disposal must have been made “wholly for money”.

This inappropriately limits the commercial flexibility of the VCT to negotiate the sale of its stake in the underlying business.

In some circumstances, the VCT may be offered or choose to structure a disposal so that it does not receive just money when it sells the qualifying holding.

For example, the VCT may be given or choose to receive equity in the acquiring business as well as cash. Alternatively it could receive other assets, such as earn-out rights. As the goal of this change is to deliver maximum flexibility to the VCT and allow it to receive money from the sale without compromising its level of qualifying holdings.

It is difficult to identify why the disposal should be ‘wholly for money’ for the disregard of the 70% test to apply. It is recommended that Schedule 16. Part 5. 19 (3) (1) (a) be amended to address the circumstances set out above so that the 70% qualifying holding condition will be disregarded where a disposal is made partly for cash.

The six month disregard should also apply for the purposes of the 30% eligible shares test. Broadly, the method of disregard has the effect of treating the disposal as happening six months later.

It would be less burdensome administratively for both the VCT and HMRC in monitoring compliance with the tests if qualifying investments are treated the same way for both the 70% qualifying holdings and 30% eligible shares tests.

There is no policy reason why the two tests should be applied differently. It is also worth noting that other enhancements could be made to the 70% qualifying holding and 30% eligible shares tests.

One concern is that the tax-status of the VCT could be threatened if a qualifying holding is liquidated under the current rules. This would be unfortunate as VCT investment is, by its very nature, risky and liquidation a hazard of operating in this market.

It would be perverse to threaten the status of the VCT for involvement with higher risk companies that are most likely to face an equity gap.

With this in mind, it is recommended that the Government either seek to make further amendments to the requirements of the 70% qualifying holdings and 30% eligible shares conditions to deal with circumstances where there is liquidation or provide reassurance during the passage of the Finance Bill.

Where liquidation would lead to these conditions being failed the VCT would be able to rely on the unavoidable breach regulation (assuming of course that the procedural conditions etc. of the regulation are observed).

Unavoidable breaches

The current inadvertent breaches’ powers of HMRC are helpful to the sector as they ensure that the status of a VCT will not be compromised where the qualifying conditions are breached due to circumstances out of its control.

At the moment the legislative basis for these powers are not certain. The proposed regulations on ‘unavoidable breaches’ are therefore extremely welcome and deliver the policy intent of allowing the Commissioners of HMRC not to withdraw approval for an unavoidable breach of the VCT conditions.

However, to promote better understanding of the nature of these new regulations the guidance on the application of these regulations should be published once they have been enacted.

Changes related to qualifying companies £ 2 million and 50 employees limits The amendments as drafted achieve the policy objective of limiting investment by VCTs which have raised funds after 5 April 2007 in businesses which have previously received up to £2million from relevant schemes in the 12 months prior to the date of investment or employ 50 staff or more.

However, a minor amendment should be made to maximise the clarity of these requirements. These new conditions are applied to “protected money” raised by VCTs (as set out in Schedule 16.

As the term ‘protected money’ is already used elsewhere in VCT legislation as amended by the Finance Act 2006 it would be sensible to change the term to avoid possible confusion.

It is recommended that an alternative such as “restricted money” be adopted in the proposed legislation.

License fees and royalties

Generally speaking, the proposed legislation gives more flexibility to groups of companies which receive royalties and License fees to transfer intellectual property between group members.

However, the change as drafted will mean that if an existing VCT investee company has acquired another company which had already began to develop any intellectual property from which license fees or royalties will be derived.

That receipt of license fees or royalties cannot be a qualifying activity since the acquired company will not have been part of the group “at all times during which it created the intangible asset”, as set out in Schedule 16. Part 3. 11. (2) (b).

It is not clear why a company should not qualify as an investment if it acquires another company which has made early progress on developing its intellectual property – after all, the assets restrictions will still apply, so the business will still be clearly within the target range for VCT investment.

The legislation should be redrafted to accommodate these companies as qualifying holdings. The Schedule 16. Part 3. 11 (2) (b) should be amended to the effect that section 306(4) (a) ITA 2007 is retained.

90% subsidiaries

The policy intention of the proposed change is to allow the qualifying trade of a company in which a VCT is invested to be carried out by a subsidiary.

This is entirely welcome. However, the way in which the legislation is drafted creates an unwelcome restriction on the way in which a qualifying company might organise its subsidiaries.

The current draft limits the qualifying trade to the second or third tier of ownership. It is not apparent why such a limitation should be imposed. While the draft rule does increase flexibility there is no reason why it should not go further.

The current formulation is also more complicated than it needs to be and makes the legislation more difficult to understand. With this in mind the Schedule 16 Part 4. 16 should be redrafted to either require the relevant investee company ‘directly or indirectly’ owns the subsidiary or that ‘at least 90% of the ordinary share capital of the subsidiary is directly or indirectly owned by the qualifying company’.

Redrafting the legislation along these lines will allow maximum flexibility for the qualifying companies to organise their subsidiaries as they wish, be easier to understand and achieve the policy intention of the proposed reform.

Guy Rainbird, Public Affairs Director,
The Association of Investment Companies

Entry Filed under: SUPPLIER AND TECHNOFIN®, Legal & Regulatory Issues