EISA’s Detailed Recommendations for expanding the EIS and SEIS schemes

Amending the EU’s State Aid and Risk Finance Guidelines

The tax reliefs received by investors under the EIS are deemed to represent State aid.

When the Risk Finance Guidelines were adopted in 2014 to replace the Risk Capital Guidelines, the Commission recognised that the previous Guidelines “proved to be too restrictive both in terms of eligible SMEs, forms of financing, aid instruments and funding structures.” The modernisation of State aid rules launched by the Commission in 2012 had three main, closely linked objectives:
1) Foster growth in a strengthened, dynamic and competitive internal market;
2) Focus enforcement on cases with the biggest impact on the internal market;
3) Streamlined rules and faster decisions.

The Competition Policy Brief published in January 2014 at the time of the introduction of the Risk Finance Guidelines stated:
“Following extensive consultations with Member States and stakeholders, the Commission is now taking a bold step by setting up a simpler, more flexible and generous state aid framework for the provision of risk finance to SMEs and midcaps. The new rules should attract and channel private financing to support the public policy goals of economic growth and job creation, which is particularly important in times of economic crisis.”

The Competition Policy Brief continues:
“SMEs are by and large still heavily dependent on traditional bank lending. Lending is, however, still limited by the refinancing capacity, risk appetite and capital adequacy of banks. The financial crisis has exacerbated problems flowing from such overreliance on bank lending – approximately one third of SMEs were unable to receive the necessary finance in recent years. Such a failure in finance markets translates into a “funding gap”, which hinders companies during the seed and start-up stages, and later during their development and growth stages. The Commission is boldly reacting to changing market realities. New State aid rules will permit a more rapid and generous distribution of risk finance aid to SMEs and mid-caps. This is an important contribution to the European Union’s efforts to re-launch economic growth during difficult times for many SMEs.”
However, since the publication of the Competition Policy Brief in 2014 Europe remains in difficult economic times and the funding gap for SMEs and mid-caps persists.
The EIS primary legislation is very long and highly detailed, and contains many restrictions which are viewed as uncommercial, but we are advised that they are necessary to meet State aid Risk Finance Guidelines. The complexity of the EIS legislation illustrates the potential to streamline further the State aid Risk Finance Guidelines.

Further liberalisation of the State aid rules could be a precursor to Member States applying the regime with fewer unnecessary restrictions on investment and with a reduced administrative burden. This would lead to faster deployment of funds raised from individuals to provide greater support for SMEs and knowledge-intensive mid-caps. This would enhance the effectiveness of the Risk Finance Guidelines to deliver development capital to SMEs and innovative mid-caps.

Replace the age limit
The EISA recommends that the Commission replace the “age restriction” on eligible recipients of State aid with a different threshold. Instead we propose a gross assets test, of say £20 million, be used instead to determine eligibility for the recipients of State aid Risk finance. The EIS scheme, for which Commission approval has been given, has an existing gross assets limit. This has the advantage of facilitating a clear assessment of eligibility. Deciding what level of gross assets to apply (within a threshold set by an updated Risk Finance Guidelines) in relation to individual applications for State aid approval, would, of course, be subject to a full market failure analysis. The size of the investee company or group would be a suitable measure for rapidly directing investment where the funding gap is most significant.

We note that the EU SME definition, according the European Commission’s User guide to the SME definition published in 2016 stated:
“SMEs are the engine of the European economy. They drive job creation and economic growth and ensure social stability. In 2013, over 21 million SMEs provided 88.8 million jobs throughout the EU. Nine out of every 10 enterprises is an SME, and SMEs generate two out of every three jobs. SMEs also stimulate an entrepreneurial spirit and innovation throughout the EU and are thus crucial for fostering competitiveness and employment. Given their importance to Europe’s economy, SMEs are a major focus of EU policy. The European Commission aims to promote entrepreneurship and improve the business environment for SMEs, thereby allowing them to realise their full potential in today’s global economy.”

The User Guide to the SME definition quotes from Jean-Claude Juncker, President of the European Commission:
‘Jobs, growth and investment will only return to Europe if we create the right regulatory environment and promote a climate of entrepreneurship and job creation. We must not stifle innovation and competitiveness with too prescriptive and too detailed regulations, particularly when it comes to small and medium-sized enterprises (SMEs). SMEs are the backbone of our economy, creating more than 85 % of new jobs in Europe and we have to free them from burdensome regulation.’

The User Guide continues:
“SMEs require assistance that other enterprises do not. Compared with other enterprises, SMEs are confronted with a unique set of issues.
Market failures: real SMEs often face market failures that make the environment in which they operate and compete with other players more challenging. Market failures may occur in areas such as finance (especially venture capital), research, innovation or environmental regulations; SMEs may be unable to access finance or invest in research and innovation or they may lack the resources to comply with environmental regulations.
Structural barriers: SMEs often must also overcome structural barriers such as a lack of management and technical skills, rigidities in labour markets and a limited knowledge of opportunities for international expansion.”

SMEs are less likely to trade across borders. They are, by definition, less likely to be significant participants in specific EU geographic or product markets. Their capacity to distort the internal market is, by definition, minimal.
The EISA believes that the reforms in the Risk Finance Guidelines did not achieve a streamlined system because of this focus on the “age” of the investment instead of its size.
The age of company test, as implemented by the UK, where the investee company is a group imposes an onerous obligation to ascertain when the first commercial sale of the investee group took place. This task is complicated because subsidiaries, which themselves may have acquired businesses, have either joined or left the investee company group. The test also takes into account a line of business which may have ceased long ago. This requires extensive due diligence and is a barrier to receiving investment.
Establishing the age of a business can be particularly difficult where companies or businesses may have been disposed of by the investee group prior to the State aided investment and the investee company no longer has access to the relevant information or staff members.

The guidance issued by HMRC in relation to this aspect of the test illustrates the difficulties:
“The rules look at all the businesses of every company that has ever been a member of the investee company’s group including businesses or parts of businesses acquired by any of the companies and take the earliest possible date of all those companies and businesses as the date of the first commercial sale. In determining a company’s first commercial sale, it does not matter that it or its subsidiaries may be, or may have been, carrying on different activities.”
If an investment is made in a company which subsequently turns out to have failed the age limit test, for example, because at one time the investee company had a subsidiary, which it subsequently disposed of, which had acquired a business with an earlier date of first commercial sale, then means that the investment is non-qualifying. The potential severity of the consequences of making a non-qualifying investment can deter individuals from making the investment.
The age of a company, in itself, is not a robust indicator of whether or not it has the capacity or knowledge to scale up its production and therefore may not act as a proxy for its ability to secure bank financing. Indeed, market changes may create the opportunities for expansion for companies that have previously been operating for a number of years which require external finance. This is confirmed by paragraph 73 of the Risk Finance Guidelines which states:
“The General Block Exemption Regulation covers SMEs which receive the initial investment under the risk finance measure before their first commercial sale on a market or within seven years following their first commercial sale. Only follow-on investments are covered by the block exemption beyond this seven-year period. However, certain types of undertakings may be regarded as still being in their expansion/early growth stages if, even after this seven-year period, they have not yet sufficiently proven their potential to generate returns and/or do not have a sufficiently robust track record and collaterals. This may be the case in high-risk sectors, such as the biotech, cultural and creative industries, and more in general for innovative SMEs. Moreover, undertakings that have sufficient internal equity to finance their initial activities may require external financing only at a later stage, for instance to increase their capacities from a small-scale to a larger scale business. This may require a higher amount of investment than they can meet from their own resources.” [Emphasis added]

Consequently, the EISA recommends that the age of company test should be replaced with a test based on size of the investee company. The EISA recommends that that size should be the gross assets of the investee company.
The EISA also recommends that size should not be determined by reference to employment, since the focus of risk finance investment should be on creating employment regardless of the age of company, in line with EU employment targets.

Requirement for business plan
Under the risk finance aid provisions of GBER, an exception to the basic age limit is granted so that that risk finance aid may also cover follow-on investments made in eligible undertakings, including after the 7-year period if the possibility of follow-on investments was foreseen in the original business plan.
This is unduly restrictive. A business plan may evolve over time and the needs of the business may not have been foreseen at the time the original business plan was drawn up. If the age limit test is retained, the AIC recommends that the requirement for the follow-on investment to be envisaged in the business plan be deleted.
Requirement for new or geographic market
Under the risk finance aid provisions of GBER, an exception to the basic age limit is also granted to companies entering a new product or geographic market which require a risk finance investment which, based on a business plan, is higher than 50% of their average annual turnover in the preceding 5 years. This exception is unduly restrictive.
If the age condition is retained, the EISA recommends that no financial hurdle be imposed on the entry into the new product or geographic market. Further, the EISA recommends that the “new product” and “new geographic” market be interpreted in accordance with general concepts of competition law, such as market definition assessments.

Lifetime limit
The Risk Finance Guidelines impose restrictions on the total State aided investment that may be received depending on whether it is a SME or innovative mid-cap. This total limit is too restrictive and complex to assess. It can inappropriately prevent further investment to scale up the business.

The EISA recommends that this restriction be removed. Instead, the size of the investee company at the time of investment, i.e. the gross assets of the investee company or whether the investee company is an SME or innovative mid-cap at the time of investment, be the determining criterion.

Replacement capital
The GBER recognises that as businesses scale up, there is a need for replacement capital. The European Commission recognised within their review of risk finance state aid that allowing replacement capital combined with an injection of development capital would better reflect market practices. The European Commission also recognised that by making it easier for investors to exit would in turn give them a bigger incentive to invest at an earlier stage. The EISA recommends that the State aid Risk finance guidelines include a similar provision allowing replacement capital in moderation which complies with state aid rules objectives.

Committing to EIS and SEIS beyond 2025
A provision in each of the 2015 Summer Finance Bill schedules (a condition for state-aid approval) introduced the inclusion of a sunset clause, intended to restrict tax relief to shares issued before 6 April 2025. There is a provision which allows that date to be amended by Treasury order.

We seek ministerial assurances that every effort will be made to ensure the continuation of both reliefs and provide maximum advance publicity to any enforced shortening of the life expectancy of the two reliefs. Tax incentive design should recognise that governments rarely, if ever, have the necessary resources and information to successfully target support to specific firms, sectors or technologies. Instead, tax incentive design should target entrepreneurial firms based on a number of criteria, such as age and size (financial and headcount)4. EIS and SEIS fulfils this aim as recognised by the EU who studied 46 tax incentive schemes across Europe. The benchmarking component of this study ranked all tax incentives observed in the country sample according to good practice in their design in order to inform policy discussion on best practice. The two highest ranked schemes are United Kingdom’s Seed Enterprise Investment Scheme and Enterprise Investment Scheme.

Remove investor restrictions
To further expand the pool of investment, the Government should investigate implementing the recommendation of Patient Capital Review’s Industry Panel to remove the “Controlling Party” restriction that investors cannot hold or control more than 30 per cent of the shares or by receive paid employment as directors or employees. Consideration should also be given to relaxing the rules preventing the parents and family members of small business owners from investing in their businesses. This would open a new avenue of retail capital. As the OTS note “The absence of any immediate tax relief for the capital contributed by the start-up owner contrasts sharply with the plethora of tax reliefs that are available to subsequent investors”.

Reduce the admin burden
Focusing on the administration and paperwork involved in EIS investments would be a good place to start. The scheme is far too complicated for most private investors to understand and can leave a negative impression after making an EIS investment. EIS investors have experienced delays in being able to claim income tax relief when investing through EIS approved and unapproved funds and only being able to claim relief on the amount invested in the underlying company, which, due to management fees and other costs, is not 100% of their subscription to the fund. Under current rules, relief for EIS investment through an EIS approved fund is given only after 90% of funds have been invested when most investors have already closed their tax affairs for the relevant tax year and paid the tax. They then have to make a backdated claim one to two years later. Again as the OTS notes, “Although HMRC approve straightforward cases quickly, initial investors in SEIS, EIS and VCT schemes often have to wait a long time to receive the documentation needed to claim the relief on their tax returns. There are a number of stages in the process of obtaining this documentation, and the OTS considers that this area would benefit from an in-depth review with a view to identifying options to streamline the process. As a result of the lengthy process, individuals’ tax returns sometimes have to be submitted before the documentation has been received to meet filling deadlines. This means that the tax relief cannot be claimed at that point. Investors may have to amend their tax returns later and submit additional forms to claim the relief once they receive the relevant documentation.” Introducing a simplified fund investment process where tax relief is received far quicker and with only one certificate required. Consistency in the administration of these funds by regulators would provide more certainty and a better environment for investors. This would reduce the time it takes to get cash into companies, and would reduce the resources HMRC has to dedicate to the service. Consideration of a vehicle that provides upfront tax relief that helps investors with the timing of their investment and more certainty over when they can expect to receive tax relief.

Raising consciousness amongst entrepreneurs and investors of EIS and SEIS
The British Business Bank’s Small Business Finance Survey 20197 shows encouraging signs that awareness amongst SMEs of external forms of finance increasing as is awareness of who to approach for specific funding but there is still work to do to ensure entrepreneurs are properly educated about all the available funding options open to them. In 2017, the Business, Energy and Industrial Strategy Committee recommended that “the Government directs resources towards promoting the SEIS, EIS and VCT schemes. This includes the British Business Bank working with HMRC to consider how to improve promotion of the schemes.” Whilst the British Business Bank and the Government committed to explore ways to raise awareness of the schemes, we believe more can be done to raise the profile of EIS and SEIS to companies seeking much needed equity finance including involving a far wider range of business support agencies such as LEPs, Universities and the IOD.

Additionally, 37,350 individuals invested in EIS in 2017/188 . Yet there are estimated to be a quarter of million taxpayers earning in excess of a quarter of a million pounds a year and almost 350,000 earning more than £150,000 per annum. Because tax incentives reduce the effective marginal cost of investing in smaller companies, in theory, more individuals should be willing to invest more capital to smaller companies through EIS and SEIS thereby benefitting from tax incentives, and at lower before-tax expected rates of return if they are aware of the schemes. The potential therefore for more individuals’ capital to be deployed in EIS and SEIS is huge and represents a significant, untapped source of investment. More should be done to promote the schemes to High Net Worth individuals and Independent Financial Planners.

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