The recent cases of Thomason & Others v HMRC (TC 00829 – FTT) and HMRC v Taylor & Haimendorf (TC/43/2010 – UTT) provide helpful insight into two separate aspects of the ‘connection test’ found in the Enterprise Investment Scheme (EIS) legislation found in ITA 2007 Part 5 Chapter 1, starting to read at section 156.
As readers will know, the EIS is a tax incentive scheme giving income tax relief and capital gains tax exemption in relation to investments in qualifying companies.
Deferral relief is also available but the rules are different and the two cases now under review have no bearing on that relief.
The EIS grew out of the Business Expansion Scheme (BES) which started in 1983 and one of its principles was that the relief should be available to arm’s length unpaid passive investors, rather than those closely involved with the company.
Over time, this requirement has been relaxed, so that paid business angels can now invest and obtain EIS relief but investors still cannot be connected through having more than a 30% interest in the company. Our cases examine two aspects of this connection test.
The starting point is to consider ITA 2007 s 163 which provides, broadly, that to obtain EIS relief the investor must not be connected with the issuing company at any time in a five-year period starting two years before the issue date. This is, however, subject to s 169(1).
There are a number of ways in which an investor can be connected.
The details of the ‘30% test’ are considered by reference to the Taylor and Haimendorf case.
In the Thomason case we focus on one provision of s 169 which allows a director to obtain relief notwithstanding they would otherwise be connected provided they were issued with the shares ‘at a time when they had never been connected with the issuing company’: so, this is a timing issue.
Thomason
In Thomason, the key investors had been closely connected with a previous company (Oldco) which went into liquidation when its assets and business were then transferred to Newco in which those key investors then subscribed: an MBO.
If they were not connected at the time of the investment in Newco, was that all right?
What was helpful about the Thomason case was that there were two shares issues in Newco: one before the transfer of the business to Newco and one occurred afterwards.
It was agreed that the issue which occurred afterwards was caught but the earlier issue which occurred before the business transfer took place afforded EIS relief, so the taxpayers argued, because at that (brief) time the individuals had never been connected with the issuing company.
The Tribunal agreed: you take ‘a snapshot’ and you simply look at the time when the shares are issued and ask yourself the simple question ‘at that time are you connected?’ So, a management buyout carefully implemented can afford EIS relief. This is most significant
Taylor and Haimendorf
Taylor and Haimendorf was concerned with another part of the connection test which is the meaning of the 30% test found in s 170.
This provides that an individual is connected with the issuing company if he or she directly or indirectly possesses or is entitled to acquire more than 30% of:
The questions which arose were as to what does the 30% apply (is it value, is it nominal value or what is it?); and in paragraph 1 above, is it one overall test (by which you aggregate the value of the loan capital and the issued share capital) or are there two separate tests both of which you have to fail?
Dealing with the second test first, the Tribunal held (perhaps not surprisingly) that it is an aggregate test. It is not a question of simply saying, ‘Well, I have too much loan capital but not enough issued share capital’.
Rather, you add together the company’s total loan capital and issued share and take 30% of that total.
The second question was whether, in looking at the meaning of issued share capital (and, as an aside, ordinary share capital), you take the amounts subscribed for the shares overall or the nominal value of the shares.
Reference was made to the case of Canada Safeway Ltd v IRC [1973] 1 Ch 374, where nominal value was adopted.
It was held that this approach (nominal value) might not be perfect (and in the author’s view it is not) but it produced a workable outcome.
Where are we now?
The general motto in relation to EIS is that it remains a very beneficial relief but, over time, the legislation has become increasingly complex and therefore great care must be taken in its application.
We have moved a long way away from the original spirit of the scheme which was to encourage individuals to put money into companies that could not otherwise get financial support from a bank (sounds familiar?), to one where one must cross every ‘t’ and dot every ‘i’ without any real consideration of what the scheme was meant to do: making things easier for investors at a time when financing is difficult.
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