VCM8540 - Venture Capital Schemes: risk-to-capital condition: the two parts of the risk-to-capital condition
The condition in detail
As explained in VCM8530, there are two parts to the risk-to-capital condition; the first relates to the intention for the company to grow and develop, and the second to the risk to the investor of losing their capital. Both parts must be met. When determining whether the condition has been met overall, any factors relevant at the time that the shares (or securities) are issued will be taken into consideration.
The two parts of the condition and a non-exhaustive list of the factors that may be considered are set out in new sections 157A (for the EIS), 257AAA (for the SEIS) and 286ZA (for VCTs) of ITA 2007, as inserted by the Finance Act 2018.
Intention to grow and develop
The first part of the condition looks at whether the company has objectives to grow and develop its trade over the long term[1].
Generic indicators of growth ambition would include plans for increasing, over time:
- revenues
- customer base and
- number of employees
However, there may be other indicators depending on the specific circumstances of each company’s activities which may be as significant in demonstrating a company’s ambition for growth. In essence, the money must be employed in a way intended to enable the company to grow and develop.
There is no definition of ‘growth and development’. Instead, the phrase takes its ordinary meaning. There are no hard and fast rules as each company will grow and develop in its own way depending on its own circumstances. For example, a company may grow by automating a manual process that may lead to reducing the number of employees, while increasing the company’s productivity. Each company will need to explain how it expects to grow in relation to its own circumstances.
Similarly, there is no definition of what is meant by ‘long term’. The schemes are intended to encourage patient capital and investors would be expected to be investing for the long term. The three year holding period for shares subscribed for under the EIS and SEIS is the minimum holding period; in general, patient capital investors would be expected to hold their shares for longer, subject to the company’s need to expand, for example by securing scale-up funding from new investors through flotation. Any indication that the company’s future operation or existence could be compromised to enable investors to exit their investment will be considered to be contrary to any stated objectives to grow and develop in the long term.
A company with limited assets and few, if any, employees that is set up solely to deliver a project, or a limited series of projects, often referred to as a Special Purpose Vehicle (SPV) – that will generate a certain amount of money once the project is complete, such as a reasonably steady income stream or gains on disposal of the asset created, would not be considered to have objectives for long-term expansion.
Though some capital preservation schemes involve the use of SPVs, their use as wholly owned subsidiaries within a group structure does not necessarily indicate capital preservation activity by the group. We recognise that the use of SPVs within a group structure is a necessary and usual part of commercial practice for some sectors (for example the creative industries), and we will take into account sector-specific practice when determining whether the risk-to-capital condition has been met.
Thus, a parent company that uses wholly-owned subsidiary SPVs may meet the risk-to-capital condition. This is as long as the group retains the capital, and the profits from the SPV’s activities are used to continue to grow and develop the group’s trade in the long term, rather than enabling investors to exit their investments. The investment will also still need to meet the other elements of the risk-to-capital condition and other requirements for eligibility.
Conversely, a parent company that uses SPVs within a group structure to carry out projects initiated and developed by other people will not be considered to meet the risk-to-capital condition. In that situation, the parent company is acting merely as a shell for the delivery of a series of projects as neither it nor its subsidiaries are seeking to establish any sort of lasting trading activity or the means to carry this out over the long term.
Risk of loss of capital
The second part of the risk-to-capital condition tests whether, at the time the investment is made, a given investment poses a significant risk of a loss of capital to the investor of an amount greater than the net return. The amount the investor puts at risk of loss must exceed all returns that are likely at the time of making the investment.
The risk of loss is determined by considering:
- the risk of losing the money invested
- the net investment return for the investors to whom the shares or securities in the company were issued
The risk is the commercial risk of the company failing in the market. The failure of a company to meet the other conditions of the relevant tax-advantaged scheme, for example to spend the money within two years, does not constitute a risk for the purposes of this test.
There is no definition of a ‘significant risk’, which depends on the circumstances of the company, and of the investor.
The net investment return includes any income, such as dividends, interest payments or other fees, as well as capital growth and, where relevant, the amount of upfront income tax relief the investors may be eligible to claim. If the investment is protected, for example by assured future income streams or capital repayment, the investment is unlikely to meet the condition.
The condition is designed to allow investments on the presumption that there will be real growth of the company and capital accretion over the long term. The net investment return is not the future return an investor making an investment in a genuine growth company hopes to realise, should the company be successful. As long as the investment remains at significant risk, the prospect of potential large returns in the future is not caught by this condition. Such growth cannot be guaranteed and therefore there is significant risk to that kind of investment.
[1] VCM8130 provides guidance on growth and development in relation to the ‘purpose of the issue’ requirement for EIS in ITA07/S174 and the similar provision for VCTs in ITA07/S286.