Breaking down the SEIS/EIS risk-to-capital condition for UK businesses

/ Posted By - Bradleys Accountants / Categories - Advice for Small Businesses, Business start-ups

The SEIS/EIS risk-to-capital condition is a relatively new entrant to the SEIS/EIS investment checklist, introduced in March 2018. It has several clauses that those applying for SEIS/EIS investment must bear in mind.

Indeed, HMRC has clarified that this is the first test against which they will review all SEIS/EIS investment applications. Let us take a closer look at what this means for both companies and investors:

What are SEIS/EIS schemes?

As a refresher, the SEIS and EIS investment schemes are designed to provide relief for investors in qualifying early-stage companies. The key condition is that the shares must be full-risk ordinary shares that have been fully paid up in cash at the time of issue.

Investors can claim EIS tax relief on their tax liability at 30% of the sum invested in the tax year when they make the investment, up to £1 million of investment. This figure is 50% for SEIS investment of up to £100,000.

These schemes aim to ensure that early-stage companies get the cash they need by incentivising investment through attractive tax reliefs.

What is the SEIS/EIS risk-to-capital condition?

According to the official UK government, the SEIS/EIS risk-to-capital condition is a principles-based condition involving a ‘reasonable’ view about whether an investment has been designed to offer a low-risk return to investors.

The scheme aims to ensure that tax-advantaged capital is reserved for early-stage companies with significant growth plans that genuinely need the extra money.

A company must meet the SEIS/EIS risk-to-capital condition before being considered for any investment under the EIS or SEIS scheme. Whether or not any individual company meets the condition will depend on the particular facts of the case.

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    The two-limbed test

    Under the SEIS/EIS risk-to-capital condition, HMRC mentions a two-limbed test, both of which must be met for a company to be eligible for the SEIS/EIS investment. Those conditions are:

    Business growth and development should be a long-term objective of the company.
    There should be a significant risk that the investor will lose more than they gain, even after getting tax relief.

    Let us examine each of these more closely.

    Condition 1

    Under this condition, the company should demonstrate that growth and development are among its objectives and that growth and development are happening because of the capital raised through the SEIS/EIS investment.

    HMRC has a statutory checklist of factors to see whether the company meets this condition, including:

    • Whether there is a projected increasing turnover
    • Whether there is a projected growing employee base
    • Whether there is a projected growing customer base
    • Whether the investment is being applied towards company infrastructure
    • Whether the investment is being used on subcontractors or particular projects

    Condition 2

    This part of the SEIS/EIS risk-to-capital condition deals with the security of the investor’s money and the company’s finances. Here again, HMRC has a list of factors it will be looking at, including:

    • What the ROI is in the company business plan
    • Whether it is a genuinely new kind of venture or a model that has been done before
    • Whether there genuinely are entrepreneurs with commercial interest among the shareholders or whether the investors own most of the company
    • Where there is any genuine commercial risk
    • How the risk has been conveyed to potential ventures (eg whether it’s been projected as a sure win)
    • What the net return to investors is after interest, dividend, fees, and so on
    • Whether the company has significant capital assets
    • Whether it has a secure income stream, like a major sales channel

    The important takeaway is to be intelligent about presenting your business scheme. Naturally, you will want to present a positive picture to attract investors. On the other hand, too rosy a picture might attract HMRC’s interest, and not necessarily in a good way.

    A good tip here is to ask yourself whether your investment offer is attractive even without the extra SEIS/EIS money. If the answer is yes, you likely have a problem with this part of the SEIS/EIS risk-to-capital condition.

    Tips for businesses seeking investment under SEIS/EIS risk-to-capital condition

    1. Prepare a robust business plan

    Investors need to see a well-thought-out business plan that includes financial forecasts, market analysis, and a clear growth strategy. This demonstrates the potential for growth and development, in line with the risk-to-capital condition.

    Your pitch should clearly outline how the investment will help scale your business, enter new markets, or develop new products.

    2. Be clear about the risks

    While highlighting potential, be honest about the risks. This transparency meets the risk-to-capital requirement and builds trust with potential investors.

    3. Use professional advice

    Consider getting advice from experts like Bradleys Accountants, specialising in SEIS/EIS tax relief funding. They can help ensure your business meets the requirements and assist in structuring your investment offer.

    They will also ensure your business complies with SEIS/EIS requirements throughout the investment period. Non-compliance can lead to the withdrawal of tax reliefs for your investors.

    Tips for investors to keep in mind around the SEIS/EIS risk-to-capital condition

    Many investors appreciate the tax relief they get for SEIS/EIS schemes. However, remember that the risk-to-capital condition scheme now disqualifies most companies with low-risk SEIS/EIS investment opportunities, i.e. cases where the tax relief is a big part of the investor’s ROI without much capital risk.

    So, as an investor, you need to be clear that you are making the investment for a genuine commercial reason, not just because you are looking to avoid paying taxes.

    HMRC judges the matter of tax avoidance on a case-by-case basis, so you want to ensure that you are truly in it because you see growth potential in the company.

    Any indication that you have made a plan with the company to use EIS or SEIS investment as a tax avoidance scheme could attract negative attention. Other factors HMRC might take into account include:

    • Whether you have any outstanding loans or agreements with the company
    • Whether you are associated with the company in any way, either as an employee or as a paid director (you can only get EIS tax relief as a paid director, not SEIS tax relief)
    • For SEIS, whether you are an associate of an employee (spouse/civil partner, business partner, or close relative)
    • Whether you have UK tax liability (however, you do not necessarily have to be a UK resident)
    • Whether you hold the SEIS or EIS shares for at least three years

    In addition, given that the SEIS/EIS risk-to-capital condition is a qualifying one, you might like to ask the company for proof of their qualification in your advance assurance application before investing your money.

    Final words

    If you are starting a company through EIS/SEIS qualification, the SEIS/EIS risk-to-capital condition is vital to remember.

    It is also important to note that there are no black-and-white rules here – there are multiple considerations HMRC may consider when accepting or rejecting your application.

    However, this also means the taxman will inform you in advance if they believe your company would not meet the criteria and ask you for the information they need. You can also appeal against any decision on their part to reject you.

    If you are an investor looking to invest in small businesses, choose companies with a genuine commercial interest and where you are confident that the company qualifies for SEIS or EIS investment.

    As always (this holds for both entrepreneurs and investors), be sure to ask your trusted Bradleys accountant for advice on navigating the investment application so that the SEIS/EIS risk-to-capital condition does not hold you up. Contact us today to find out more.

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