High time for EIS/SEIS

If Einstein was famously baffled by income tax, you can forgive the current sense of confusion around UK tax reliefs in the entertainment sector.

With few tax incentives available to UK media enterprises, schemes such as the Enterprise Investment Scheme (EIS) and the Seed Enterprise Investment Scheme (SEIS) could be increasingly important to the entertainment sector. The sector is heavily reliant on raising private finance, especially in the context of film finance. The relevance of equity finance is heightened in the current economic climate, with banks tightening their purse strings, levying higher fees and taking more security for loans, and with equity investors more cautious and keen as ever to ensure tax efficiency.

In July 2012, the Finance Bill 2012 was given Royal Assent, and EIS and SEIS benefited from significant increases in various thresholds. Broadly speaking, these allow companies to raise more funds under looser test conditions, potentially enhancing the advantages of the schemes for media finance.

There is, however, a new “disqualifying arrangements” test, designed to prevent a scheme from being used primarily as a tax mitigation product or from delivering tax-efficient benefits to another, non-qualifying entity. Although HM Revenue & Customs (HMRC) has issued draft guidelines to interested industry bodies as part of a consultation process,¹ it remains uncertain how the test will apply to media financing structures involving multiple companies with different roles. HMRC may also be reluctant to grant advance assurance to schemes in such contexts, which would dampen enthusiasm for them. One thing is clear: the structuring of media finance transactions will now need careful scrutiny if the company raising finance is to qualify for EIS or SEIS.

How the schemes work

EIS and SEIS allow individuals to invest directly into qualifying unquoted companies, while taking advantage of potentially significant tax reliefs. Reliefs are available on income tax, capital gains tax (CGT) and inheritance tax (IHT), as long as the shares are issued to investors to raise funds for the purpose of a qualifying trade and for genuine commercial reasons, and not for tax avoidance purposes. EIS investors can also benefit from CGT deferral relief.

SEIS

SEIS was introduced in 2011 to encourage individuals to invest in small businesses and is particularly suited to start-up companies, as directors can participate (unlike EIS). Following the changes introduced by the Finance Act 2012, the key features of SEIS are as follows:

Benefits:

• A qualifying company can raise up to £150,000 under the scheme during the 2012-2013 tax year. The funds must be used within three years.
• An individual whose interest in a qualifying company is 30% or less will benefit from 50% income tax relief up to £100,000, although a claim for relief can only be made once 70% of the funds raised have been utilised in a qualifying business activity. The 50% relief is also available to directors who invest in their own company, subject to meeting certain qualifying conditions.
• Any gains realised in 2012/2013 that are invested through SEIS in the same year and held for at least three years will be exempt from CGT for individuals. Any gains realised on SEIS shares held for three years or more will be exempt from CGT

Conditions:

• To qualify as an SEIS company, the company must have (A) no more than 25 employees at the time of investment and (B) no more than £200,000 of assets at the time of investment.
• Relief will apply to a company whether it is preparing to trade or currently trading (but not for more than two years before shares are issued under the scheme).
• An individual is limited to investments of up to £100,000 per annum across all investments.
• Although the SEIS threshold is relatively low and may not be sufficient to fund certain media projects, such as film or theatre productions, once 70% of the SEIS funds raised have been spent, the company can seek further funds under EIS, as long as it qualifies for EIS.

EIS

EIS was introduced in 1994 to encourage individuals to invest in small trading companies. Investment in such companies usually attracts a greater degree of risk and is traditionally more difficult to secure.

EIS advantages

The main advantages of EIS investments made during the 2012-2013 tax year are as follows:

Income tax credit

Benefit:

• For investments made on or after 6 April 2012, a tax credit of 30% is available to qualifying individuals on cash investments up to £1 million for newly issued shares in a qualifying company.

Conditions

• The individual must have sufficient income tax liability to cover the credit in order to obtain the relief in full.
• The shares acquired must be held for at least three years.

CGT relief

Benefit:

• CGT relief could be available on the disposal of the shares.

Conditions:

• Income tax relief must have been given on the relevant shares and not withdrawn.
• The company must carry on its qualifying activity until at least three years from the issue of the relevant shares or (if later) three years from the start of the qualifying trade (Relevant Period). After this time, even if the company carries on non-qualifying activities, CGT relief will still be available when these shares are sold.

CGT deferral

Benefit:

• Capital gains on the disposal of any asset by an individual could be deferred if re-invested in EIS companies through subscription in cash for new ordinary shares.

Conditions:

• The disposal of the assets on which a capital gain has been made must have been made not more than three years before, nor more than one year after, the investment is made into the EIS companies.
• Deferred gains will become taxable if the shares subscribed for in the EIS company are disposed of to someone other than a spouse, are exchanged for non-qualifying shares or cease to be eligible shares within the Relevant Period.
• Deferred gains will also be taxable if, during the Relevant Period, the investor becomes non-UK resident (subject to certain exceptions) or if the EIS company ceases to be a qualifying company. If the investor receives certain prohibited benefits in the period starting a year before the subscription for shares and ending on the expiry of the Relevant Period, deferred gains may also be taxable.

IHT

Benefit:

• 100% IHT relief could be available on a gift or death.

Condition:

• The investor must hold less than 30% of the total share capital of the EIS company.

Qualifying for EIS

To take advantage of the benefits under the EIS, both the investing individual and the company issuing shares need to meet certain criteria.

Qualifying individual

For investors to benefit from income tax relief:

• They must be individuals.
• Neither they nor their associates can own more than a 30% interest in the company (an “interest” meaning shares, voting rights or assets).
• They must not receive excessive dividends, assets at an overvalue or undervalue, repayment of certain loans or repayment of share capital.
• They must not be paid directors, except in limited circumstances.
• They must not be employed by the company or any company in which that company has an interest of 50% or more.
• To benefit from CGT relief, the individual must be resident and ordinarily resident in the UK.

Qualifying company

For qualifying individuals to benefit from the reliefs described above, the shares they acquire must be issued by a qualifying company. For shares issued on or after 6 April 2012, the following must apply:

• The company must have fewer than 250 full-time or part-time equivalent employees at the time when the shares are issued.
• The company cannot raise more than £5 million through EIS.
• The value of the company’s gross assets must not exceed £15 million immediately before, and £16 million immediately after, the investment.
• The company must not be in financial difficulties when the shares are issued.
• The company must not be under the control of another company.
• The shares must be ordinary shares and must not have preferential rights, except in certain circumstances for dividends.
• The shares must not be quoted shares, except on the AIM Market. The shares may, however, be quoted after the expiry of the Relevant Period, as long as there were no previous arrangements in place to do so.
• The funds received must be used in qualifying activities within 24 months from the later of the issue of the shares and the start of trade.
• The company must have a “permanent establishment” in the UK throughout the three-year period from the issue of the shares.
• The company must carry on a qualifying trade throughout the three-year period from the issue of the shares.
• There must not be a pre-arranged exit in place, either by the cessation of trade or a disposal of assets.
• The company must not have any disqualifying arrangements (see below).

Qualifying trades

Qualifying trades are not set out in the legislation, but trades specifically excluded include: exploitation of intellectual property (although where 50% or more of the value of the asset was created by the company, receiving royalties and licence fees is not an excluded activity); dealing in land, shares or commodities; property development; farming; the operation or management of hotels or nursing homes; financial activities; leasing; legal and accounting services; ship building; and coal and steel production.

Most other trades will generally be regarded as qualifying trades if they are conducted on a commercial basis with a view to making profit. A small amount of excluded activities may be permitted if they do not account for more than 20% of the total activities of the company or its group (if applicable) as a whole.

Disqualifying arrangements

The prohibition on “disqualifying arrangements” was introduced by the Finance Act 2012.² The requirement applies to shares issued on or after 6 April 2012, but applies even if the disqualifying arrangement occurred before that date. It affects both SEIS and EIS.

Put simply, arrangements are disqualifying if:

1. all or the majority of the monies raised under the scheme are, in the course of the arrangements (whether directly or indirectly), paid to or for the benefit of one or more parties to the arrangements (and/or to connected person(s) of those parties) (defined as “relevant persons”, which may or may not include the issuing company); or
2. in the absence of the arrangements, it would be reasonable to expect that all or the greater part of the company’s qualifying activities would have been carried on as part of another business by such relevant person(s).

In broad terms, therefore, the test is aimed at preventing relief where the arrangement seems to be, in substance, a financing arrangement in favour of a third party, or where monies are invested in a company that has no or little commercial purpose other than to achieve tax relief.

In many entertainment enterprises, arrangements have historically been structured so that a special purpose vehicle (SPV) is incorporated as a company to raise funds and to hold the resulting intellectual property rights of the project. Production services are often outsourced almost entirely to another company – commonly the company responsible for establishing the SPV in the first place.

The HMRC’s draft guidelines³ include some commentary on disqualifying arrangements. The guidelines suggest that HMRC may decline to give advance assurance for schemes where HMRC considers that there might be disqualifying arrangements, in which case HMRC would instead examine the features of the scheme when the company provides its compliance statement (i.e. after the shares have been issued). HMRC would consider each case on its own merits, and gives a non-exhaustive list of factors that are likely (but would not conclusively) indicate reasons for disqualification.

Even if just in draft form, these factors have been seen by industry bodies as limiting opportunities for independent financial advisers to set up media finance funds and restricting the scope for outsourcing media production services. There has, accordingly, been much lobbying from interested groups, including those representing the entertainment industry (such as the British Screen Advisory Council), to request clearer and more specific guidance, as well as detailed examples. At the time of writing, the final set of guidelines has not been published, so it remains uncertain exactly how the “disqualifying arrangements” test will affect media finance.

Comment

There are some significant tax advantages in structuring equity investment through SEIS and EIS, and many media companies have successfully done so in the past. Since the introduction of the “disqualifying arrangements” test, however, media companies may be required to re-think established business models. In particular, the scope for separating financing, rights-holding and production functions could be curtailed. Media finance companies will therefore need to give detailed thought to financing structures if they are to benefit from the schemes.

In the meantime, media investors may be reluctant to provide equity finance until clearer HMRC guidelines are available and/or advance assurances can be obtained that they will be eligible for tax relief. Winston Churchill once remarked that some regard private enterprise as a “predatory tiger to be shot”, while others look on it as “a cow they can milk”. Much the same could be said of EIS/SEIS, with the UK government keen to promote use of the schemes, while anxious to limit any scope for abuse.

An overabundance of caution from HMRC would be misplaced, however. EIS/SEIS could be – just as, in Churchill’s mind, enterprise should be – a “healthy horse, pulling a sturdy wagon”.

Giao Pacey

Associate, Michael Simkins LLP

Article written for Entertainment Law Review.

If you would like further information on EIS and SEIS generally, please contact Giao Pacey. For information on EIS and SEIS in the media sector, please contact Jonathan Blair.