Enterprise Investment Scheme (EIS) investors should be aware of a recent case which indicates that EIS tax relief can be lost as a result of a share restructuring, even where there is no attempt to gain a tax advantage.
In the case of Abingdon Health Ltd v HMRC  UKFTT 800, the First-tier Tribunal ruled in favour of HMRC’s decision to withdraw EIS relief following the creation of a perceived “preference” resulting from the introduction of new class of “growth shares”.
As part of the introduction of new employee share scheme, a new class of growth shares was created by the company. The premise of growth shares is that they only participate in future growth in the value of a company above a “hurdle” level (which is often around 5-10% above the value of the company at the time the shares are issued). Since they participate in future growth in value only, the initial market value of a growth shares will be relatively low, and this enables an employee to acquire an equity interest in a tax efficient way with minimal initial outlay. The intention would be that any future growth in value of the shares would be taxable in the employee’s hands as capital gain, rather than income.
In order to protect the interests of the holders of ordinary shares, the company amended its articles of association to include a liquidation preference under which, on a return of assets, holders of ordinary shares would be paid in priority to holders of growth shares up to the amount of a specified hurdle.
In order to qualify for EIS purposes, the relevant shares must be treated as ordinary shares which do not, at any time during a restricted period, carry any present or future “preferential right” to a company’s assets on a winding up.
HMRC guidance on this issue provides that, where a right to a residue of assets on a winding up is purely theoretical (for example, in the case of a very small company, a right of holders of deferred shareholders to one penny per share after the first £20 million has been distributed to ordinary shareholders), the ordinary shares should not be treated as carrying preferential rights (Venture Capital Scheme Manual VCM12020).
In the case of Abingdon Health, HMRC withdrew the EIS relief that had been claimed previously by holders of ordinary shares, and refused EIS relief in respect of a new application for relief by the company on a further issue of ordinary shares, on the basis that the ordinary shares had been granted a “preferential right” on a winding-up.
The key elements in the Tribunal’s decision are as follows:
- The ordinary shares could not be treated as “qualifying shares” for EIS purposes because they carried a preferential right to assets on a winding up during the restricted period. The Tribunal considered that the preferential right existed whether or not the hurdle was achieved.
- The preferential right was not purely theoretical, and the company could not therefore ignore it and rely on the exemption in HMRC’s guidance in VCM12020.
- It was not necessary to determine how likely a winding up might be, since the legislation only considered whether the relevant shares carried preferential rights, and there was no opportunity to consider whether the rights were likely to arise in practice.
The Tribunal’s decision confirms the generally accepted view and makes clear that, even where there is genuine commercial activity, the drafting of the EIS legislation can give rise to, at the least, unintended consequences, and perhaps even traps for the unwary. This needs to be noted particularly where share restructuring or new employee share scheme arrangements are involved. Companies and EIS investors will also be well-advised to consider the published HMRC guidance very carefully in the light of this case.
For companies wishing to combine EIS status on ordinary shares with growth shares, all is not necessarily lost. By giving the ordinary shares a priority right to a capital return on a sale of the company but not on a liquidation, the requirements of the legislation can still be complied with. Many companies are willing to accept this on the basis that a liquidation is very unlikely. We would be pleased to discuss this possibility with any company wishing to consider this approach.