EIS Disqualifying Arrangements – can we have a normal main purpose test?
In our response to the consultation on the EIS disqualifying arrangements legislation, we made the point that the main purpose test as drafted captures virtually every conceivable EIS structure
In our response to the consultation on the EIS disqualifying arrangements legislation, we made the point that the main purpose test as drafted captures virtually every conceivable EIS structure (unless EIS relief is obtained by accident).
The relevant main purpose test currently reads as follows (emphasis added):
"Arrangements are “disqualifying arrangements” if—
(a) the main purpose, or one of the main purposes, of any person (“P”) in being a party to them is to secure—
(i) that the issuing company, or a qualifying 90% subsidiary of that company, carries on a business which consists of or includes the relevant qualifying business activity, and
(ii) that one or more persons (whether or not including P) may obtain relevant tax relief in respect of shares issued by the issuing company which raise money for the purposes of that activity or that such shares may comprise part of the qualifying holdings of a VCT, and
(b) one or both of conditions A and B are met."
The question is whether the main purpose test is a real filter, or if virtually every EIS structure will always fail.
Where a normal commercial company seeking venture capital is simply raising funds where EIS relief is to be claimed by the investor, in our view it is almost always a main purpose of the investor to secure EIS relief and for the EIS company to carry on business in an EIS compliant manner. We know that EIS relief is subjectively very important to the investor - from his perspective the EIS relief may even be a "must have".
A "normal" main purpose test would not cause this issue. A normal main purpose test would open with the words "the main purpose or one of the main purposes of the arrangements is to secure…"
This is an edited version of what we have said to HMRC in an effort to change the test into a "normal" main purpose test. It is a credit to Kathryn Robertson and her team at HMRC that this sort of dialogue is encouraged, and accepted in the constructive spirit in which it is intended.
"For the record, it is absolutely NOT the case that a main purpose test applying to the "arrangements" needs all parties to the arrangement to have the relevant main purpose. See any and all case law on the main purpose tests already in place (there is a lot) - the courts have NEVER taken this interpretation and they are now constrained from doing so by clear and strong House of Lords level precedent. The question in a normal main purpose test is which human beings are the driving mind or minds behind the arrangements (see for example Brebner v IRC, a decision of the House of Lords) and what are their purposes. Those human beings can include directors, shareholders, external promoters and even tax advisers, depending on the facts. It is very much NOT the case that a single innocent mind somewhere in the arrangement protects the arrangements. For a recent example of precisely this point (where the tax payer lost), see AH Field Holdings, reported last month, and which can be accessed here: http://www.financeandtaxtribunals.gov.uk/Aspx/view.aspx?id=6178.
I don't think the fact that there are two prongs of Section 178A(2)(a) helps me.
In the situation I had today (non-media entrepreneurial company doing a normal EIS fund raise), the driving minds behind the "arrangement" (the raising of funds and the application of those funds) were very clearly THE DIRECTORS of the company, so the purposes of the investor would be irrelevant on a normal main purpose test.
However, it is (very nearly) ALWAYS a main purpose of an EIS investor BOTH that he gets EIS relief AND that the money he subscribes for his shares is used for the purposes of the relevant qualifying activity (this is a necessary condition for EIS relief, so if it is not his purpose then he should not expect to get the relief!). An investor is usually investing on the basis that his money will be used for a particular business proposition, whether it is formalised in an investment memorandum or just a "handshake". EIS investors generally have some form of reassurance from the investee company (or the fund raiser) that the investee company will comply with the EIS requirements, including employing the funds for the purpose of the relevant qualifying activity (required by s175 ITA). This is therefore a "main purpose" of the EIS investor just as much as obtaining EIS relief is a main purpose. An EIS investor could only fail to meet both requirements of s178A(2) if either (i) he obtains EIS relief by accident and/or (ii) he does not care what the company he invests in does. Although this is not impossible (some family-investment situations I have seen spring to mind), it is very much the exception.
In an abusive situation, the driving mind(s) behind the "arrangement" would generally be the promoter(s) of the arrangement (whoever that might be - director, shareholder, counterparty, promoter, and on the right facts even tax adviser), and that promoter would I think in all circumstances fail a normal main purpose test. In other words, if the EIS shareholder were the driving mind behind the arrangement, then a normal main purpose test would be failed even if every other party did not care about EIS at all.
So, a normal main purpose test works and, with respect, the currently drafted main purpose test does not. As drafted, the main purpose test will virtually always be failed and the clause would be almost exactly the same if it were simply deleted. I don't believe that is the intent. We are therefore advising our clients that they should in practice look straight to conditions A and B and that the main purpose test is a false filter which taken at its face will almost never apply.
I find it surprising that no one else raised this flaw in the current drafting in consultation…. It was the first thing which jumped off the page at me when I read the original drafting. The fact that no one else raised it doesn't mean it isn't there.
As I say, this is not a hypothetical problem, it is affecting how we are advising clients… The current drafting leads in principle to exclusion of relief by law and allowance of relief by practice, on the assumption that you will apply the spirit rather than the letter of the law. This is not a good place for us to be."
We hear that the final draft of the legislation may indeed reflect a normal main purpose test, which would be a welcome improvement to the legislation.
The relevant main purpose test currently reads as follows (emphasis added):
"Arrangements are “disqualifying arrangements” if—
(a) the main purpose, or one of the main purposes, of any person (“P”) in being a party to them is to secure—
(i) that the issuing company, or a qualifying 90% subsidiary of that company, carries on a business which consists of or includes the relevant qualifying business activity, and
(ii) that one or more persons (whether or not including P) may obtain relevant tax relief in respect of shares issued by the issuing company which raise money for the purposes of that activity or that such shares may comprise part of the qualifying holdings of a VCT, and
(b) one or both of conditions A and B are met."
The question is whether the main purpose test is a real filter, or if virtually every EIS structure will always fail.
Where a normal commercial company seeking venture capital is simply raising funds where EIS relief is to be claimed by the investor, in our view it is almost always a main purpose of the investor to secure EIS relief and for the EIS company to carry on business in an EIS compliant manner. We know that EIS relief is subjectively very important to the investor - from his perspective the EIS relief may even be a "must have".
A "normal" main purpose test would not cause this issue. A normal main purpose test would open with the words "the main purpose or one of the main purposes of the arrangements is to secure…"
This is an edited version of what we have said to HMRC in an effort to change the test into a "normal" main purpose test. It is a credit to Kathryn Robertson and her team at HMRC that this sort of dialogue is encouraged, and accepted in the constructive spirit in which it is intended.
"For the record, it is absolutely NOT the case that a main purpose test applying to the "arrangements" needs all parties to the arrangement to have the relevant main purpose. See any and all case law on the main purpose tests already in place (there is a lot) - the courts have NEVER taken this interpretation and they are now constrained from doing so by clear and strong House of Lords level precedent. The question in a normal main purpose test is which human beings are the driving mind or minds behind the arrangements (see for example Brebner v IRC, a decision of the House of Lords) and what are their purposes. Those human beings can include directors, shareholders, external promoters and even tax advisers, depending on the facts. It is very much NOT the case that a single innocent mind somewhere in the arrangement protects the arrangements. For a recent example of precisely this point (where the tax payer lost), see AH Field Holdings, reported last month, and which can be accessed here: http://www.financeandtaxtribunals.gov.uk/Aspx/view.aspx?id=6178.
I don't think the fact that there are two prongs of Section 178A(2)(a) helps me.
In the situation I had today (non-media entrepreneurial company doing a normal EIS fund raise), the driving minds behind the "arrangement" (the raising of funds and the application of those funds) were very clearly THE DIRECTORS of the company, so the purposes of the investor would be irrelevant on a normal main purpose test.
However, it is (very nearly) ALWAYS a main purpose of an EIS investor BOTH that he gets EIS relief AND that the money he subscribes for his shares is used for the purposes of the relevant qualifying activity (this is a necessary condition for EIS relief, so if it is not his purpose then he should not expect to get the relief!). An investor is usually investing on the basis that his money will be used for a particular business proposition, whether it is formalised in an investment memorandum or just a "handshake". EIS investors generally have some form of reassurance from the investee company (or the fund raiser) that the investee company will comply with the EIS requirements, including employing the funds for the purpose of the relevant qualifying activity (required by s175 ITA). This is therefore a "main purpose" of the EIS investor just as much as obtaining EIS relief is a main purpose. An EIS investor could only fail to meet both requirements of s178A(2) if either (i) he obtains EIS relief by accident and/or (ii) he does not care what the company he invests in does. Although this is not impossible (some family-investment situations I have seen spring to mind), it is very much the exception.
In an abusive situation, the driving mind(s) behind the "arrangement" would generally be the promoter(s) of the arrangement (whoever that might be - director, shareholder, counterparty, promoter, and on the right facts even tax adviser), and that promoter would I think in all circumstances fail a normal main purpose test. In other words, if the EIS shareholder were the driving mind behind the arrangement, then a normal main purpose test would be failed even if every other party did not care about EIS at all.
So, a normal main purpose test works and, with respect, the currently drafted main purpose test does not. As drafted, the main purpose test will virtually always be failed and the clause would be almost exactly the same if it were simply deleted. I don't believe that is the intent. We are therefore advising our clients that they should in practice look straight to conditions A and B and that the main purpose test is a false filter which taken at its face will almost never apply.
I find it surprising that no one else raised this flaw in the current drafting in consultation…. It was the first thing which jumped off the page at me when I read the original drafting. The fact that no one else raised it doesn't mean it isn't there.
As I say, this is not a hypothetical problem, it is affecting how we are advising clients… The current drafting leads in principle to exclusion of relief by law and allowance of relief by practice, on the assumption that you will apply the spirit rather than the letter of the law. This is not a good place for us to be."
We hear that the final draft of the legislation may indeed reflect a normal main purpose test, which would be a welcome improvement to the legislation.