Political and regulatory news

Issue 1 - 26 February 2010

VCT rule changes on the horizon

HMRC has published draft rule changes for VCTs required as a result of the State Aid approval process and to ensure that funding is directed appropriately.

Venture capital trusts were granted State Aid approval by the European Commission in April last year.  This was the result of a two year process during which the UK Government had to demonstrate that the VCT rules comply with European rules on providing assistance to businesses.  Approval was conditional on various changes being made to the VCT rules, which will apply to funds raised after the rules are introduced.  This means existing money will be protected from these changes.  HM Revenue and Customs has now published drafts of the new regulations.  It is also consulting on other changes to the VCT rules which are designed to ensure that VCTs invest in suitable companies.

The four rule changes required as a result of the State Aid approval process are:

• to require the investee company to have a permanent establishment in the UK (rather than the current requirement to carry on its qualifying trade wholly or mainly in the UK)
• to require the VCT to be traded on an EU regulated market (rather than the current requirement to be included in the UK’s Official List)
• to introduce a new requirement that the investee company must not be in difficulty, and
• to increase the level of VCT investments which must be held in equity.

The first three changes, the first two of which represent a relaxation to the current rules, are not expected to disrupt VCT investment activity.  However, proposals to require VCTs to hold 70% of their investment in equity, rather than 30% which is the current position, will mean a change to current practice.  It will mean that VCTs will be less able to invest through traditional deal structures, which commonly have a significantly higher proportion of debt than equity.  This change is unavoidable as it is necessary for State Aid approval.  However, the AIC has made recommendations to HMRC which are designed to help maximise the range of investment structures available for VCT investment.

For example, the AIC wants to ensure that VCTs are allowed to benefit from certain preferential rights to dividends.  The Commission’s position is that returns derived from shares should arise from a profit and an exposure to risk.  As dividends paid by an investee company, whether preferential or not, are dependent on company profits a right to certain preferential dividends should be acceptable.  The AIC is also recommending that changes are made to the control test to enable VCTs to receive higher levels of dividend payments, particularly given the substantial increase to the proportion of the fund that has to be held in equity.

HMRC is also considering measures to ‘target’ VCT investment more tightly.  It wants to stop “larger businesses benefiting from the schemes and from investment that might otherwise go to those intended to benefit from the reliefs”.  It is proposing a new definition for the size of entity that a VCT can invest in based on the European Commisison’s definition of a ‘small enterprise’.  However, there are concerns that the effect of this change goes beyond preventing poorly targeted investment and would apply recently created rules across the whole VCT sector.  This would be a significant move away from the current approach.  The AIC is also very concerned that a change of approach is unnecessary because it has not been demonstrated that there is a problem with the targeting of VCT investment or that existing mechanisms are insufficient to exercise required control. 

Following representations, HMRC has now agreed that new legislation based on the European Commission’s small enterprise definition should only apply to money raised after the detailed legislation has been announced.  This is a very welcome change of policy. 

Nevertheless, even applying the proposals to new VCT funds threaten to change the character of the VCT scheme.  Further consideration is needed and the AIC is therefore pleased that HMRC has extended the consultation period on these proposals from 1 February until 12 March.  This will give the industry a better opportunity to voice its concerns and work with HMRC to achieve the best possible outcome.

To view HMRC’s updated consultation ‘Venture Capital Schemes’, click here.

To view the AIC’s initial response to HMRC’s proposals on eligible shares, click here.

Next article: Stewardship Code for institutional investors

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