From their inception, there have always been shades of grey when it comes to interpreting the EIS Rules. The latest provisions causing consternation amongst the investment community and their advisers, not to mention the SCEC inspectors, are the carve-outs to the new permitted maximum age requirement for companies looking to raise EIS monies.

Section 175A of the Income Tax Act 2007, introduced by the Finance (No. 2) Act 2015 restricts the availability of EIS funding to companies to a period within 7 years of their first commercial sale (10 years in the case of knowledge-intensive companies). The EIS Rules refer to this period as the “initial investing period”. If the investment occurs later, subject to two exceptions, it will not be a qualifying investment. Important to note too is that the 7 year period includes any time in which the trade in question was carried out by another person before being carried on by the company looking to raise EIS investment.

The exceptions referred to above are where either one of the following conditions is satisfied:

Condition B – where the new EIS investment is at least 50% of the company’s average turnover over the last 5 years and is employed for the purposes of entering into a new product or geographical market.

Condition C – where a company previously satisfied Condition B and some or all of the new EIS investment monies were employed for the same business activity as the previous EIS investment.

This article focuses on the new product market limb of Condition B and considers in light of HMRC’s recently published draft guidance and correspondence with SCEC inspectors what HMRC is willing to accept as entering into a new product market.

My colleague Roger Blears has written about the new EIS Rules gold-plating the EU Risk Finance Guidelines for acceptable State Aid, going significantly over and beyond what is required. This very much applies to HMRC’s guidance as to when it will allow a company to take advantage of Condition B.

HMRC’s guidance states that a “product market” is all those products and/or services which are regarded as interchangeable or substitutable by the customer, by reason of the product’s characteristics, their prices and intended use. This is the same definition used by the EU Commission for the enforcement of EU Competition Rules. The EU Commission traditionally takes a narrow view of what constitutes a relevant market in its decisions – the narrower the market, the more likely an undertaking is distorting the market or abusing a dominant position in the market, and therefore the easier it is to prove a competition law breach. With regard to the EIS Rules however, HMRC, in its guidance at least, appears to be taking a much broader view of what constitutes a product market, deliberately making it harder for older companies to satisfy the maximum age requirement.

This is a policy aim. HMRC has stated that the new product/new geographical market should not be taken as a mechanism to get around the age limit restrictions to access tax-advantaged funding. EU state aid law permits state aid to be granted only where there is what is described as an asymmetry of information such that the market does not have sufficient information concerning a company’s ability to make sales in, what for the company will be, a new product or geographical market, as to establish a track record on which ordinary market funding might be available. It seems that not only would a reputation from past sales be taken into account but also a reputation gained solely on the basis of widespread test sales.

Significantly new business activity

For this reason, HMRC has said that the new geographic/new product market exemption will only apply where a company wishes to embark on a significantly new business activity that is so different from its existing business activity and requires disproportionately more investment compared with the company’s normal activities, that potential investors cannot rely upon the company’s existing track record to determine whether the investment is likely to be successful.

This significantly new business activity requirement is not found in the EIS Rules. It is an additional “smell test” that HMRC has introduced for itself via its guidance. This “smell test’ allows HMRC to block any funding to companies who propose to operate in a new product market which is similar or merely incremental to their existing product markets. Companies looking to raise EIS monies to do something in a similar sector in which they already operate need to proceed with caution.

As to whether the guidance is binding on companies, unless companies – and importantly new investors – are willing to go ahead with an EIS investment without advance assurance and then challenge HMRC in the courts, there is little option but to ensure HMRC’s requirements are satisfied from the off. HRMC’s advance assurance process is not statutory and there is no formal appeal process until after an investment has been made.

In its draft guidance, HMRC has provided a handful of case studies from which a white list of factors can be extracted which, if satisfied, ought to give the best possible chance of HMRC accepting that the new product or service being launched constitutes entering into a new product market for the purposes of the EIS Rules. These are as follows:

•  Completely new product and new sector – a company intends to make/supply a completely new product in a different sector from the one in which the company is currently operating (HMRC gives the example of a company developing and manufacturing specialist medical products which it sells to hospitals which then wants EIS monies to launch an air pollution monitoring product);

•  New customers – a company’s proposed new product is to be targeted at completely different customers from the company’s existing customer base (though note where a company intends to supply a new product to a new customer at a different level of an existing supply chain, HMRC may not accept there is a new customer where the end-user remains the same);

•  Track record/reputation – a company has no track record or reputation in respect of the new product/service it proposes to launch with EIS investment;

•  No test sales prior to EIS investment – a company preferably should have made no test sales of its new product. If a company has made test sales which prove its concept and market demand for the new product produced by the company, HMRC’s view is that a company would have enough of a track record with which to approach commercial lenders and investors; and

•  No significant R&D spending or time commitment prior to EIS investment – similarly, a company which has already committed significant time and R&D funding to the development of a new product might be in a position to demonstrate a track record or potential with which to approach commercial lenders or investors.

That is not to say that operating in a similar sector completely precludes older companies from taking advantage of the new product market exemption though in our experience to date, HMRC has been more reluctant to grant clearance where a company’s new product prima facie appears to be similar to existing products.

When making advance assurance applications looking to fall within the new product market exemption, care should be taken to clearly demonstrate how that new product differs materially from existing products. The application should provide as much technical information as possible and evidence how the new product cannot be substituted for the previous product. A SCEC inspector needs to be convinced that the new product is not incremental to the company’s existing product line but a whole new business in its own right.

For further advice on the new EIS Rules and the EIS application process, please contact any one of our lawyers.

Adam Lawrence