The Enterprise Investment Scheme (EIS) can provide very significant tax relief for investors in unlisted companies but a recent case in the First Tier Tribunal (“FTT”) shows how strictly the rules of the Scheme are interpreted.
One of the many conditions of EIS relief is that the shares issued to the investor must not have any preferential right to a company’s assets on a winding up. The requirement is included so that an investor cannot obtain the tax advantages of EIS relief while being shielded from the economic risk of the investment.
Flix Innovations Ltd (“Flix”) was a technology company which had developed a new method of providing digital content to cinemas. It required an additional £300k of investment to develop and market its product. However, the company's shares were structured in such a way that it would have been difficult to attract outside investment.
Flix therefore decided to restructure its shares to make it easier to attract such investment. The shareholders had wanted to cancel one class of shares to achieve this but, since company law did not allow this in the circumstances, they decided to strip most of the rights from one class of shares instead, leaving a class of “deferred shares”.
The result was that, in the event that Flix was wound up, holders of ordinary shares had the right to receive the nominal value of their shares in priority to holders of the deferred shares. The total value of the preferential right was £933, which represented only 0.05% of the market value of all shares in Flix at that time.
However, HMRC refused to approve an application for EIS relief from Flix on the basis that some of the shares had preferential rights.
Flix first argued that the value of the preferential right was so small that it was de minimis and should be disregarded.
The FTT accepted that, in some cases, the courts can use a de minimis principle when interpreting legislation, so that matters which are “too negligible for the law to be concerned about” are disregarded. However, the FTT concluded that, because the conditions of EIS relief are so detailed and specific, the principle did not apply here.
Flix also argued that the purpose of the legislation was to prevent tax relief being obtained by investors who did not take on the full risks of investment. Since the investors in Flix would not be shielded from this risk, EIS relief should be available to them. However, the FTT concluded that Parliament had only intended the legislation to apply where the exact conditions were met and therefore refused to allow the appeal.
Flix is perhaps a typical example of the type of company intended to benefit from EIS relief. It had restructured its shares for genuine commercial reasons and had it done so in a slightly differently way it could have met the conditions of the relief. However, this case shows that the conditions of EIS are applied stringently by the courts and emphasises the importance of ensuring that the letter as well as the spirit of the law is followed.