Can an investment be EIS qualifying if a company acquires intellectual property and/or generates revenue from royalties?

Posted by on Jan 27th, 2021

Can an investment be EIS qualifying if a company acquires intellectual property and/or generates revenue from royalties?

The Enterprise Investment Scheme (EIS) is an attractive option to those wishing to grow their business and attract the attention of investors (by offering tax reliefs to those who invest).

In order to qualify for EIS there are a number of conditions that must be satisfied in order for a business to be able to offer these tax reliefs to investors, including that the monies must be used for a qualifying business activity, the investment satisfies the risk-to-capital condition and the company or group satisfy the basic age condition (further information on the scheme and the additional conditions that must be satisfied can be found on our previous blog  “How to qualify for EIS Tax Relief” here).

This blog discusses the issues around situations where:

(a)     Intellectual Property (IP) has been acquired or assigned from a previous business; and/or

(b)     Royalties or licence fees generated from IP.

By way of background, IP refers to intangible creations of human intellect (e.g.: copyright, patents etc.). These can range from anything such as a logo or an invention. Separately, royalties refer to an amount paid by a third party to the owner for the use of these creations each time they are used, while licence fees usually relate to a fixed payment for another person or company to use that IP, ordinarily covered under a licence agreement. In some instances, there may be a licence agreement that has a fixed fee in relation to using the IP for a certain period of time or in perpetuity, which also contains provisions for further royalty payments.

Risk-to-capital Condition

This condition is considered a gateway test, crucial to the acquisition of EIS advance assurance and of which HMRC is afforded an element of discretion in determining whether or not an investment would qualify or fall foul of the condition. HMRC have made it clear that this condition consists of two criteria:

  1. The company must have objectives to grow and develop over the long term; and
  2. There must be a significant risk that the investor stands to lose more than they stand to gain as a return.

Basic age Condition

Generally speaking, companies must meet the basic age condition to be EIS qualifying. This condition ensures that the tax relief is targeted on earlier-stage companies; requiring that the relevant investment (as defined in ITA07/S173A) be made before the end of the initial investing period.

The initial investing period for EIS ends 7 years after the company’s first commercial sale. The date of commencement of trade or the date the business was started are also valid starting points for the initial investing period, should a company prefer to use these. This 7 year period is extended to 10 years for knowledge intensive companies (“KIC”) (further information on KICs can be found on our previous blog “Knowledge Intensive Companies and the Enterprise Investment Scheme” here).

There are, however, exceptions to the basic age condition. The following three scenarios define the conditions under which a company may receive EIS funding after the end of its initial investing period.

  • Condition A – The funding is used for the same qualifying business activities as the first relevant investment and is foreseen in the company’s business plan at the time of planning the initial investments.
  • Condition B – The amount of the relevant investment (together with any other investments made within a 30-day period) is at least 50% of the company’s average annual turnover over the past five years and the money is used for entering a new product market and/or geographic market.
  • Condition C – Condition B is satisfied and the rules from Condition A are followed.

(See our previous blog “EIS: Raising money outside of the seven-year basic age condition” for further details here)

IP acquired or assigned from another business

HMRC needs to be satisfied that a SEIS/EIS qualifying company has developed or owns IP that is central or significant to the growth and development of the business. This could be anything from commercialising an invention or growing the company’s brand.

However, issues often arise where the IP was initially developed by another business and it has since been acquired and assigned to the company that is seeking to apply for SEIS/EIS advance assurance. HMRC states that the rules look at all the businesses that have historically been a part of the company’s group. This pertains to parts of the business acquired by the company. Thus, if a company acquires IP from another company, there is a possibility that HMRC may take the date of the first commercial sale from the company that first developed the IP as a starting point for the acquiring company’s initial investing period.

The SEIS/EIS company must be developing its own IP. IP acquired from another company must normally be a basic form of foundational IP, which will need to be significantly developed in order for the IP to be fit for purpose/commercially viable.

In addition, there remains a possibility that the risk to capital condition could be affected by the acquisition of another company’s IP. If the company providing the IP is well-established, it could be seen as de-risking the investment which falling foul of the second strand of the risk to capital condition.

To overcome this issue, it is important to ensure that the companies are not connected to one another and the transaction should merely be for the sale and purchase of the basic IP, with plans in place to significantly develop and commercialise the basic IP in a separate entity. HMRC can, in some cases, frown upon ongoing payments being made to the older company (for example in the form of royalty payments) however this isn’t necessarily detrimental to any application.

Qualifying Trade/ Activity

The money raised from EIS must be used for a qualifying trade or, alternatively, the preparation, research or development that is expected to lead to a qualifying trade. For a single company, it is required that it exists for the purposes of carrying out a qualifying trade.

Activities are non-qualifying if they are non-trading activities or if they fall under the excluded activities list (ITA07/S192(1) and S303(1)). However, mere inclusion of these activities in your business does not amount to complete exclusion from being able to benefit from EIS advance assurance – these excluded activities must make up a substantial part of your company’s trade (with substantial being undefined but frequently applied by HMRC as above 20% of the company’s or group’s trade).

Among this list, the receipt of royalties/licence fees is listed as an excluded activity. Receipt of such fees/royalties can arise through the exploitation of IP, but they are not mutually inclusive.

Waiving the Exclusion

It is important to note that the exclusion of royalties and licence fees is not absolute, even if the activity makes up a substantial amount of the trade. The exclusion may be waived where the royalties or licence fees are attributable to the exploitation of ‘relevant intangible assets.’ That is, if the asset has been created by the company or, alternatively, if a company acquired an asset at an early stage of development and develops it to the point where they have created the greater part of it.

Example of how we have helped

We have helped to successfully secure EIS advance assurance for a company who entered into a licensing agreement to acquire and develop a patent from another established public limited company. The public company had been in existence for around 10 years and had developed some foundational IP upon which some of the managers wished to commercialise further. The business spun out and the public company licenced the basic patent to the company that instructed us, allowing the company to commercialise and significantly develop the patent further.

Upon the successful development of this patent, a small royalty would be paid to the original owners. In this case, despite the presence of the IP acquisition and royalties to be paid, HMRC recognised that the company had remained unconnected to the more established public company and had added value to the IP since acquisition – waiving the exclusion.

Summary

The EIS qualification of companies acquiring IP and of companies generating revenue from royalties are common issues that can exist by themselves. However, when dealing with either issue, it is crucial to ensure that your company’s involvement in either falls in line with HMRC’s requirements for EIS.

It is possible for a company to acquire IP and/or generate revenue from royalties whilst protecting its EIS qualification. A company can acquire IP from a well-established company without falling foul of the risk to capital condition as long as there is no financial support or on-going relationship between the two transacting parties. A company may acquire IP from another without any effect to the start date of their initial investment, as long the amount of IP is insignificant both to the company providing it and the company acquiring it.

The generation of revenue from royalties/ licence fees may be a part of the business’ trade without sacrificing EIS qualification if it makes up less than 20% of the trade overall. Conversely, if it makes up more than 20% of a company’s trade, the company may still be EIS qualifying if the asset in question was created by the company or acquired and then developed on.

All in all, your company’s acquisition of IP or its licence fee/royalty revenue needn’t affect the success of your EIS application. Nevertheless, they are essential considerations when carrying out business pre-EIS as well as when it comes to presenting your business activities to HMRC, in particular as there is significant discretion around HMRC’s determination as to whether or not a business satisfies the risk to capital condition and/or the IP is going to be significantly developed.

In any event, it will often be vital that you seek assistance where any of the IP issues above are, or may be, present within your business and you are seeking to apply for EIS.

How can we help?

Having advised many clients on numerous SEIS and EIS applications, we are pleased to announce that in 2020 we were successful in receiving approvals from HMRC on 100% of our applications.

Given our success and experience in the area we are prepared, in the majority of cases, to offer a no-approval, no-fee quote.

If you would like to discuss submitting an EIS advance assurance application, or if you would like to know more about the process and our fees, we offer a 20-minute no cost, no obligation call as a starting point. If this is of interest, please get in touch via the wewillhelp@jonathanlea.net email address to schedule a call with one of our fee earners.

About Callum Ritchie

Callum has undergone a number of work placements with different law firms throughout his studies, gaining experience in a variety of practice areas. Callum’s studies at both undergraduate level and on the LPC, as well as previously working for start-ups in different industries, have given him a strong understanding of how to practically apply his knowledge of the law in a commercial context.

The Jonathan Lea Network is an SRA regulated firm that employs solicitors, trainees and paralegals who work from a modern office in Haywards Heath. This close-knit retain team is enhanced by a trusted network of specialist self-employed solicitors who, where relevant, combine seamlessly with the central team.

If you'd like a competitive quote for any legal work please first send an email to wewillhelp@jonathanlea.net with an introduction and an overview of the issues you'd like to discuss, following which someone will liaise to fix a mutually convenient time for a no cost no obligation initial call with one of our fee earners

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