R&D: When can VC holdings be ignored?by
When should a venture capital holding in an SME company be ignored for the purposes of the SME definition for R&D schemes?
Small or medium sized (SME) companies can use the SME R&D scheme that entitles the company to an additional deduction of 130% of relevant R&D costs. If the R&D company is not an SME it can only claim under the less attractive large company R&D Expenditure Credit scheme.
Where another enterprise has a holding of 25% or more in the R&D company then that enterprise’s headcount, turnover and balance sheet numbers will need to be considered in determining whether the R&D company is an SME.
If the investment of that upstream enterprise represents less than a controlling interest and it is one of a number of specific categories of enterprise – in this case a venture capital company – then it can be ignored for these purposes.
A Malaysian quoted conglomerate – the Genting Berhad (GB) group – owned, by way of a special purpose vehicle (SPV) a little short of 50% of the shares in DNAe Group Holdings Ltd (TC08227). At first glance, this would mean that DNAe would fail the SME tests as the SPV would be a partner entity. DNAe considered that the SPV was a venture capital company in relation to its investment and relied on the relevant exception in the SME definition.
HMRC disagreed with this interpretation and issued closure notices, against which the company appealed.
The key problem facing the parties in this case (and other similar cases) is that the EC definition of an SME does not actually define what a venture capital company is.
What is a venture capital company?
The tribunal considered that a venture capital company would usually exhibit a number of the following characteristics:
- It invests in high risk, speculative new (or relatively new) ventures – which promise significant growth potential – with a view to a high reward.
- It intends to maximise the return on its investment usually by an exit strategy.
- The investment is usually medium to long term, rather than a short-term dealing.
- It focuses on the balance sheet value of the investee company rather than its day-to-day trading – although its profitability and its liquidity will also be matters of scrutiny – and it will pay attention to questions of risk and methods of mitigating risk.
- It may offer strategic advice but will not be concerned with the day-to-day management of the investee company’s business.
- Notwithstanding the previous point, it may sometimes provide its expertise to the investee company in, for example, marketing, management and planning.
- It will usually have board representation on the investee company commensurate with the scale of its investment.
- Its obligation or right to inject additional finance may be subject to the attainment of certain objective criteria.
HMRC relied on its guidance at CIRD92100 (with underlining added):
We have seen examples of large groups that, through a group member, make strategic investments in new activities that have an obvious link with the overall business of the group. In these circumstances we would be unlikely to consider that the company was acting as a venture capital company if its aims were closely linked with the strategic aims of the group business. In these circumstances we would be more inclined to view this activity as the carrying out of an overall group purpose to expand the business by strategic investments rather than to invest for high growth and a lucrative realisation. But each case will need to be judged on its own facts.
In this case, HMRC noted that the GB group included another company (ACGT) that was a centre for excellence in genomic science. DNAe itself was a spin-out from Imperial College London and specialised in R&D into ‘point of care’ solutions for DNA gene sequence detection. HMRC argued that GB’s investment in DNAe was ’strategic’ in so far as it supported the business of ACGT. The SPV was not, therefore, a venture capital company.
Importance of business history
The tribunal seems to have spent a lot of time analysing the business history with respect to the DNAe investment and comparing its business with that of ACGT. Importantly, distinctions were drawn between the focus of ACGT’s business, which was agriculture and DNAe’s, which was very much human medicine.
The tribunal showed some sympathy to the first part of the guidance at CIRD92100, specifically stating that ‘if an investor sacrificed its commercial return for a group-wide strategic benefit it would not be a venture capital company.’
Importantly, however, the tribunal went on to say that the question of whether or not an investment was strategic was one of fact and degree. On these facts, the tribunal was satisfied that any strategic benefit was purely incidental and that the investment in DNAe was for the purposes of commercial return.
The SPV was a venture capital company, and thus DNAe won its appeal and could use the SME R&D scheme.
Three losses in a row
This is the third case involving these special types of investors (Monitor Audio dealt with institutional investors) and HMRC has lost again.
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I am an independent specialist adviser on the taxation of innovation, advising companies and other advisers on areas such as R&D tax relief, Patent Box and Creative Industry reliefs, as well as IP tax issues more generally.
Formerly a Tax Partner with KPMG LLP (UK), I left in 2011 to establish Aiglon Consulting.