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By Andrew Drylie, 11 March 2022

What are HMRC Approved Knowledge Intensive Funds?

At Autumn Budget 2017, the government published its response to the Patient Capital Review. As part of a revised focus of the venture capital schemes, it announced that ‘a new Knowledge-Intensive EIS Approved Fund structure will be consulted upon, with further incentives provided to attract investment’. The government published a consultation, ‘Financing growth in innovative firms: Enterprise Investment Scheme knowledge-intensive fund’, on 18 March 2018 which asked for input on how to draw more capital to knowledge intensive companies. The consultation responses suggested that the new rules for the approved fund provide more flexibility for investors to claim relief. The result was that Legislation was to be introduced in Finance Bill 2019 to amend the requirements for an EIS approved fund in section 251 ITA 207. The rules will be amended to introduce an ‘approved knowledge-intensive fund’ that will:

  • require the funds to focus on investments in knowledge-intensive companies;
  • give approved funds a longer period over which to invest fund capital (requiring 90% within two years, compared to the current requirement of 90% within one year);
  • allow investors in an approved fund to set their Income Tax relief against liabilities in the tax year, or against their liability of the previous tax year, before the fund closes.

Funds deemed “HMRC approved Knowledge Intensive Funds” are funds whose tax status has been approved by HMRC prior to seeking investment. The approval status does not relate to performance; rather the status signifies that the fund is investing in companies qualifying as “Knowledge Intensive” and the fund is meeting certain timing criteria outlined below:

  • The Fund must invest 90% of the Investor's subscription within 24 months of the Fund’s closing date; and
  • The Fund must invest 80% of the Investor's subscription into qualifying knowledge-intensive investee companies.

In comparison, a normal or unapproved EIS Fund will have a deployment schedule that is to be decided by the Investment Manager. Approved Knowledge Intensive Funds were therefore introduced as a means of providing greater clarity to investors from a tax planning perspective and therefore encouraging private capital to be invested into companies qualifying as knowledge intensive.

 

 

What are Knowledge Intensive Companies?

The definition of Knowledge Intensive Companies includes those involved in research and development, product or technological innovation at the point of investment.

The company must be conducting one of the following at the one that shares are issued to investors:

  • Engaged in the development of intellectual property; or
  • More than 20% of the employees must be carrying out research that requires at least a Master’s degree from the date upon which investment is made for a period of at least three years.

Advantages of HMRC Approved Knowledge Intensive Funds:

Obtaining approval from HMRC as an approved Knowledge Intensive Fund has its merits, the main one being that investors are able to obtain EIS tax relief on the full amount invested earlier than unapproved EIS funds.  When investing in an HMRC approved knowledge intensive EIS fund, the investment date for self-assessment purposes is the closing date of the Fund. This differs from a normal EIS Fund, where this date is the date that funds are deployed into the underlying investee company. Most EIS Funds have a deployment window of 12-18 months, which can make tax planning more complicated.  

When investing in an approved EIS Fund, an investor knows that they will be able to avail of the income tax relief in the tax year of investment or may be able to carry back to the previous tax year. Another reason that may steer investor preference towards an approved Knowledge Intensive Fund is that it allows investors to submit a single EIS 5 form as part of their tax return as opposed to the individual EIS 3 forms, which are issued when funds are deployed into the underlying investee companies. 

Disadvantages of HMRC Approved Knowledge Intensive Funds:

There are some disadvantages in that the fund must be closed prior to the investments placed, so evergreen funds are not able to avail of the approved status and the fund cannot raise in tranches.  Furthermore, if the prospectus is issued for a fund to be managed by a person already managing another fund, the approved fund cannot close until the earlier fund has invested at least 50% of its capital. 

A further  disadvantage of approved Knowledge Intensive Funds is that the fund has to invest in Knowledge Intensive Companies. These companies tend to have extensive R&D processes meaning that their runway to revenue generation is often longer when compared with a SaaS or Fintech company. An investment in a Knowledge Intensive Company therefore will not appeal to every investor seeking to invest via EIS. Another disadvantage is the relatively low number of companies that qualify as EIS knowledge intensive companies. According to statistics from HMRC, in 2019-2020 there were only 385 Knowledge Intensive Companies raising funds compared to 4215 companies raising funds under EIS.

Approved Knowledge Intensive Funds can provide greater clarity to investors when investing in EIS Funds. The capacity to know the exact date upon which tax relief can be claimed should certainly be welcomed. However, there aren’t as many Knowledge Intensive Companies around, which may pose constraints to fund managers.  It could be argued that the scheme could easily be widened further to allow more companies to qualify as Knowledge Intensive  by relaxing the requirement for 20% of a company’s employees to be engaged in R&D. Many companies at the early stages of development may not have developed to the stage where employing staff is even viable. Perhaps relaxing this requirement to include founders and directors would further increase the number of companies eligible for the scheme. Consequently, this would increase the number of funds and investment opportunities available in the market, making a notable impact in improving clarity for EIS investors. Ultimately, this could drive even more private investment into the EIS market in the UK.