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Dead or Alive: the future of the BES Scheme

Irish Tax Review - March 2007

[Note: since this article was written, the BES has been replaced by the Employment and Investment Incentive Scheme]

In last December’s budget, it was proposed that the ‘Business Expansion Scheme’ (BES) would be continued and extended. Following this announcement, the matter was referred to the European Commission by the Irish Congress of Trade Unions. They complained that the BES was simply a “vehicle for tax avoidance for wealthy people”1 and, therefore illegal. The Irish government then said it would make its own referral to Brussels to confirm the proposed continuation was in line with EU guidelines.

If the European Commission does not approve the proposals, it will have ramifications for entrepreneurs, investors, the Government and would amount to an about face for the Commission. At present, entrepreneurs have to approach investors with uncertainty surrounding whether or not an investment will come with attractive tax relief. Investors are being asked to invest in the hope that Commission approval will be forthcoming. This article examines the BES, the proposed amendments, the European Commission’s guidelines for such measures and the likely outcome of the post-Finance Act 2007 referrals.

Business Expansion Scheme
The BES is referred to in the Taxes Consolidation Act as ”Relief for Investment in Corporate Trades” and is found in sections 488 to 508 inclusive.

The aim of the scheme was to provide an incentive to private investors to invest in small and medium sized enterprises operating in certain sectors that would otherwise find it difficult to raise such funding. It provided tax relief for such investors.

Prior to 31 December 2006, individuals could claim tax relief on investments up to €31,750 per annum. The investor had to be Irish resident and had to purchase new ordinary shares in a ”qualifying company”. The shares could not carry any preferential rights and the investor could not be connected with the investee company. The shares had to be held for a minimum of five years. No future options over the shares could be granted during this period. No agreements could be put in place which would have had the effect of eliminating the risk that there will be no return on the investment.

Investors could also utilise “designated investment funds” to spread the investment and benefit from expert advice in appraising potential companies. A ”designated investment fund” required approval from the Revenue Commissioners and the Irish Financial Services Regulatory Authority. A “qualifying company” was one which was engaged in certain activities which were identified as risky. The activities had to be certified by a relevant authority. For example research and development activities had to be certified by the Industrial Development Agency. The company had to be unquoted and incorporated in the European Economic Area with an establishment in Ireland.

The maximum BES holding in a company was €1,000,000 – limited to €750,000 in any one year. If the company was wound up within 3 years of the investment being made, it had to be for bona fide commercial reasons.

In August 2004, the European Commission wrote to the then Minister for Foreign Affairs, Brian Cowen, in relation to the BES. The Commission determined that the BES constituted State aid to enterprises. Such aid is prohibited save in certain circumstances. The Commission indicated that the scheme came with the guidelines set out in its communication on State Aid and Risk Capital (SARC) and was, therefore, lawful.

Proposed Amendments
In the budget speech, Brian Cowen, now Minister for Finance, announced that the BES would continue until 2013. The limits on investment would be increased: qualifying companies could raise €2,000,000 and individual investors could claim relief on investments of €150,000 per annum. Investments made before 31 January 2007, could be used to relieve 2006 taxes.

The ICTU reacted by describing the main effect of BES as “to shield high income earners, who ‘invest’ in what are too often risk-free BES schemes, from income tax”. They made reference to the fact that 14 millionaires paid no tax in 2003 by utilising loopholes such as the BES. The responses to this were not varied:

• “ICTU appears to have missed the link between wealth creation and tax generation and the ongoing need to foster an entrepreneurial economy.”
• ICTU should “get into the real world and immediately retract their objection to an initiative that supports small enterprises, the backbone of the Irish success story.”7
• “We need to help not hinder job creation. ICTU should reconsider their position.”
• “The suggestion that the scheme would be used as a tax avoidance measure flies in the face of the reality that anyone who invests in business is taking a risk.”

Obviously, there is a divergence of opinion on the BES. The proposals have hit a nerve and the outcome of the referral to Brussels will be eagerly awaited. But what is the likely outcome?

EU Rules
Article 87 of the EC Treaty prohibits State aid which has the effect of distorting intra- Community trade. Strictly speaking, all State aid to enterprises is capable of having this effect. Among the exceptions to this rule is where the aid is to promote economic development and certain activities. Tax relief to investors is considered a State aid to promote risk capital investment.

In August 2006, the European Commission produced ‘Community Guidelines on State Aid to Promote Risk Capital Investments in Small and Medium Sized Enterprises’ (referred to below as the ‘guidelines’). These guidelines replace the previous set under which the 2004 review of the BES was carried out.

The choice of form of an aid measure lies in general with the Member States. Included in the types of measure envisaged are “fiscal incentives … to investors to undertake risk capital investment”. Thus, tax relief is an acceptable form of State aid to promote risk capital investment.

The guidelines point out that a State must target a specific market failure for the existence of which there is sufficient evidence. In other words, there must be proof that BES companies would find it difficult to raise equity capital in the absence of the scheme. The Department of Finance carried out a review of the scheme in 2006, the results of which were included in a report published on 19 February 2007. Interestingly, the results do not clearly indicate a ‘specific market failure’. The results do indicate that BES funding is very much welcomed by the investee companies and that there is a demand for further funding.

A 2003 review of the BES by the Department of Enterprise, Trade and Employment concluded that there was a shortage of early stage development capital and this was accepted in the Commission’s 2004 letter. Moreover, the current Commission guidelines do note that there is an ‘equity gap’ in the risk capital market mainly concerning “high-tech innovative and mostly young firms with high growth potential”.

The Review Process
Under the guidelines, a referred measure will be subject to preliminary review to assess whether the measure meets “conditions for compatibility” with Article 87. If it does not, the measure may still be approved following a more detailed assessment of it.

The “conditions for compatibility” are as follows:

The maximum level of investment in any twelve months is €1.5 million.

The measure must be restricted to enterprises up to expansion stage for small enterprises and, where located in ‘assisted areas’, medium enterprises.

Regard will be had to the degree of risk borne by the investor, the potential losses to the investor, the level of profit dependent remuneration, and what the investor receives in the event of insolvency.

At least 50% of the funding must come from private investors.

The measure must ensure decisions to invest are profit driven – i.e., based on the prospect of a significant profit potential. This criterion will be met if there is a high level of private investor participation, a detailed business plan exists, and a clear exit strategy exists for each investment.

The management team must behave as managers in the private sector, seeking to optimise the return for their investors.

The Commission may accept measures which provide relief for funds with a sectoral focus such as innovative technologies or even sectors such as health, IT or biotechnology. The final two conditions would apply to ”designated investment funds”.

ICTU argue that, in reality, the investors do not bear risk – contrary to the third condition. However, the Irish legislative provisions do provide that where an arrangement is in place which results in the elimination of risk for an investor, the relief will be withdrawn.

Detailed Assessment
Where the risk capital measure falls outside the conditions for compatibility, a more detailed assessment of the measure will be carried out. The assessment will be based on the following “balancing test”:

1. Is the aid measure aimed at a well-defined objective of common interest, such as growth, employment, cohesion and environment?

2. Is the aid well designed to deliver the objective of common interest, that is does the proposed aid address the market failure or other objective?

a. Is State aid an appropriate policy instrument?

b. Is there an incentive effect, i.e., does the aid change the behaviour of firms and/or investors?

c. Is the aid measure proportional, i.e., could the same change in behaviour be obtained with less aid?

3. Are the distortions of competition and effect on trade limited, so that the overall balance is positive?

Possibly Permitted
The guidelines set out what types of measure may be permitted following a detailed assessment:

• Those which exceed the €1.5 million per annum limit will be permitted where there is evidence to support that this level funding is required and it will not be forthcoming from the risk capital market.
• Support at expansion stage for medium sized firms in non-assisted areas is permitted again provided there is evidence that it is necessary.
• Measures which provide for follow on investments are permitted provided they are consistent with the initial investment and with the size of the fund.
• Less than 50% private participation may be permitted.
• Measures involving investment vehicles may be permitted where there is clear evidence that they are necessary.
  
• Grants which cover the ‘scouting’ costs incurred by risk capital funds in identifying SMEs may be permitted subject to conditions.

Evidence
Evidence showing market failure must be based on a study showing the level of the ‘equity gap’ with regard to the enterprises and sectors targeted by the risk capital measure. Presumably, that is what the recent Department of Finance report (referred to above) is supposed to be. Notably, on its face, that report does not clearly demonstrate that, in the absence of the tax incentive, risk capital investment would be unavailable for the benefiting companies.

Appropriateness
The member state will have to establish that the measure is appropriate. It can do this by demonstrating that it considered other policy options and the advantages of using the measure in question. The interaction of the measure with other measures taken to redress the ‘equity gap’ will be considered.

Incentive Effect
It is crucial that the proposed measure has an ‘incentive effect’. In other words, the measure must ensure that there is an incentive for investors to invest and for the company to generate profit.

Proportionality
The extent of the State aid (in this case, tax relief) must be no more than is necessary to achieve the desired end. If the BES does fall for detailed assessment, ICTU will argue that the measure is disproportionate in that it provides too much tax relief which only the wealthy can maximise the benefit of.

Negative Effects
In carrying out a detailed assessment, the Commission will require evidence that private investors (outside BES) are not crowded out of the market by incentivebased investments or encouraged to wait for the State to provide aid for such investments. A risk capital measure may have the effect of keeping inefficient companies afloat which would otherwise disappear under normal competition conditions. To ensure this is not the case, the Commission will examine the profitability of companies, the rate of their failure, the size of the investment tranche permitted, and the over-capacity of the sector benefiting from the aid.

Conditional Approval
The Commission may attach conditions to the approval of a scheme to reduce competition distortion and re-introduce proportionality. The sample conditions are all intended to bring the measure in line with the ‘conditions for compatibility’ set out above. The Commission may make approval conditional on reduced tax relief for investors.

Conclusions
On an initial review of the government’s proposals for the continuation and extension of the BES, it would appear that the scheme will meet the European Commission’s conditions for compatibility with Article 87(3) of the EC Treaty. Indeed, the BES seems to be exactly what the European Commission had in mind. However, in the event that the BES fails to meet those conditions, it will fall for detailed assessment. Such an assessment would require the government to show that the BES is necessary, appropriate, effective and proportionate.

For the Commission to wholly disapprove of the BES, it would have to revisit the guidelines which it set down a mere 6 months ago. However, the guidelines are sufficiently vague to enable the Commission to make a determination which at least restricts the proposed extension of the scheme. For example, it may point to the lack of evidence of a gap in the equity market or determine the scheme is disproportionate in its effects. While these outcomes are possible, they do not appear to the writer to be probable. That said, Brussels has been the source of surprises in the past and the outcome of the referrals will be highly anticipated.

LINK to full article with citations.