Budget Feedback, the Patient Capital Review and Productivity

My last post on the Chancellors Budget was written quickly but seems to have covered most of the important points. Perhaps one significant item missed was the additional liability of foreign investors for capital gains tax on property sales, although institutional investors may be exempt. This might have some impact but as the details are not yet clear, it remains to be seen what.

Otherwise the media feedback on the budget was generally positive although there was a big emphasis on the poor economic forecast for growth that the Chancellor announced. The OBR has substantially reduced growth forecasts which is one reason why debt will not be falling as quickly as previously indicated and future tax revenues will likewise be lower. Part of the problem is a failure to improve productivity. This also means that average wages in real terms may not grow as expected.

Why did I not comment on this? Because firstly economic forecasts (the OBR or anyone else’s) are notoriously unreliable, and secondly it makes little difference to most UK investors. It might suggest it would be wiser to invest more in overseas companies than UK ones, but in reality many UK companies have major revenues and profits from abroad. In any case, a lot of investors have already hedged their portfolios against the possible damage of a “hard Brexit” by adjusting their portfolios somewhat.

My experience is that investing based on country economic forecasts is very questionable. Good companies do well irrespective of the state of the general economy.

Patient Capital Review

On Budget day the Government (HM Treasury) also published their consultation response to the “Patient Capital Review” – or “Financing Growth in Innovative Firms” as it is officially called. You can find it on the internet. This review was aimed to review incentives to invest in early stage companies with a view to promoting more investment in such companies as part of the attempt to improve productivity in the UK economy. It potentially had significant impacts for investors – for example on the EIS and VCT tax reliefs. What follows is an attempt to bring out the key points:

The review considered not just the tax incentives, and whether they were effective, but whether more direct investment (supported directly or indirectly by the Government) should be undertaken. They got more than 200 written responses to the original consultation on this subject (see mine here: http://www.roliscon.com/Roliscon-Response-to-Financing-Growth-in-Innovative-Firms.pdf ; the ShareSoc/UKSA official response is here: https://www.sharesoc.org/wp-content/uploads/2017/09/ShareSoc-UKSA-Patient-Capital-Patient-Capital-Review-FINAL-VERSION-20170924.pdf), plus some on-line responses and they also used a panel of industry experts.

Although they have not published all the responses or broken them down in detail, one gets the impression that most respondents considered that the VCT/EIS regime was generally effective in stimulating investment in early stage companies and that there were few abuses. But the Treasury had expressed concern about some of the investments made in EIS/VCT companies which were often focussed more on “asset preservation” than in funding new growing businesses. So the rules are being tightened in that regard – see below.

A personal note: having invested in two EIS schemes that promoted country pubs the asset preservation capability might have made for a good sales pitch by the promoters but they subsequently turned out to be very poor investments even after the generous EIS tax reliefs. One is being wound up with the assets being sold for much less than purchased while the other one only made any money after it turned into a bailiff business subsequent to a shareholder revolt. The Government’s policy of ensuring a focus on “riskier” investments might actually be good for the investors as well as the economy! It will avoid inexperienced investors getting sucked into dubious investments by sharp promoters who can make even lemons sound attractive because of the generous tax reliefs.

On the support for new investment front, the Government is taking these steps:

• Establishing a new £2.5 billion Investment Fund incubated in the British Business Bank with the intention to float or sell once it has established a sufficient track record. By co-investing with the private sector, a total of £7.5 billion of investment will be supported.
• Significantly expanding the support that innovative knowledge-intensive companies can receive through the Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCTs) while introducing a test to reduce the scope for and redirect low-risk investment, together unlocking over £7 billion of new investment in high-growth firms through EIS and VCTs.
• Investing in a series of private sector fund of funds of scale. The British Business Bank will seed the first wave of investment with up to £500m, unlocking double its investment in private capital. Up to three waves will be launched, attracting a total of up to a total of £4 billion of investment.
• Backing first-time and emerging fund managers through the British Business Bank’s established Enterprise Capital Fund programme, supporting at least £1.5 billion of new investment.
• Backing overseas investment in UK venture capital through the Department for International Trade, expected to drive £1 billion of investment.
• Launching a National Security Strategic Investment Fund of up to £85m to invest in advanced technologies that contribute to our national security mission.

In addition the Pensions Regulator will clarify guidance on inclusion of venture capital, infrastructure and other illiquid assets in portfolios and HM Treasury will encourage defined contribution pension savers to invest in such assets.

Entrepreneur’s Relief rules will be changed to reduce the disincentive to accept more outside investment, and the Government will also look at a guarantee programme modelled on the US “Small Business Investment Company”.

They will also work with the Intellectual Property Office on overcoming the barriers to high growth in the creative and digital sector. What this implies is not clear. Does that mean they are suggesting introducing software patents perhaps?

Several gaps in the investment market for early stage or follow-on funding were identified but one telling comment from the expert panel was this: “…the UK venture capital market has historically delivered poor returns; this results in less capital being attracted to the asset class, which in turn results in less talent being attracted to the patient capital sector; this then depresses returns, completing the circle”. But they did suggest this could be fixed.

There apparently were many comments on the importance of the EIS/SEIS schemes for funding innovative businesses – for example: “EIS and SEIS incentives have been particularly effective at stimulating investment and are extremely valuable to bioscience investors”. But I suspect that has been of more benefit to companies raising capital than it has been in terms of achieving long-term positive returns for investors. It is a pity not more evidence was provided on that.

The Treasury response is to double the annual investment limit to £2 million for EIS investors, so long as any amount over £1 million is invested in knowledge-intensive companies. Also the annual investment limit for knowledge-intensive firms will be doubled from £5 million to £10 million for EIS and VCT companies, and a new fund structure for such firms will be consulted upon. There will also be more flexibility on how the “age limit” is applied for companies applying. Question: what is a knowledge-intensive company? The answer is not given in the Treasury’s response.

A “principles-based” test will be introduced for all tax-advantaged venture capital schemes. This will ensure that the schemes are focussed “towards investment in companies seeking investment for long-term growth and development”. Tax motivated investments where the tax relief provides most of the returns to investors will be ruled out in future. There must be “a risk to capital” for firms to qualify. Detailed guidance will be published on this and there are some examples given in the response document, although it is far from clear from those what the rules might be. Comment: as this is going to be “principle-based” rather than based on specific rules it looks like a case of the Treasury saying “we can’t say what is objectionable now but we will know when we see it”. This might create a lot of uncertainty among VCT and EIS fund managers and company advisors.

The rules for VCT investments will also be tightened up with the following changes:

• from 6 April 2018 certain historic rules that provide more favourable conditions for some VCTs (“grandfathered” provisions) will be removed
• from 6 April 2018, VCTs will be required to invest at least 30% of funds raised in qualifying holdings within 12 months after the end of the accounting period
• from Royal Assent of the Finance Bill, a new-anti abuse rule will be introduced to prevent loans being used to preserve and return equity capital to investors. Loans will be have to be unsecured and will be assessed on a principled basis. Safe harbour rules will provide certainty to VCTs using debt investments that return no more than 10% on average over a five year period
• with effect on or after 6 April 2019 the percentage of funds VCTs must hold in qualifying holdings will increase to 80% from 70%
• with effect on or after 6 April 2019 the period VCTs have to reinvest gains will be doubled from 6 months to 12 months

Comment: these changes would not seem to cause great difficulties for VCT managers and should not affect the returns to investors. Some of the changes might be helpful. The feedback from VCT managers is awaited.

But the income and capital gains tax reliefs for investors are basically unchanged, as is Business Property Relief on “unlisted” companies such as AIM stocks which were both mooted as being under consideration. As I wrote in my previous blog post on the budget, at least the Chancellor and the Treasury seem to have minimised the changes which is always helpful for investors. Being unable to plan many years ahead because of taxation rules and levels continually changing has been a major problem for investors. So on that score alone, the budget is to be welcomed.

As regards Entrepreneurs’ Relief, the government is concerned that the qualifying rules of Entrepreneurs’ Relief should encourage long-term business growth. The rules will therefore be changed to ensure that entrepreneurs are not discouraged from seeking external investment through the dilution of their shareholding. This will take the form of allowing individuals to elect to be treated as disposing of and reacquiring their shares at the then market-value. The government will consult on the technical detail. Comment: this seems to be yet another complication to taxation rules which is unfortunate.

Productivity

These changes to the tax incentivised schemes, and the Government investment in funds, may assist to improve the productivity of the UK population by focussing on high growth technology businesses. One cannot improve productivity by employing more coffee bar baristas, and such jobs are always likely to remain low paid. The budget change to increase the National Living Wage (the Minimum Wage) from next April will also promote improvement in productivity as it will make employers consider investment in automation rather than simply employing more staff.

There is also investment in infrastructure committed to in the budget, which might assist. Is it not the case that productivity is reduced because of the distances and time wasted in commuting in the South-East of England? The transport network (road or rail) is truly abysmal in the UK and has been getting worse. This means that folks are tired before they even get into work.

Unfortunately the housing market has been made more inflexible in recent years in some respects so people cannot move nearer to their workplace. Stamp duty increases have deterred moving to reduce travel costs, and higher house prices in some areas have not helped. For example, this writer recently met someone who lives in Southampton when his employer was based in Oxford – he could not afford to move. The reduction in stamp duty for first-time buyers in the Budget is not going to make a big difference to these problems.

So overall the Budget changes are more “nudges” in the right direction to improve the economy, while not being revolutionary. The Government’s tax base is not undermined and investors tax planning not significantly affected, so Philip Hammond may find he is in the job longer than expected after all.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )