Introduction

Increased investment in small and medium sized enterprises has long been a key objective for Ireland Inc. and, given our current state of affairs, rarely has such investment been so important. With this in mind, successive governments have sought to use tax incentives to shape taxpayer behaviour. For many decades, our tax laws have contained an array of incentives designed to promote investment in companies.

Finance Act 2011 made substantial changes to many of these incentives. As a whole, the changes should be seen as positive. However, some incentives have been curtailed and some of the new rules could be modified slightly to enhance their attractiveness. The recent changes are discussed in this article.

Interest on Borrowings Used to Invest in Companies

Since 1974, individuals have been entitled to a deduction for any interest paid on borrowings used to purchase shares in (or lend to) certain companies. This relief is frequently used by taxpayers, subject to high-earners relief restrictions where applicable.

However, following Finance Act 2011, the deduction will not be allowed in respect of interest paid on any borrowings taken out after 7 December 2010. Moreover, any individuals that have already borrowed to invest in companies will see their relief restricted such that only 75% of the interest will be deductible in 2011; 50% in 2012, 25% in 2013 with no relief available thereafter.

The removal of this relief will effectively mean that the funding cost associated with investing in a company (i.e. interest) will not be deductible, while the return arising from any such investment (e.g. dividends, interest, capital gain) will be fully taxable. Obviously, these changes will negatively impact the appetite for investment.

Relief for Investing in Employer Company

Share offerings to employees have long been used as an effective means of capital raising for companies. Up to 7 December 2010 employees who purchased shares in their employer company were (in certain circumstances) entitled to a deduction for the cost of the shares. This relief has been abolished by Finance Act 2011. The removal of this relief is likely to adversely impact certain companies’ capital raising activities in the future.

Investment in Film Companies

Tax incentives available for investing in film production companies are being extended to 31 December 2015. Under this scheme taxpayers are entitled to a deduction for the cost of their investment in film schemes. Tax based financing has become an important source of capital for Irish film companies and therefore the extension of this relief is a welcome initiative to come from Finance Act 2011.

Employment and Investment Incentive

One very welcome change introduced by Finance Act 2011 is the proposed revamping and extension of the Business Expansion Scheme (“BES”). BES relief has been available for certain investments since 1984. However, BES was of limited benefit to many companies as the range of qualifying activities was severely restricted and the cap on the overall funding that a company could raise from such a scheme was only €2 million.

The revamped scheme is called the Employment and Investment Incentive (“EII”) and will come into effect after a ministerial order has been passed. In many ways the EII is similar to the BES. However, it has been enhanced in several key areas. Like BES the rules for EII are complex but may be summarised as follows;

The Relief

Where a qualifying individual makes a qualifying investment in a qualifying company, they will be entitled to deduct thirty forty-firsts (i.e. 30/41) of the cost of the investment from their total income in the year of investment. If, after a three year holding period, the company has increased its number of employees or has increased its expenditure on research and development, a further deduction of eleven forty-firsts (i.e. 11/41) of the cost of the investment will be allowed.

Therefore, provided the company expands, the investor will get an income tax deduction for the full cost of their investment. If an individual cannot take a full deduction for the EII in any one year, the relief may be carried forward to future years. The individual must hold the investment for at least three years. If they do not meet this condition, the deduction may be reduced or, in certain cases, entirely disallowed.

The BES allowed for a full deduction for the investment cost in the year when the investment was made. However, under the BES scheme the investment had to be held for a period of five years. The reduced holding period of three years under the EII should be seen as a significant improvement by investors. The relief is currently scheduled to end by 2013.

The Investment

The investment must be made via the subscription for new shares in the company. The shares must be fully paid up and must not carry any preferential rights. The minimum qualifying investment for relief is €250 and the maximum for any one year is €150,000.

The investment must be used by the company to either:

• carry on relevant trading activities, or;
• carry out pre-trading research and development activities (subject to certain restrictions).

In either case, it must be shown that the investment will directly contribute to the creation or maintenance of employment by the company.

The Company

In order for the relief to apply, the company must satisfy the following conditions:

• It must be registered in Ireland or in another European Economic Area (EEA) State and the shares in the company must not be quoted.
• It must be tax resident in Ireland or in another EEA state.
• If resident in another EEA state the company must be carrying on a business in Ireland. Moreover, the company must exist wholly for the purpose of carrying out relevant trading activities in the state.
• The company must be a micro, small or medium sized enterprise (within the meaning of Annex 1 to Commission Regulation (EC) No. 364/2004 of 25 February 2004). In the case of medium sized companies the relief will only be available if it is operating in an assisted area or is in a start-up phase.
• All of the company's share capital for the 3 year investment period must be fully paid up.

As with the BES scheme, there is a limit to the amount of EII funding that any one company may raise. However, the limits have been significantly increased and are as follows:

• Up to €2.5 million of EII funding can be acquired by a company in any one year. Previously, the limit was €1.5 million for the BES.
• Up to €10 million of EII funding can be raised in total by a company. Previously, the limit under the BES scheme was €2 million.

The expansion of these limits is a very positive development.

Certification of companies under BES could, at times, be administratively onerous. It is expected that the certification under the EII scheme will be more straightforward and will be primarily handled by Revenue.

The Activity

Under BES only certain types of trading activities could qualify for the relief. Although the list of qualifying activities had been expanded over the years it remained restrictive and with the introduction of the EII it has been widened further.

The EII essentially allows any trade to qualify subject to the following exceptions:

• adventures or concerns in the nature of trade (e.g. once off trading transactions)
• dealing in commodities, futures, shares, securities or other financial assets,
• financing activities,
• the provision of certain professional services,
• dealing in or developing land,
• the occupation of woodlands,
• operating or managing hotels, guest houses, self-catering accommodation or comparable establishments,
• operating or managing nursing homes or residential care homes or managing property used as a nursing home or residential care home,
• operations carried on in the coal industry or in the steel and shipbuilding sectors, and
• the production of a film

The company should be trading when the investment is made. However, in cases where the company has not yet begun to trade the relief will be available so long as:

• it commences to trade within 2 years from the date of the investment, or;
• it spends a minimum of 30% of the proceeds in research and development activities connected with the trade. Under the old scheme companies were required to spend 80% of the funds on R&D

The individual

In order to qualify for the relief individual investors should not be connected with the company. The rules determining whether investors are connected with companies for the purpose of the EII are complex. However, the following people would generally be considered to be connected with a company:

• partners of the company in question;
• employees and directors of the company (who receive payments from the company in excess of a market rate for goods and services provided);
• people who hold (or have the right to acquire) 30% or more of the company's shares;
• people holding a controlling interest in the company.

In certain situations people may still invest in their own companies provided the total share capital and loan capital of the company does not exceed €500,000.

Drawbacks

The EII brings much needed and welcome improvement to the former scheme, albeit that there is still room for improvement. Firstly, it is likely that many of the people actually in a position to make investments into small and medium companies are high earners. However, the deduction available under the EII is a specified relief for the purposes of the high income earner's restriction. Therefore, depending on the investor's circumstances, up to 75% of the deduction could be deferred. Such a deferral could significantly erode the perceived benefit of the EII. It may be worthwhile introducing a full or partial exclusion of EII from the list of specified reliefs (which would be consistent with the BES Economic Impact Analysis carried out by the Department of Finance).

As currently drafted, if an investor were to make a loss on the sale of their EII investment, they would not be entitled to any capital gains tax losses. In order to provide a meaningful incentive for investors to invest in more high risk ventures, the rules could be changed to allow investors to retain the capital losses.

Finally, the EII only applies to the purchase of shares in a company which is an inflexible funding source that is difficult to repay. Many investors may be owner managers and may not want to sell their shares in the company at the end of the three year period. In order to give such investors a mechanism for recouping their investment, consideration could be given to allowing owner managers to make investments by way of loan capital. This would also go some way to making up for the removal of interest relief for investments in companies.

Seed Capital Relief

The seed capital relief has been extended in a number of ways most notably to widen the definition of qualifying trading activities in the same way as they were for the EII.

Three Year Corporation Tax Exemption

The existing exemption from corporation tax for start-up companies is being extended to companies commencing in 2011. The current relief exempts from corporation tax both trading income and capital gains on the disposal of trade-related assets by certain new or “start-up” companies in each of the first three years for which the trade is carried on. The exemption applies to the extent that a company's corporation tax liability for that year does not exceed €40,000, with marginal relief available for companies with tax liabilities of between €40,000 and €60,000.

Conclusions

Overall, the changes introduced in Finance Act 2011 should be viewed as a positive development. The removal of certain reliefs will negatively affect some taxpayers. However, replacement of BES by the EII scheme (once effective) should facilitate increased investment in small and medium companies. The benefits of the scheme and development of the SME sector could be encouraged further by making additional changes as suggested in this article.

Lorraine Smyth is Head of Group Tax with Bank of Ireland.

Kevin O'Hehir is Divisional Tax Manager also with Bank of Ireland.

Email: lorraine.smyth@boi.com or kevin.o'hehir@boi.com