TAC0062

Written evidence submitted by Octopus Group

 

 

Overview             

 

Octopus Group welcomes the opportunity to contribute to the Committee’s inquiry into tax after coronavirus. Our response below covers those questions set out in the consultation where we feel we can add value from our experience and expertise.   

 

Founded in 2000, Octopus manages £9bn of funds on behalf of 60,000 investors, including around £2.5bn of growth capital – both retail and institutional, including pension funds. Over the years we have invested in more than 500 SMEs including household names such as Secret Escapes, Graze.com and Zoopla Property Group. Octopus is the largest venture capital investor in the UK, with £890m of funds under management, representing 21% of the market. Our investments have helped businesses to create many thousands of new jobs.

 

Octopus Group also invests in critical infrastructure in the UK economy, including renewable energy and real estate. We are the largest solar investor in the UK and our renewable energy assets generate enough electricity to power 730,000 homes. We have also invested £50m into two fibre broadband businesses – Swish Fibre Limited and Jurassic Fibre Limited - which aim to bring full-fibre broadband to underserved homes and businesses in the UK.

 

 

  1. What is the role of tax reliefs in rebuilding the economy and promoting economic growth and efficiency? Does the current regime of tax reliefs perform this role well?

 

1.1 Introduction

 

As a long-time investor in high-growth small businesses, Octopus is well placed to assess the impact that tax reliefs have on the start-up and small business ecosystem and indeed how they will play a role in the upcoming economic recovery. We manage a diverse portfolio that is built on a range of products and tax reliefs that are designed to incentivise investment into British businesses and we hope that the breadth of our experience in this space can add insight into this inquiry.

 

In the sections below, we explain how the existing range of investment incentives is effective in directing private equity investment from different demographics into a spectrum of fast growing businesses at different stages of their growth journey. We also explore how patient capital can be especially valuable during times of economic instability, enabling businesses to retain the funding they need even when there is uncertainty in markets.

This is important in the context of the upcoming economic recovery. -We believe a holistic approach needs to be taken to ensure that as many UK businesses as possible have access to the capital they need - to survive this crisis, grow and thrive and support the levelling up of all parts of the UK. In particular, we will cover Business Property Relief (BPR), Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EIS), each of which has played a specific and important role in the UK start-up success story of the last 25 years and can all, if properly protected, help power an economic recovery in which growth is spread across the UK.

 

BPR in particular, which as an Inheritance Tax (IHT) relief is particularly attractive to older investors, is an ideal relief to support the coronavirus-era economy. It provides incentives to individuals who accumulated their wealth in a more positive economic climate and who will have been protected to a large degree from the economic consequences of the pandemic to take risk with some of their accumulated wealth, investing into growing British businesses and helping to unlock productivity.

 

It is important that such reliefs are harnessed as the country recovers from the economic shock that the pandemic has created. With the UK set to exit the Brexit transition at the end of December, there is also a need to ensure structural support for growing businesses so the UK remains an attractive base for foreign investment and talent.

 

Existing reliefs such as BPR are making a major contribution to jobs and prosperity across the whole of the UK - now is not the time to risk the benefits they offer our economy.

 

 

1.2 A thriving start-up ecosystem

 

The start-up finance ecosystem in the UK has been functioning well, thanks in large part to the success and stability of existing tax interventions in this space, starting with the launch of Venture Capital Trusts (VCTs) and the Enterprise Investment Scheme (EIS) 25 years ago. Successive governments have supported these schemes as an important incentive for private investors to take more risk with their wealth by backing early stage, growing companies. At around the same time, Business Property Relief (BPR), an inheritance tax incentive, was extended to all levels of shareholdings and shares in unlisted companies and those listed on growth markets. This effectively created a third investment incentive sitting alongside EIS and VCT that harnesses wealth from older investors towards supporting the growth of typically slightly later stage growing companies. It also coincided with the launch of the Alternative Investment Market (AIM) which is celebrating its 25th anniversary this year. The tax reliefs available help investors to offset this risk, and rebalance early stage investments into something attractive.

 

Whilst often talked about alongside one another, VCTs and the EIS play very different roles in reality, attracting very different pools of capital. Both are essential to the healthy functioning of the UKs early stage investment environment, offering investors upfront tax relief as an incentive for taking the risk of investing into smaller companies. EIS is a crucial mechanism for individual angel investors to provide funding in the form of initial injections of capital into companies, often at the very early stages of growth. This forms a valuable part of the overall ecosystem for entrepreneurs at a time when raising outside financing is likely to be the most challenging. 

 

At a slightly later stage of their development, VCTs become the perfect ‘patient’ capital vehicle for companies due to their unique structure. They have a number of characteristics highlighted by the Patient Capital Review as being optimal to provide support to companies with growth potential. Investors incentivised by BPR then provide a pool of capital once companies become too large to qualify for further EIS and VCT investment – exactly the point at which the Review identified the main funding gap to be.[1]

 

We think that these three tax interventions – VCTs, EIS and BPR - each have their own, highly valuable role to play in helping companies grow and develop in the UK. We have many examples within our portfolios where our ability to provide support to a company during its early, typically loss-making years, through IPO and beyond has enabled UK companies to take a long-term view and flourish. And importantly in the current economic climate, they each encourage investment from different demographics of investor, something we think is essential given the potential for inertia from private investors that uncertainty creates.

 

The strength of this ecosystem is clear not only from the pool of private financing that the well-structured tax incentive regime has made available, but also from the range of incubator and accelerator programmes all across the country that provide support, coaching and a wide range of ‘softer’ support to entrepreneurs as they strive to grow their businesses. As the Patient Capital Review noted, the different elements needed to create and scale-up successful businesses have developed simultaneously over the past decade, including finance, entrepreneurial ambition, skills and networks.[2] Often these support networks are linked to or provided by assets managers who have been able to develop a deep specialism in smaller company investment and growth through the VCT and EIS funds that they manage.

 

This support underpins a critical component of the UK’s economy. According to the Federation of Small Businesses (FSB), at the start of 2019 there were 5.82m small businesses (with 0 to 49 employees) in the UK, accounting for 99.3% of all business conducted in the country. High Growth Small Businesses are a particular engine of economic growth, employing around 1.9m workers and accounting for 84% of net employment growth between 2016 and 2017. They have been among the UK’s most productive businesses, contributing £113bn in gross value added to the economy over the same period.

 

The broad-based ecosystem that has evolved from the stable funding environment has clearly set the UK apart amongst its global peers as a place for budding entrepreneurs to start and finance their businesses. This in many ways put UK smaller companies in an advantageous position going into this recession compared to their international counterparts.

The Government’s “Financing Growth in Innovative Firms” consultation response in 2017 concluded that “the UK is “already more successful than our European peers” as a “place for growing businesses to obtain the long-term patient finance they need to scale up”. This is partly due to “successful government policy interventions such as the Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCTs)”.”

 

We consider the existing range of tax reliefs available to encourage private individuals to make equity investment into unlisted and AIM listed companies to form an important spectrum of support for businesses, taking them from very early stage through the growth phases of their development. These schemes have had a vital role to play in creating the individual success stories and strong entrepreneurial ethos that all parts of the UK benefit from today. They will play an important part in helping UK businesses access capital in the challenging economic environment that the coronavirus crisis has created.

 

Ensuring stability for these schemes is vital – both to give investors confidence in the investments they make, and to ensure the balance of risk and reward remains appropriate. Any changes to reliefs will inevitably involve a time lag as they are created, potentially undermining investor certainty at a critical moment for our economy.

 

1.3 EIS

 

EIS typically appeals to investors who are happy to invest into one or more individual early stage companies in the hope of achieving significant capital growth on exit. As this is an investment into the shares of individual companies rather than a fund, the opportunities for exit are very limited and investors will expect to hold each qualifying investment for a long period, typically 5-10 years or more.

 

EIS is a crucial mechanism for individual angel investors to provide funding in the form of initial injections of capital into companies, often at the very early stages of growth. As a result, EIS typically appeals to very experienced investors who may select their own EIS qualifying investments, or may select a specialist manager to create and manage a small portfolio for them. Because of the structure, an EIS investor’s money is typically spread across only a few companies. This means that the risk of losing money is high but the rewards of investing into early stage and high growth companies can be significant when viewed over a 5-10 year period.

 

In addition to the upfront income tax relief, the key mechanisms that incentivise EIS investment are the ability to claim relief for losses on exit from an unsuccessful investment against income tax, and capital gains tax free growth. These reliefs taken together ensure that for the right investor, the risks and rewards of investing significant sums for a long period into the UK’s brightest potential businesses are balanced. As a result, investors have become confident to use an EIS to put money into small and exciting companies and the wider start-up ecosystem benefits from higher injections of capital.

 

1.4 VCTs

 

A VCT is a listed investment company that pools investments in order to take minority stakes in a large number of small, early stage qualifying businesses. VCTs are often considered to be the perfect ‘patient’ capital vehicle. Because a VCT is a pooled investment vehicle, the support it can provide to an investee company tends to be much longer term. Individual investors can realise their investment if they want to, but that does not result in the VCT ceasing to invest in each underlying smaller company – liquidity is provided at the VCT level rather than through the shareholder withdrawing their capital from the portfolio company. Due to the fact they are a closed ended listed fund, they are also able to provide follow on funding to entrepreneurs from funds that they raise on an ongoing basis.

 

From an investor incentivisation perspective, the tax reliefs applicable to VCTs work to encourage long term investment. Of particular importance is the VCTs ability to pay investors tax free dividends, which in our experience is very effective in ensuring investors do not look to sell their VCT investment once the five year minimum holding period has ended. VCTs typically work very well to incentivise smaller annual investments from individuals who have put the maximum contribution into their pension and ISA each year. In this way, investors gradually build a larger well diversified pot comprising many multiple small interests in the underlying portfolio companies.

 

As a large, professional investor, VCT managers often take a seat on the board of their

portfolio companies, providing valuable advice and support gathered from years of smaller

company investment experience. They can also invest in tools, networks and resources to

help companies scale and compete globally providing a range of support in areas such as IT, operations, management and financial guidance. For example, the Octopus Ventures team has an office in New York for the sole purpose of helping UK portfolio companies enter the US market, and navigate its complexities, as smoothly as possible. VCTs are therefore a major contributor to the culture of entrepreneurship that has been built over the last twenty years in the UK.

 

We have found that this structure of VCTs naturally fosters a very positive relationship between managers and entrepreneurs right up to the point of a managed exit from their investment.

 

VCTs have effectively supported the investment of patient capital to date and offered solutions to all four main stated weaknesses in UK patient capital as highlighted in the Government’s Patient Capital Review consultation in 2017. These were: the fact that VCTs are stronger than average in their investment outside London; the provision of follow-on investment; AIM VCTs are well suited to support smaller IPOs; Venture debt is increasingly used by VCT-backed technology companies as a way of improving capital efficiency.

 

VCTs therefore form an important part of the UK’s thriving small business ecosystem and not just in London, but across all regions. This is key as we look to ensure that the economic recover meets the Government’s levelling up agenda and does not leave regions behind.

 

1.5 BPR

 

Business Property Relief plays a key role in encouraging investment into both unlisted and AIM listed companies when they reach a slightly larger size and are no longer able to be supported by EIS or VCT. This is exactly the stage of a company’s growth journey that the Patient Capital Review identified as presenting the biggest funding gap.[3]

 

BPR encourages older investors to make longer term, less liquid investments with their wealth by providing inheritance tax relief on the investment when they die. BPR has unlocked deep pools of retail capital from a demographic of investors who, without the availability of tax relief, would not be incentivised to invest their dormant capital in supporting growing companies outside of the main markets.

 

While the minimum holding period to qualify for BPR is two years, due to the nature of the tax relief BPR qualifying investments are often the most patient form of capital to which growing companies have access. This is because BPR encourages the holding of an investment “forever” as shares have to be held when an investor dies. This provides a very stable source of capital for AIM listed companies and enables them to fulfil their growth potential. 

 

This longevity is particularly valuable across market cycles, with BPR qualifying investors having no incentive to sell in fear of a market downturn. Octopus has seen no uplift in outflows from BPR qualifying investors since the start of lockdown.

 

We know that most investors inevitably underestimate their own life expectancy, which explains why half of our BPR investors who made their initial investment more than 10 years ago remain invested. Life expectancy statistics would suggest they may hold their investment for 20 years or more. This enables businesses like ours to support companies for the long term – for example, of the 39 AIM listed companies that currently form part of our clients’ portfolios, 33 have been part of our portfolios for more than 5 years, and 16 for more than 10 years. This contrasts with the approach of typical fund managers who tend to have short time horizons and holding periods, thereby hindering the ability of the management teams of those companies to focus on long-term growth.

 

This is important in the context of the ongoing recession because it demonstrates the security and stability that AIM listed and BPR qualifying companies have against short-term permutations in the economy. The knowledge that investors are in it for the long run – and that a significant percentage of AIM listed companies are owned by BPR shareholders - gives other potential investors confidence to back such companies, creating resilience in challenging economic conditions.

 

1.6 AIM

 

Since the launch of the AIM market, the ability for companies to raise funds through EIS or VCT at very early stages, then to find follow on support from investors who may be entitled to claim BPR at a later date has significantly contributed to the growth and success of companies listed on AIM.

 

This year marks the 25th anniversary of the AIM market, which as the London Stock Exchange has noted is among the most successful growth markets in the world.[4] This is in no small part due to the existence of these successful investment incentives. We have never seen an AIM market that has not benefitted from the support of these reliefs, and retail investors encouraged to invest as a result have often formed cornerstone investors both at IPO and in additional funding rounds. BPR qualifying investors can often represent more than 15% of a company’s shareholders, forming a stable and long term shareholder base that allows management to take a long term, growth outlook for the company.

 

BPR’s key strength as a deployment mechanism for long term growth capital is that, since investors hold it until death, it is less prone to exit during market downturns. By definition, the majority of investors hold it until they die, throughout positive and, most importantly, negative downturns in the market.

 

EIS, VCT and BPR have opened up AIM to private investors, who otherwise would be unlikely to venture outside of more mainstream assets with their wealth. This is important for two reasons:

 

  1. There is less analyst research available on AIM listed companies and so many retail investors will not be able to, or have the confidence to, invest in AIM without significant financial incentive.
  2. As a junior market whose principal goal is to raise finance, companies listed on AIM do not feature in passive funds and so do not benefit from having automatic buyers by being part of a tracker index fund.

 

As simple, low cost passive investment continues to grow in popularity, tax incentives like BPR become even more critical to incentivise capital inflows into this otherwise underserved part of the market. Management of portfolios of AIM listed companies is accordingly a specialist service which commands a premium over FTSE trackers and unit trusts. For many investors, the risk/reward profile would be insufficient without BPR as an initial motivator to take incremental investment risk.

 

Tax incentives are an effective way of stimulating investment in small but high potential new businesses on AIM because they can compensate for some of the additional risks associated with investing in such companies. They form a core part of the Octopus business model and the business models of many investors in the UK economy . They are also the foundation for AIM as a critical growth platform for smaller companies. Revenue growth reported by AIM companies is above 40% year on year for the first three years following IPO, with smaller companies seeing particularly strong growth in that period.[5]

 

1.7 ISAs

 

It is also worth noting the Government’s decision to enable AIM shares to be held within an ISA wrapper, which has been a significant success story. Since the rules changed in 2013, we have raised and deployed £1bn into AIM companies with a growth mandate, comprising both new ISA investments and the transfer of existing ISA portfolios that would previously have been invested in large FTSE listed companies or cash. This success has been entirely attributable to the fact that AIM listed companies operating in qualifying sectors can qualify for BPR, so older investors have been incentivised for the last six years to move some or all of their ISA savings from cash or main market assets into BPR qualifying AIM listed shares. 

 

 

1.8 Conclusions

 

The UK has adopted a well-structured range of tax reliefs that have been successful in attracting risk capital across demographics of high net worth investors and that, in their totality, have created the thriving start-up and expansion ecosystem that we discussed at the outset of this section. In the context of an economic recovery, this is important because we need to ensure that long-term equity support for UK companies from private investors remains available as an important source of growth capital.

 

We expect the UK to benefit from ensuring that the capital owned by wealthier older investors who are likely to have suffered the least negative financial impact from the pandemic continues to be directed towards supporting the growth of unlisted and AIM listed companies. We also expect those wealthier individuals who want to build patient and diversified portfolios in wake of the economic recession can use a VCT, and that wealthier investors who have accumulated capital while the economy has been closed can use an EIS to look to create fast and sizeable returns that, in turn, support innovative UK start-ups.

 

This entire ecosystem of investment and innovation has flourished in large part because of products and funds that are made attractive by tax reliefs. It is by continuing to drive growth and innovation in this way that tax reliefs and incentives can have a genuine and sizable impact on the UK’s economic recovery, across all parts of the UK.

 

 

  1. Which areas of the tax system are most in need of reform, and which are best left alone?

 

2.1 Introduction

 

Octopus believes that leaving alone VCTs and EIS would be a good course of action for the Treasury, and one that would benefit economic recovery. As we say above, the system is working to the benefit of the UK start-up ecosystem and the wider British economy. Not only is there is no real incentive to drastically change the way that tax reliefs in this area work, doing so would undermine the UK’s recovery from the coronavirus crisis and ability to level up all regions of the country.

 

 

2.2 Leaving BPR alone

 

One area where we think there is absolutely nothing to be gained from reform is BPR. BPR has significantly contributed to the success story that is the AIM market and incentivised countless older investors to invest in growing British businesses.

 

We think the coronavirus crisis makes BPR more essential than ever. It has resulted in the older generation being the most obvious demographic with money to invest – wealthy older investors have not seen their incomes reduced or eliminated and remain as financially secure as they were pre-crisis, or even more so as reduced consumer spending has likely led to the accumulation of incremental capital. At the same time by ensuring that private investors remain incentivised to invest in growing UK businesses, they can form a cornerstone of capital available for companies to use for growth.

 

 

2.3 Enabling unquoted companies to be held in ISAs

 

In our experience, customers like to retain assets in their ISA for as long as possible, only removing money from their ISA as a last resort which can make it one of the most patient forms of capital.

 

Given the success of the government’s decision to allow AIM shares to be held in ISAs, allowing investment into privately owned, unlisted companies from ISAs is the logical next step. Currently investors can make loans from their ISAs to unlisted companies as a result of the Innovative Finance ISA, which often results in them taking equity-type risk (due to smaller early stage companies being more poorly capitalised and having few assets) without having any potential to qualify for incremental upsides that only attach to equity investments.

 

We would expect the enabling of unquoted companies to be held in an ISA to be easily understood and therefore start to deliver benefits very quickly. There is currently £584bn (source: HMRC) of money held in stocks and shares ISAs, so even a very small percentage of it moving into unquoted companies would make a significant impact on the amount of patient capital available. It would also provide an additional source of financing for companies that have exceeded the VCT investment limits and start to create an investment environment more akin to the US system.

 

The legislation required to achieve this would be straightforward to implement, and some of the existing anti-avoidance legislation employed for SIPPs could be borrowed to prevent special purpose vehicles from qualifying.

 

 

2.4 Conclusions

 

The system of tax reliefs and investment vehicles in the UK is working for British investors and businesses alike. A major overhaul would therefore not only be unnecessary, but could have widespread detrimental impacts on start-up financing at a time of acute economic crisis. Octopus would therefore encourage the Treasury to be extremely cautious in its approach to tax in this area and, in particular, steer clear of removing or adjusting BPR.

 

That said, there are minor adjustments that we feel could be reasonably made that could enhance the investment environment for small and growing companies even further and aid the recovery, specifically enabling unquoted companies to be held in ISAs.

 

Octopus is keen to work with the Treasury and wider Government to ensure that the UK continues to be have a world leading start-up ecosystem and facilitative investment environment. We would also welcome further discussions with the Committee that builds on the points that we have raised in this response.

 

September 2020

8

 


[1] HMT consultation response, ‘Financing growth in innovative firms’, Nov 2017 P5 https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/661398/Patient_Capital_Review_Consultation_response_web.pdf

[2] HMT consultation response, ‘Financing growth in innovative firms’, Nov 2017 P5 https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/661398/Patient_Capital_Review_Consultation_response_web.pdf

[3] HMT consultation response, ‘Financing growth in innovative firms’, Nov 2017 P5 https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/661398/Patient_Capital_Review_Consultation_response_web.pdf

[4] London Stock Exchange press release, ‘London Stock Exchange celebrates 25 years of AIM’, 19 June 2020   https://www.londonstockexchange.com/discover/news-and-insights/london-stock-exchange-celebrates-25-years-aim?lang=en

[5] Grant Thornton report, ‘Celebrating the contribution of AIM to the UK’, 17 June 2020 https://www.grantthornton.co.uk/globalassets/1.-member-firms/united-kingdom/pdf/publication/2020/economic-impact-of-aim-june-2020.pdf