Community Affair

How will community investment tax relief introduced in the Finance Act 2002 work? ALLISON PLAGER reports.

THE CURRENT CHANCELLOR of the Exchequer is extremely keen to encourage wealthy investors to put their money into worthy projects, and what is more, he is prepared to make it worth investors' while. He does this by dangling generous tax reliefs under their noses, so that provided the relevant rules are met, investors are rewarded with substantial tax savings.

Community investment tax relief typifies such a relief. In a nutshell, the idea of this relief is to encourage investment in businesses and social enterprises in disadvantaged areas. Based on research carried out by the Social Investment Task Force in October 2000 and subsequent consultations, the scheme is enshrined in the legislation as section 57 of, and Schedules 16 and 17 to, the Finance Act 2002, together with accompanying regulations. The relief started life as a community investment tax credit, but was later transformed into a tax relief.

Community investment tax relief is available to individuals and businesses which invest in accredited community development financial institutions, which will in turn use the investors' money to fund small businesses working in or for disadvantaged communities. The scheme came into force on 23 January 2003, the Government having received clearance from the European Union regarding state aid, and applies to investments made on or after 17 April 2002.

Financial intermediaries

The principal aim of a community development financial institution is to provide finance and business advice to enterprises for disadvantaged areas. It can be a company or partnership, but not an individual. It will be able to make investments in the form of loans or equity investments, or a combination of the two in various enterprises, e.g. a business already operating, a new business, for-profit commercial businesses, social enterprises and community-based activities. However, the business will have to meet the criteria linked to the European Community definition of a small and medium-sized enterprise, i.e., the business must have:

• no more than 250 employees;
• an annual turnover which does not exceed 40 million euros, or an annual balance sheet total which does not exceed 27 million euros;
• no more than 25 per cent of its capital controlled by an organisation which is not itself a small or medium-sized enterprise.

Two categories of community development financial institution are possible:

• wholesale community development financial institutions will finance other smaller financial institutions;
• retail community development financial institutions will invest directly in enterprises in disadvantaged areas.

The institution will have to go through an accreditation process in order to qualify as a suitable vehicle for the community investment tax relief. The Small Business Service, an executive agency of the Department of Trade and Industry, will deal with accreditation applications. Once granted, the accreditation will last for three years, but can be renewed after that period if the institution continues to meet the criteria. Throughout the three-year period, the institution has to make annual reports to the Small Business Service to maintain its accredited status, and will be liable to a penalty of £500 if it fails to do so within the time limits stated in the regulations.

A list of all eligible disadvantaged communities in the United Kingdom, defined geographically, is contained in Annex A of the CITR Material published by the Secretary of State for Trade & Industry, which can be found on the Small Business Service website at:www.sbs.gov.uk/finance/citr.php.

Types of investments

A qualifying investment into a community development financial institution can be a loan, securities, or shares. The most significant condition that applies to an investment is that the community development financial institution must have control of it for five years, even though the institution can only be accredited for three years at a time. The risk is clear: the investor's money is tied up for five years, but the community development financial institution's accreditation is for only three years, albeit renewable. So, if further accreditation is not renewed, the investor cannot receive relief for the year in which the accreditation ceases and any following years covered by the investment.

The institution must issue a tax relief certificate to the investor or its nominee within 30 days of receiving the investment. Tax relief will only be granted to investors who possess such a certificate. A retail institution may issue certificates in respect of up to £10 million in any one accreditation period, while a wholesale institution may issue certificates for up to £20 million. A penalty of up to £3,000 may be imposed if a certificate is issued fraudulently or negligently.

The investor may protect himself against the risk provided that the arrangements are reasonable and much as would be expected, and would be made for commercial reasons if the investment were made in the course of a business of banking. That is, normal business risk protection is acceptable, but special arrangements are not permitted. The Revenue's own guidance notes say, at paragraph CIG1034, that an acceptable example of protecting the risk would be if a loan by an investor to a community development financial institution was secured by a charge on a property owned by the institution.

Who can invest?

The investor must not control the institution during the five-year investment period. The definition of control for the purposes of a corporate community development financial institution is provided by section 840, Taxes Act 1988, and section 839 for other types of institutions. He must be the sole beneficial owner of the investment, and where the investment is a loan, he must be beneficially entitled to repayment of that loan.

The investor cannot be accredited as a community development financial institution. The purpose of this is that where a wholesale institution invests in another accredited institution, only the first investment is relievable.

Individuals and companies who have the appropriate tax relief certificate can claim tax relief in each of the five years of up to five per cent of the invested amount. Alternatively, the investor can claim the amount which would reduce his annual income tax liability to nil.

Relief is only given to individual investors after taking account of:

• relief on taxable gains on life assurance policies;
• enterprise investment scheme relief; and
• relief under the venture capital trust scheme.

Furthermore, enough tax must be left in charge to cover any payments made under gift aid. For companies, the relief is given after taking account of marginal small companies relief, investment relief under the corporate venturing scheme and deduction of any double taxation relief.

Terms of investment

The invested amount of a loan is, for the tax year or accounting period in which the investment date falls, the average capital balance for the first year of the five-year period. For the following years or accounting periods, it is the average capital balance for the one-year period beginning with the anniversary of the investment date falling in the relevant year or period. For the third, fourth and fifth years, the amount must not exceed the average capital balance for the last six months of the second year of the five year period.

Example

Imogen loans £50,000 to an accredited community development financial institution on 1 August 2002. The terms are that £10,000 must be repaid each year beginning on 1 August 2004. Imogen's tax relief will be as follows:

If the loan is repaid early, no tax relief is due in the year or period in which that repayment occurs.

The invested amount for shares and securities is the amount subscribed for the shares or securities by the investor. Thus where an individual subscribes £20,000 for shares in a community development financial institution, and which are redeemable after six years, the invested amount for each year will be £1,000.

Investment return

Tax relief allowed to investors who receive dividends or interest from the community development financial institution in respect of their investment should not be affected, provided such payments are 'insignificant'. The legislation states that an amount of insignificant value is an amount which does not exceed £1,000. However, if the amount is more than this, then in respect of a loan investment, the amount should be insignificant 'in relation to the average capital balance of the loan' in which the value is received, and in respect of shares and securities, the amount should be insignificant 'in relation to the amount subscribed by the investor'.

The 'receipt of value' rules apply for six years beginning one year before the investment date, which is known as the period of restriction. Where value is received, the tax relief may be reduced by the equivalent amount. An investor receives value from the community development financial institution when it:

• repays, redeems or repurchases any securities or shares;
• releases any of the investor's liability to the institution;
• makes a loan to the investor which is not fully repaid before the investment is made;
• provides a benefit or facility for the investor;
• disposes of an asset to the investor at undervalue or acquires one at overvalue;
• makes a payment to the investor which is not in respect of a commercial transaction.

Generous, but risky

The new community investment tax relief is generous, although one of the obvious risks attached to it is that the investor is tied in for five years, while the community development financial institution's accreditation only lasts for three years, albeit renewable.

Potential investors will need to be fully apprised of this risk, as well others attached to the particular investment, before they proceed.

Read all about it

A wealth of information is available about community investment tax relief, and the Revenue has also promised further guidance aimed at investors, to compliment the guidance published for its own use. A selection of relevant useful websites follows:

• www.inlandrevenue.gov.uk
• www.hm-treasury.gov.uk
• www.sbs.gov.uk/finance/citr.php

Issue: 3899 / Categories: