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Incentives: Ready to rent? Latent risks with a business operation's pivot to circular economy product leasing

Posted on 17 January 2024

Demands for a more circular economy mean some business operations are diversifying into product hire and leasing, whether that is clothing, plant and machinery or other assets or products. If an item isn't shifting from the shelves as a sale, or is not currently being used within the business, perhaps it can generate additional revenue if contracted out on a lease (whether that's hire a handbag for a week, a forklift truck for a month or a drone for a year). In the shift to hybrid working, care also needs to be taken if now surplus premises space is sub-let.  

Such a shift can, however, put at risk tax-advantaged arrangements for investors and employees.  It can also throw up issues in relation to VAT and credit hire regulations.  

This article will focus on how such a shift in business activity can negatively impact tax relief for investors under the Enterprise Investment Scheme (EIS), and potentially disqualify on-going eligibility for tax-advantaged status of employee share options under Enterprise Management Incentive (EMI) plans.

Non-qualifying trading activities

Time will tell if, post-Brexit, our new domestic subsidy regime will open up greater flexibility in relation to the trading activities eligible for EIS and EMI. The existing legislation criteria are founded on requirements that had to meet EU State Aid rules.

As things stand, for both EIS and EMI, leasing is a non-qualifying activity. This is defined in the statute as including letting other assets on hire. It therefore encompasses any trading activity which allows a customer the use of the trader's property. It applies where, subject to reasonable conditions imposed by the trader, the customer is free to use the property or asset.

Standalone companies and Grouped entities have a different test applied

The tipping point at which the activity causes a problem differs depending on whether the business is a standalone company or part of a trading group.

Where a non-qualifying activity is undertaken by a standalone company, the activity must only be incidental and insignificant. There is no statutory definition to give any more clarity to those terms, but it generally means the non-qualifying activity must be negligible when compared to the other activity of the business.

In relation to a group, there is a little more tolerance. The tipping point arises when the non-qualifying activity becomes substantial. Unhelpfully, there is no legislative definition of 'substantial' for these purposes.

Whether excluded activities amount in aggregate to ‘a substantial part’ of a trade is therefore a matter of fact, to be decided in the light of all the relevant circumstances. Where, judged by any measure which is reasonable in the circumstances of the case (for instance, by reference to turnover or capital employed), such activities account for no more than 20 percent of the activities of the trade as a whole across the group, HMRC will normally accept that they are not ‘substantial’. This reflects HMRC's published guidance in its Venture Capital Schemes Manual. The guidance is however just that, guidance.

The meaning of 'substantial' in relation to trading activities has been considered by the courts. Albeit in a slightly different context. In relation to eligibility for business asset disposal relief (BADR) the underlying company must not carry on substantial non-trading activities. HMRC had long applied a 20% test in that context, however an Upper Tribunal case has looked at this in more detail and the interpretation explored in that case is worth considering in analogous scenarios too.

In Assem Allam vs. HMRC [2021] UKUT 0291, the Upper Tribunal found that previous HMRC guidance using a simple 80/20 test of trading versus non-trading activity is not always going to produce the correct answer when deciding if BADR relief is available. HMRC guidance has not completely done away with the 20% test, but less emphasis is now placed on it. As such the test for substantial qualifying v non-qualifying activities for EMI and EIS purposes might also now be viewed as more nuanced.

It may also now be relevant to consider the proportion of expenses spent on non-qualifying trading activities, as well as the amount of time and resources incurred.

The relevant factors might be measured over a period of time and not just at one point in time; particularly if the non-qualifying trading activity is seasonal.

Risk to Capital

Specific to EIS (and not relevant for EMI) there is also a need for a business to continue to meet the risk to capital condition. This condition is considered a gateway test and HMRC is afforded an element of discretion in determining whether or not an investment would qualify or fall foul of the condition. This condition consists of two criteria: 

  1. The company must have objectives to grow and develop over the long term; and
  2. There must be a significant risk that the investor stands to lose more than they stand to gain as a return.

The second criterion is relevant to consider where assets are being leased. The general policy objective of EIS tax relief is to provide benefit to those who put capital at risk. Asset-backed activities therefore generally form the basis for the list of non-qualifying trading activities. If longer-term asset leasing is now forming a significant portion of revenues and on an annuity basis, there might be an argument that the shift in business model has de-risked investors and therefore the tax relief might be exposed to withdrawal, at least in part.


There is therefore not an outright ban on such activity diversification, but a careful watch needs to be kept on the extent to which activity ramps up in relation to the performance of the wider trading operations. If the non-qualifying activity becomes substantial before the statutory termination date of the most recent EIS investment, or at any time whilst EMI options remain unexercised, then a disqualifying event is triggered that will negatively impact investor tax relief and curtail the prized tax-advantages of EMI.

Upsetting both investors and key employees is unlikely to be wise a move. Furthermore, unless the liability for employer national insurance contributions (NIC) has been transferred, by joint agreement, to the EMI option holders, the fact that the options become non-tax-advantaged from the date of the disqualifying event, means that the employer entity is exposed to a downstream employer NIC liability. The business will also need to consider how future equity incentive awards are to be delivered and whether that will require a different form of incentive arrangement to manage tax leakage and keep management motivated.

These are matters that will be scrutinised on future transaction due diligence, so beware just instructing your legal counsel to prepare new commercial contracts for asset leasing. Instead, ensure your trusted advisers can also highlight and advise you on the adjacent issues to minimise risk of inadvertent collateral damage, whether that is in relation to EIS, EMI, VAT or financial services regulations.  

For further information contact Liz Hunter

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