Of feathers and tax
12 December 2019
Around 350 years ago, LOUIS XIV’S FINANCE minister, Jean-Baptiste Colbert, famously declared that “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”
In a somewhat less grizzly tone, around 10 years ago Moira Stewart declared “tax doesn’t have to be taxing” as part of a HM Revenue & Customs ad campaign.
The Colbert quote has stood the test of time because it rings true. Who’s placing any bets on poor Moira still being quoted in three centuries’ time? Me neither.
But after taking a deep breath and accepting that a little hissing is inevitable, it’s time to remember the sort of incentives that the tax system has to offer. A guide to keeping a few more feathers, if you like. We’re focusing here on the SME market, as lots of incentives are aimed at younger / smaller enterprises, and in particular on getting investment and looking forward to possible sale.
The big incentives available here remain the Enterprise Investment Scheme (EIS) and Seed EIS schemes. These provide tax incentives for people who invest in your equity and can help you attract money more easily. The rules are targeted at outside investors so founders / managers cannot typically benefit, but it may help friends and (some) family invest.
Focusing on EIS (which has the most generous thresholds) if your business qualifies then investors can get 30% of their investment back as income tax relief, sell the shares capital gains tax-free if they hold on to them for 3 or more years, and can claim further income tax relief if the investment fails. Talk about loading the dice!
The downside to all this Government largesse is a very complicated set of rules, ostensibly intended to target the relief at those most deserving, but in practice providing dozens of ways to accidentally trip up and lose the reliefs. The change that was made in 2018 that deserves close attention is that money raised through EIS should be used for “growth and development”. In other words it’s not enough for EIS money to be used just to pay the bills – there needs to be a bigger plan to grow, for example, revenues / customer base / headcount. Give thought to your business plan and (crucially) follow through on that as best you can to make your EIS status as robust as possible
Structuring for Sale
One angle on this is deciding how to incentivise / tie in your senior team. For those trading businesses with gross assets of less than £30m and fewer than 250 full-time equivalent employees, Enterprise Management Incentive (or EMI) options should definitely be considered. The beauty of them from the company’s point of view is that until it’s exercised an EMI option is a piece of paper, not an actual shareholding, so you don’t need to complicate your shareholder decision-making or pay dividends to lots of smaller shareholders. If an employee leaves at any time before an exit you can specify that their EMI option simply vanishes. This is often called an ‘exit-only option’ because the employee only benefits if they’re around when there’s an actual sale or IPO. But the terms are flexible and you can specify that leavers get to retain some of their option if you want. This is popular with start-ups where the options are functioning as part of the remuneration package in lieu of a market salary.
The beauty of an EMI option from the point of view of the employee is that they are taxed (more or less) as if they had held an actual equity investment from the day they got their option. In other words, growth in value from that date is taxed as capital gain even though they didn’t have to put their hand in their pocket and actually take any risk. Even better, if an EMI optionholder sells after two years or more, they can claim entrepreneurs’ relief and pay as little as 10% tax on that growth in value. Even if they don’t hold the 5% which is normally required to qualify for entrepreneurs’ relief.
The key trap many businesses fall into with EMI options is leaving it too late. The tax treatment depends on the value of the shares at the date of option grant, so the sooner you can grant the options the lower the value you get to lock in for tax purposes (and the better it is for everyone).
Entrepreneurs’ relief is a bit of a vexed subject for all shareholders because at the time of writing (pre-election) we have had some recent reforms which tightened the rules. These reforms make sure that you need to hold a genuine 5% stake in the company and hold it for two years, not one, to qualify. Nonetheless, the relief is under fire from various quarters and could be at risk under any future Government. It’s still best to get your shareholdings in order and get them documented properly (something that’s very easy to miss for a fast-growing business with Other Things to Think About). If anyone is actively expecting entrepreneurs’ relief on eventual sale then make sure they will meet the conditions.
There are lots of other reliefs and incentives we haven’t covered here e.g. research and development reliefs, if your business has an innovative tech angle, and capital allowances which can give you valuable tax relief if you’re refurbishing your premises or IT hardware. But keep your eyes open and you may just get to keep a few more of those feathers.