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Formative years

01 June 2006 / Kevin Nicholson
Issue: 4060 / Categories: Comment & Analysis , Income Tax , Investments , VAT
KEVIN NICHOLSON looks at the tax benefits available when starting up a business.

SUCH HAS BEEN made by the Chancellor of the Exchequer in his Budget speeches of promoting an enterprise culture and the role that this increasing dynamism can play in generating economic growth. It is therefore a good time to look at the fiscal incentives available to new businesses and, in particular, those setting out on the difficult road to long term prosperity by incorporating a company.

In the first of a series of three articles looking at formative stages in a company's development, this article discusses the reliefs available to the budding entrepreneur. The other articles will look at the reliefs available for management incentives and on obtaining external capital from the venture capital industry.

Getting off the starting blocks

In raising the necessary capital for investment in a new company, entrepreneurs will often look to their family, friends and other contacts for the funds to subscribe in new share capital. With the exception of the enterprise incentive scheme, however, few tax incentives encourage this initial investment. Interest relief may be available on the cost of borrowing to invest in the company, but if the investment does not qualify for EIS relief, there is nothing to offset the initial cost of subscription in the shares.

A full analysis of the restrictions that govern the availability of EIS relief is outside the scope of a general article such as this. However, the restrictions governing the individual investor's connection with the company substantially restrict the potential ambit of the relief. The 30% limit on the amount of ordinary share capital that can be held by an investor prevents the relief being given to new entrepreneurs who, not unreasonably, wish to retain a majority interest in the company as founder shareholders. As the interests of associates must also be taken into account in assessing whether the 30% limit is breached, this means that another source of potential funds, those of the founder's parents, is also prevented from qualifying for relief.

There are further restrictions on an investor who is involved in the management of the business. Commonly, a company will be incorporated with only a small amount of capital but as plans develop and the full costs of doing business become apparent, additional share capital may be required. However, where the investor is connected with the company through either prior personal employment by the company of himself or of his associate, EIS relief will again be denied for the funds invested.

The general effect of the restrictions governing the availability of EIS is that those directly involved in the management and day to day running of the company will generally not qualify for any tax relief on their investment, whereas relief may be available for third party investors who have no direct involvement in its operations. It is a moot point whether the risk that an external investor assumes when making such an investment is more deserving of tax relief than those who are willing to put at risk substantially more of their net worth either by working in the company in order to make their idea work, or encouraging their family to do so.

There are a host of other restrictions governing the availability of EIS income tax relief and capital gains tax deferral relief, some more esoteric than others. The continuous requirement to ensure that these are not breached for the three year qualifying period means the requirements do not sit easily with an entrepreneurial 'can-do' mindset where decisions may be taken rapidly and implemented immediately.

None of these requirements will prevent EIS relief being applicable to some or all of the funds invested but, equally, the relief is also commonly used when additional funds are invested to provide additional funding for an existing company. Consequently, the proposals in the Finance Bill to reduce the size of the gross assets for a qualifying company to £7 million before investment and £8 million afterwards may further restrict its use, both by reducing the number of qualifying companies available and also by increasing the risk to the individual investors. At the same time, the amount that might be invested by any one investor and still qualify for income tax relief has been increased to £400,000. Nevertheless, a relief more targeted to specific start up ventures might be more effective in promoting an enterprise culture than the existing EIS.

Administrative hurdles

Small businesses often face considerable administrative and regulatory burdens, diverting valuable time from the entrepreneur and even resulting in additional compliance costs. Several welcome developments have taken place on this front and HMRC appear to be intent on improving all aspects of their relations with smaller businesses to assist them and make the entire process more efficient and effective for all concerned.

The form 42 reporting requirements can present a stumbling block for the budding entrepreneur to overcome, particularly where there may be frequent subscriptions for new shares as the company's demands for increased capital grow. While the reduced reporting requirement for newly incorporated companies is welcome, the simplified form can only be used where shares do not have any restrictions attached to them. In practice, most private company shares have restrictions over marketability and therefore the full form will usually have to be completed. The 2005 regulatory impact assessment acknowledged a cost of between £40 and £200 for completion of the form, prior to any additional cost where a share valuation was necessary. This can seem a needless expense where there is no immediate tax liability arising and a disincentive to those small entrepreneurs at a stage where they need every encouragement.

Investing the funds

Regardless of whether the funds that are invested in the company attract tax relief, can the new company rely on tax law to ensure it retains as much of its funds as possible for future investment?

A new company will inevitably require some capital expenditure and the current regime favours the smaller company through first year allowances on general plant and machinery. However, this in itself has been subject to significant variation with a 40% allowance for the period 2003-04 increasing to 50% for 2004-05, then 40% for 2005-06 and now 50% for a further year from 1 April 2006. These constantly changing rates of allowance do not show a co-ordinated approach to encouraging capital investment by smaller companies.

The 100% first year allowance for expenditure by smaller companies on computers, software and Internet-enabled mobile phones between April 2000 and 31 March 2004 has now been phased out, although the rationale of encouraging small companies to invest in technology remains.

Not just mad scientists

A more targeted relief for companies operating at the cutting edge of innovation is the research and development tax credit. Small companies benefit over their larger counterparts from this legislation in two particular ways. The additional relief available on qualifying research and development expenditure is worth 50% of the expenditure incurred by the company, rather than 25% available for larger companies. In addition, smaller companies which may not have any tax liability owing to start-up losses, can obtain immediate benefit from this relief by surrendering the enhanced loss for cash at the rate of £24 for each £100 of qualifying research and development expenditure, up to the value of the PAYE and National Insurance that the company has paid over.

The ability to surrender the loss is a welcome way of enabling the smaller company to retain cash in the business to assist its future development and one wonders if this could be extended to other areas to encourage other specific behaviours, such as expenditure on environmentally friendly plant and machinery.

In practice, claims to research and development relief are often met by an enquiry from HMRC with questions ranging from the very eligibility of the company's activities through to how the claim has been calculated. Many small companies will not have the reporting systems necessary to identify accurately the time and materials spent on qualifying activities. Their small size will normally dictate that the employees involved not only undertake research but have numerous other responsibilities. Furthermore, the distinction between what might be termed experimental development (qualifying) and commercial development (non-qualifying) is a difficult one for all businesses, but particularly in a small company where the pressure to launch the product as soon as feasible in order to bolster revenues may, in any event, be that much greater than in a large entity. The cost and time involved in resolving a potential HMRC enquiry might therefore be more of a disincentive to making a claim than the £10,000 threshold for qualifying expenditure.

Build in VAT reliefs

Several VAT provisions giving savings as well as administrative benefits are aimed specifically at smaller businesses. The flat rate scheme allows small businesses with less than £150,000 net taxable supplies to account for VAT on a much simplified basis, with net VAT payable on a percentage of VAT inclusive turnover and with no adjustments made for input tax incurred on actual purchases.

The annual accounting scheme allows businesses with expected net taxable supplies of £1.35 million or less a year to submit returns on an annual basis, while making three quarterly or nine monthly instalments towards its ultimate liability for the year. This provides some potential savings in administration.

For smaller entities starting up, the cash accounting scheme allows companies with expected net taxable supplies of £660,000 or less a year to account for their output tax on the basis of payments received rather than as invoices are issued. The quid pro quo is that the company cannot reclaim its input tax until it pays the supplier. However, it gives a useful cash flow benefit to those who are usually in a net VAT payment position or may suffer a high level of bad debts.

PAYE flexibility

Small companies can defer some of their PAYE liabilities where their average monthly payments of PAYE, deductions from subcontractors, student loan deductions and NICs for the current year are likely to be less than £1,500. In these cases they can choose to pay quarterly, although the liabilities must still be calculated on a weekly or monthly basis as employees are paid. Again, this is a welcome relaxation of the normal reporting requirements and one that might be extended further.


The smaller company also benefits from lower corporation tax rates than its larger brethren. The plethora of rates that might be charged on a small company's profits and the complexity introduced by the non-corporate distribution rate have now been replaced by a return to a simpler regime. With effect from 1 April 2006, a company will pay tax at 19% on its first £300,000 of profits or at 30% on profits above £1.5 million, with a 32.75% marginal rate when profits fall between these two limits, subject to the rules for associated companies. While simplification is a welcome return, the introduction of the 0% corporation tax rate for the first £10,000 of profits was intended, according to the Chancellor's 2002 Budget speech, 'to send out the strongest signal about the importance we attach to small businesses and the creation of wealth'.

While the resulting dash to incorporation might in many eyes have demonstrated a commendable entrepreneurial spirit by many to maximise their own wealth, the subsequent non-corporate distribution rate and a return to a 19% tax rate (rather than the 10% rate that preceded the 0% rate), could be seen as equally heavy handed. Might a better alternative have been a reduced rate for a time limited period from the date of incorporation or to cover perhaps the first say £50,000 or £100,000 of profits earned by the company from establishment?

More support from the tax system?

For a country where successive Governments have promoted enterprise and small business, it is surprising that UK tax laws have so few provisions that are specifically targeted to assist the formation and development of new companies. The current Government has significantly reformed the capital gains tax regime. The introduction of business asset taper relief has placed the focus more on the shareholders' input into their business, encouraging them to maximise the value of their company by enabling them to retain a higher proportion of the ultimate sales proceeds. However, many small companies fail to reach their potential through the lack of sufficient initial funding and some targeted tax incentives to encourage the start up and development of such businesses might promote increased wealth throughout the economy.          

Kevin Nicholson is the UK head of entrepreneurs and private companies for PricewaterhouseCoopers LLP.

Issue: 4060 / Categories: Comment & Analysis , Income Tax , Investments , VAT
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