Why Does The Uk Government Offer Startups Tax Relief
The government recognises the value that profitable startups bring to the economy in the long run. However, investing in startups is notoriously risky. Many startups fail during their first year, which offers little assurance to investors that their money is safe.
So, the government are keen to offer incentives in the form of tax relief to smooth the path to startup success for both entrepreneurs and investors.
Improve Treatment Of Startup Investment Losses
As a counterpart to the Section 1202 tax treatment of angel investment gains, Section 1244 of the tax code allows investors in qualified small businesses to deduct losses on such investments as an ordinary loss rather than as a capital loss. Normally, the tax code treats equity investments as capital assets and, therefore, losses are deducted as capital losses to offset capital gains. If capital losses exceed gains in a particular year, remaining losses are deductible up to a limit of $3,000 annually, with any additional remaining losses carried forward to subsequent years. By contrast, a loss on a Section 1244 investment is deductible from ordinary income up to $50,000 for individuals and $100,000 for couples filing jointly.
To qualify for Section 1244 treatment, the issuing companys aggregate equity capital must not exceed $1 million at the time of issuance, the company must have derived more than 50 percent of its income from business operations rather than passive investments for the previous five years, and the shareholder must have purchased the stock directly from the company and not received it as compensation. Startups generally dont issue stock for years after launch, if ever nor have they been in existence for five years and, therefore, currently dont meet the requirements of qualifying small businesses.
Payoff From Organizing As A C
For a C-corporation, the firm pays corporate income taxes at the rate ty. The remaining after-tax income is retained inside the firm and changes the final sale price as before . As with the LLC case, we assume that the investor has other capital gains against which to offset any passed-through capital losses, so a capital loss will generate a tax benefit. The firm-level after-tax payoff, Ic, i, to investors is initially expressed as:
Where i= 1 if Yi> 0 and 0i1 if Yi 0.
The net portfolio payoffs under the C-corp are thereforeFootnote 14:
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Business Asset Disposal Relief Previously Called Entrepreneurs Relief
BADR is, in outline, broadly similar to Investors Relief: a reduced 10% rate of CGT applies to qualifying gains, subject to a lifetime cap of £1 million . The key difference is in focus: unlike Investors Relief , BADR is aimed at those with an active involvement in the business.
BADR is available on qualifying disposals of unincorporated businesses, as well as on shares. In the case of shares, relief is only available where, throughout the 24 months before the disposal, the shareholder:
- Is an officer or employee of the company and
- Holds more than 5% of the ordinary share capital and voting rights of the company and either
- Is beneficially entitled to at least 5% of the companys distributable profits and 5% of the companys assets for distribution to equity holders in a winding up or
- Is beneficially entitled to at least 5% of the proceeds on a sale of the entire ordinary share capital of the company .
Where a company issues new shares to raise funds, diluting an individuals holding below the 5% level, the individual will be able to make a deemed disposal of the shares immediately before the dilution, locking in their entitlement to BADR on the accrued gain up to that point.
The company itself must be a trading company, or the holding company of a trading group. Note that the EIS, SEIS and VCT restrictions dont apply here, and trading takes its usual broader meaning .
When You Can Claim Income Tax Relief
For EIS, SEIS and SITR, you can either claim relief in:
- the tax year you make the investment
- the tax year before you make the investment – if you choose to treat some or all of the investment as being made in a previous year
You can only claim relief against the amount of Income Tax you need to pay in the UK.
You cannot carry forward unused Income Tax relief to future tax years.
If you invest in a VCT, you can only claim tax relief in the tax year you invest. You do not need to pay Income Tax on any dividends from a VCT .
You cannot claim Income Tax relief if you invest through SITR and receive new shares or debt investment in a company you already hold other shares or debt investments in, unless the shares you already hold:
- were issued to you when the company was formed
- have had a compliance statement submitted for them
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Tax Relief For Directors Connected To The Company
For SEIS, you can get tax relief if youre a director of the company.
For SITR, you cannot claim tax relief if youre a paid director of the social enterprise. Unpaid directors can claim tax relief.
For EIS, you cannot claim tax relief if, at the time the shares are issued, youre a paid director of the company, unless your payment is a permitted payment. A permitted payment is any:
- reimbursement of work related expenses
- reasonable interest on loans to the company
- dividend which does not exceed a normal return on the amount invested
- payment for supplying goods at their market value
- payment of reasonable commercial rent
- reasonable payment for services provided within their trade or profession, other than secretarial, managerial or similar services to the company – these must be included in their accounts for tax purposes
You may be able to claim tax relief if, at the time the shares are issued, you:
- are an unpaid director of the company
- have not previously been involved in the same trade that the company is seeking investment for
If you become a paid director, you can keep any Income Tax relief you previously received. You can also claim tax relief under EIS after becoming a paid director if either you were:
Tax Reliefs For Investment In Uk Businesses
The UK tax system offers various tax reliefs that are intended to encourage investment in UK businesses.
The way in which tax relief is given, and the conditions which need to be satisfied, vary considerably. In the majority of cases, relief is only available for investment in a trading company, and shares will generally need to be held for a period of time to benefit from the relief. Another common condition is that where the investment takes the form of shares, they are in an unquoted company .
This factsheet outlines some of the key tax reliefs available, but does not attempt an exhaustive analysis of the various conditions. Non-domiciled individuals using the remittance basis may be eligible for Business Investment Relief see our separate factsheet for more detail.
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Section 1244 Small Business Corporation Losses
The third tax exemption available to startup investors is if you have a loss on one of your investments. Under Section 1244, you may be able to write off qualifying losses as ordinary income, up to $50,000 individual or $100,000 joint.
Since these losses are being written off as ordinary losses instead of capital losses, and since you can write off up to $50,000 a year instead of the $3,000 limit for capital losses, this can result in larger tax savings than you otherwise would get for public market stock losses.
To qualify as an SBC loss, several requirements must be met, such as:
What if a company raises more than $1 million in a single round or a follow-on round brings the total amount raised over the $1 million threshold? Typically, the company would have to earmark the first $1 million as Section 1244 stock. Otherwise, the 1244 deduction would likely be allocated among all the capital raised in that round.
Does The Company Youre Interested In Qualify
N.B. These tax breaks are only available to UK based companies investors do not need to be UK resident but must have some UK tax liability against which to set the tax relief.
For a company to qualify for the EIS scheme it must meet a number of qualification tests. The full procedure manual can be found here:
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The Enterprise Investment Scheme
The Enterprise Investment Scheme was launched in 1994 to encourage investments in small, high-risk companies in the UK i.e. to encourage people to invest in startups.
Eligible EIS investments allow you to take advantage of the following reliefs on up to a cap of £1m per tax year .
Read more about the Enterprise Investment scheme by downloading our EIS Guide.
- Income tax relief of 30% of your investment. This can be used in the year of investment or carried back one year.
- Capital gains exemption on profits earned on shares held for a minimum of three years.
- Loss relief, should the company youve invested in fail, equivalent to your tax bracket multiplied by your at risk capital .
- Capital gains deferral on gains realised on the disposal of any asset which is reinvested in an EIS qualifying company.
- Inheritance tax exemption on shares held for a minimum of two years.
State Tax Credits For Angel Investors
Investors should also be aware that some states have angel investment tax credits available for qualifying investments. While the minimum thresholds may be higher and there may be other restrictions regarding the business location and your state of residency, it is always worth checking.
Search online or contact a local angel network to find out more about potential tax credits in your area.
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How To Apply For Advance Assurance With Seedlegals
You can complete your AA application online via the SeedLegals website. Its free to sign up and begin the application process, and, in addition, our support team will provide advice on any aspect of the application whenever you need it.
Before you get started, make sure you have your companys UTR number to hand, as this will be necessary to identify your organisation on the application form. If you cant find it or you dont think you received one when you registered your company, you can request it from HMRC.
Apply for SEIS Advance Assurance on SeedLegals. Questions? Book some time in with an expert here.
Lets take a look at the main components of the AA application:
Application Form
In the application form youll need to provide all the information necessary to demonstrate that you fulfil HMRCs SEIS criteria. This includes:
- The date your company started trading
- Details of any other venture capital schemes youve benefited from
- A 3-year business plan with financial forecast
- A response to the Risk to Capital Condition
- The name, address, and intended amount of investment of at least one potential investor .
Cover Letter
Supporting Documents
Youll now need to gather the supporting documents to attach to your application. These include:
- Your latest bank statements or accounts
- A current copy of the companys memorandum and articles of association
- A pitch deck
- A financial forecast
- Documents confirming previous investments or grants
Checklist
Submitting your Application
Incentive For Research Expenses
Start-ups with a significant research and development component may be eligible for the R& D Tax Incentive. This is not just for tech companies or inventions the main criteria is whether the business is doing something different or new to the market.If a business qualifies, the R& D concession provides a 43.5 per cent refundable tax offset. This means even if your start-up is operating at a loss, the tax benefit will be refunded to you as cash.
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Sec 1202 Up To A Hundred Percent Exemption On Qsbs Gains
Internal Revenue Code Section 1202 provides the first startup tax credit . For qualifying stocks held for more than five years, this exemption allows up to 100 percent tax-free profits on gains of up to $10 million .
Qualified Small Business Stock stipulates that an investment must satisfy the following conditions to be eligible:
Even when contrasted to long-term capital gains, Section 1202 could provide investors with substantial rewards.
How do you feel about cashing out on an under-five-year QSBS investment?
Do Startups Need Accountants
Startup founders are known for their visionary approach to business, but when it comes to the accounts its a good idea to keep your feet firmly on the ground.
Accounting for startups is all about deciding on the best structure for your business, registering for VAT, taxes and payroll as well as raising that crucial initial finance.
An accountant can walk you through the application process for each of the tax relief schemes detailed above, as well as lend their seasoned expertise to your business planning process to give your startup the best possible chance of success. If youd like to learn more about what help is available, get in touch!
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Seed Enterprise Investment Scheme
The SEIS was launched in April 2012 to incentivise investment in early-stage firms, kick-starting UK economic growth by encouraging new enterprises and helping them to grow.
Although aimed at very early-stage companies, it is hugely attractive to startup investors, as they can receive initial income tax relief of 50 per cent on investments, up to £100,000 per tax year.
Further benefit comes from capital gains tax relief. Investors can claim relief against capital gains tax if they reinvest the gain in a qualifying SEIS company, irrelevant of where the gain was made. With up to 50 per cent of the reinvested gain exempt, the investor receives an effective 14 per cent rate of relief. Therefore, the total tax relief on an investment of £100,000 could be worth £64,000.
A maximum 30 per cent stake in the company can be bought, while the startup must be recently incorporated and have no more than £200,000 of gross assets and 25 employees at most.
The latest annual count, in 2016/17, shows that 2,260 startups received investment through SEIS, with a total of £175m funds raised.
As with EIS, information and communications firms dominate, making up 39 per cent of all investments.
Our investor’s guide to the SEIS offers an in-depth overview of the scheme and the available tax reliefs within it, but the below details the key points of the SEIS:
From The Date Of The Investment Both You And The Company Will Be Subject To Certain Obligations In A Period Of Ownership:
- The company cannot distribute dividends or make payments in connection with capital reductions during the year the new shares were acquired or in the next three calendar years.
- You or your related parties cannot be, or previously have been, shareholders in the company/group in which the investment is made.
- Nor can you or your related parties be, become or have been, employees of the company/group during the three-year period.
- You must retain the shares in the year you acquired them and in the next three years.
- Under the regulations, if you invest in year 1, you will not be able to sell the shares, receive dividends etc. until year 5 if you do, the deduction will be reversed. If the rules are broken, the entire tax benefit will be reversed.
If the conditions are breached in the binding period, you must make changes to your tax return as soon as possible for the income year in which the deduction was granted. If you give away all or some of the shares as a gift or an advance on inheritance in the binding period, this is considered a breach of the condition to keep the shares in the acquisition year and the three subsequent years.
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A Potential Win For Start
Additionally, all the old drivers of EIS business remains strong, such as restrictions on pensions for higher earners and tax increases on buy to let investment and dividends.
Alex added: ‘EIS is a fertile hunting ground, provided youre happy to invest early stage and the risks that entails.
‘For the right type of people, such as wealthier and more sophisticated investors, EIS investments can be hugely attractive.’
But EIS isn’t just potentially good for the investor. It’s been pivotal in ensuring start-ups in the UK can reach their potential.
Under EIS, small businesses can raise up to £5million each year, and a maximum of £12million in the companys lifetime.
This also includes amounts received from other venture capital schemes. The company must receive investment under a venture capital scheme within 7 years of its first commercial sale.
Since its inception 25 years ago, the scheme has helped over 30,000 SMEs and has raised more than £22billion.
Investment into SMEs creates jobs and because of the types of businesses the money goes into, namely fast-growing tech enabled businesses, these tend to be high value jobs.
Alex said: ‘Creating lots of high-value jobs, lots of higher-rate taxpayers and lots of economic growth is a win for investors, companies and the economy.’
