Stephen Hemmings – Business Tax Partner
In part one of this content series, we looked at the initial investment stage and the value of Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes (SEIS) for technology businesses and their investors. This second part explores some of the other opportunities for businesses going through growth.
Growing the business
As the business develops, two key requirements for success are continued investment in innovation and retention of key staff. With careful consideration, tax incentives are available to help this happen.
Research and Development (R&D) tax relief
R&D tax relief rewards companies for investing in innovation, and SMEs can claim 230% tax relief on qualifying expenditure. At current corporation tax rates, this provides corporation tax relief on 43% of the qualifying investment. Where companies are making a loss, this can even be converted into a cash credit, which is particularly important for fast growing, cash poor businesses.
The key criteria for R&D are that uncertainty of some kind needs to be overcome by someone with the recognised skills to create an advance in the relevant area. This could involve a product or a process and can be applied to a varied range of activities or businesses. Menzies has assisted technology businesses and clients with claiming R&D in a number of situations ranging from:
- The costs related to the building of customer platforms
- Developing off the shelf software
- Integrating different systems following a merger.
Some key points to bear in mind with R&D:
- There has to be a company cost! The owner’s blood and toil may not qualify if they have NOT charged salary to the company. It is often tax efficient for the owner to charge a salary for their work and claim R&D on this amount.
- The relevant work does not necessarily have to be undertaken by employees. Subcontractor costs can qualify, but the relief is reduced to 65% of the normal benefit.
- The project does not need to be successful to qualify. In fact, a failed project demonstrates the inherent uncertainty.
One good thing is that a company has two years from the end of its accounting period to make the claim. So, if a business has been slow to recognise its R&D, all may not be lost.
Enterprise Management Incentive (EMI) share option scheme
Fast growth businesses typically suffer from cash flow restraints because of the level of investment required to get the business off the ground and fund its accelerated development. Despite these financial restraints it is vital that key employees are retained, as their expertise and experience is often critical to the eventual success of the company.
Business owners typically recognise that they cannot afford to remunerate these employees to the same level as larger businesses, but the sharing of equity is proven as an effective retention tool. Used well, this approach acts to align the interest of the employee with that of the overall business and encourages them to remain until they share in the benefit of a future sale.
Without careful planning, the issue of equity can lead to unwanted income tax and NIC liabilities, as the equity is treated as a reward for employment. Such liabilities are further magnified as the employees will not have received cash from which the liabilities can be paid.
Why consider an EMI scheme?
The EMI scheme provides an extremely tax effective way of issuing equity. Employees are issued with options over equity, which can be exercised at a later date, typically at the time of a wider exit.
The individual suffers no tax when the option is issued and future growth in value of the company is subject to only 10% tax provided that certain conditions are met. Where options are exercised immediately before a sale, the cash for the exercise price can be withheld by the company out of these proceeds, and their resulting tax liability settled out of their proceeds from sale. As such, there is no net cash outflow for them.
From the company’s perspective, the existing shareholders do not give away any control or voting rights by issuing options. The idea is that by including the employees in equity participation, the eventual value of the business can be higher than would otherwise be achieved. The company will also get a corporate tax deduction at the time the company is sold, reflecting the value that is deemed to have been provided to the employee.
Another practical point to consider with EMI is that the company value at the time of option issue can be agreed with HMRC, and this typically incorporates a very significant minority discount. This reflects the fact that they have no control over the company. So long as the options are exercised for a value no less than this amount, there will be no income tax consequences. As the sales proceeds are based on the base value, this effectively allows a further transfer of value to the employee, on which they effectively pay 10% tax.
During the course of this feature we’ve explored the tax reliefs and incentives available for technology businesses and their investors to benefit from during their early life. It is important that businesses are aware of them and understand the nuances of the various regimes to ensure that they achieve an optimal tax position, providing the company with a strong platform to be successful.