The Essential Guide to for Fast Growth Companies Tax Incentives IN ASSOCIATION WITH Contents 3 Introduction How to use tax to benefit your tech business What is The Enterprise Investment Scheme? What is a knowledge-intensive company? Why investors like The Enterprise Investment Scheme What is The Seed Enterprise Investment Scheme? How owner-managers could benefit Where companies go wrong Use tax to incentivise your staff What is an Enterprise Management Incentive scheme? The pros and cons of Enterprise Management Incentive schemes for tech firms Incentivising staff through share schemes Could you make R&D tax relief work for your business? How R&D relief works Types of R&D relief What qualifies for R&D tax relief? What costs qualify for R&D tax credits? What businesses get wrong Entrepreneurs’ Relief: Helping you save tax on the sale of your business What is Entrepreneurs’ Relief? How Entrepreneurs’ Relief can be used Employees with Enterprise Management Incentive shares 4 5 6 6 7 7 8 9 10 11 12 13 13 14 15 16 17 EISs are unquoted investments which are highly illiquid, with investors potentially having difficulty in realising their investment at a given time. They should therefore only be considered as a long-term investment, i.e over five years. They also carry the risk of potentially losing all or part of your capital investment and therefore the return of your capital is not guaranteed. Page 3 The Essential Guide to Tax Incentives for Fast Growth Businesses Britain is a world-leading hub for technology firms and startups, with a new tech business being formed in London every hour. The sector is booming, creating jobs at twice the rate of companies in non- digital industries. One of the key reasons for this success is a generous tax regime offered to fast- growing businesses. Last year was a great year for funding. British digital tech companies raised £5.8bn in venture capital investment during 2017, almost double the previous year. The UK is the envy of the world in terms of how innovation is nurtured. Alongside the great imagination, dynamism, and expertise in evidence across the digital industries, the Government has created a favourable tax environment for these pioneering enterprises, encouraging investment and driving business growth. Introduction Tax reliefs such as the Enterprise Investment Scheme (EIS)/ Seed Enterprise Investment Scheme (SEIS), Enterprise Management Incentive (EMI) share scheme, Research and Development (R&D) tax credits and Entrepreneurs’ Relief make it easier for smaller, higher risk companies to attract investors. Fast growth tech businesses exist in a world of constant change and face particular challenges when scaling up their operations. Tax reliefs available can also aid cash flow as well as helping employers recruit and retain the best talent. Vitally, these schemes are designed to reward those who are developing new technologies, encouraging them to build the big businesses of tomorrow. Fergus Caheny Partner Smith & Williamson 020 7131 4216 Page 4 The Essential Guide to Tax Incentives for Fast Growth Businesses An unquoted trading company can raise up to £5m in any 12-month period (under the Venture Capital Schemes comprising SEIS/EIS/Venture Capital Trust investment) by offering tax reliefs to those subscribing for new shares or securities. Up to £10m can be raised in the same period by so-called “knowledge-intensive companies”. Up to £12m can be raised in the enterprise’s lifetime, with this cap rising to £20m for “knowledge-intensive companies”. EIS monies must be used to grow or develop the business, whether, for example, that is hiring more staff, developing new products / services, or moving premises – anything indicative of company expansion. What is EIS? How to use tax to benefit your tech business EIS and SEIS offer generous Income Tax, Capital Gains Tax (CGT) and Inheritance Tax reliefs for those investing cash for equity in new or relatively early-stage businesses, with digital and technology firms particularly benefiting. The schemes are very effective in attracting investors, as they are a highly tax-efficient way to invest in higher risk, innovative, fast-growth companies. To qualify for EIS, a company must, amongst other things: • Have its first commercial sale less than seven years ago. • Be carrying out a qualifying activity. • Have fewer than 250 employees and less than £15m in gross assets at the time of the relevant investment. • Not be quoted on a recognised stock exchange. • Have a “permanent establishment” in the UK. • Not be under the control of another company, or of another company and any other person connected with that other company. The business must be registered with HMRC to be an EIS or SEIS company. A pre-clearance process is available whereby HMRC can grant assurance under the schemes before the relevant shares are issued. This often helps the marketing of the enterprise as an investment prospect. Investors in EIS firms can subscribe up to £1m per tax year in one or more EIS qualifying companies, receiving 30% up front income tax relief, with no CGT liability on the sale of the relevant shares if they are held for at least three years. There is a facility to carry back income tax relief to the previous tax year if the investor has unused EIS capacity. The £1m per tax year subscription limit is increased to £2m for investment in knowledge-intensive companies. Page 5 The Essential Guide to Tax Incentives for Fast Growth Businesses What is a knowledge-intensive company? • Spending 10% of operating costs on R&D in each of the three years before investment, or at least 15% in any one of those three years. • Creating its own intellectual property, where it is reasonable to assume that most of the company’s business will derive from this IP within 10 years. • Having at least 20% of full-time equivalent employees as “skilled employees” having a relevant master’s degree or equivalent higher qualification. 10% Spent on operating costs on R&D in each of the 3 years before investment. Within of full-time employees have a relevant master’s degree or equivalent higher qualification. the company’s business will derive from its own intellectual property. 10 years 20% Knowledge-intensive businesses are governed by more flexible rules and can raise more money. The good news is most tech businesses are likely to qualify. Knowledge-intensive businesses can be older than standard EIS companies – a company can have traded for up to 10 years in relation to attracting EIS investment. HMRC classifies a knowledge-intensive business as: Page 6 The Essential Guide to Tax Incentives for Fast Growth Businesses Why investors like EIS EIS is likely to be as good as it gets for investors in terms of balancing the tax reliefs against the inherent risk of the company failing. It is likely to apply to slightly more mature companies and therefore provide some reassurance to many investors. Any shares held for the qualifying period (three years) are CGT free, this means that relevant shareholders do not have to pay tax on any profit made through holding their shares. CGT arising on other gains can be deferred against the amount invested in EIS shares if the reinvestment takes place in the period one year before and three years after the date of the relevant disposal. Even if EIS shares are disposed at a loss, an investor can offset this against their taxable income in the tax year the loss crystallises. For a 45 per cent taxpayer, the combination of EIS income tax and loss relief means only 38.5% of the original investment is at risk. If shares are retained for at least two years, the shareholding will attract business property relief at 100% for inheritance tax purposes. Investors in SEIS firms can subscribe up to £100,000 per tax year in one or more SEIS qualifying companies, receiving 50% up front income tax relief, with no CGT liability on the sale of the relevant shares if they are held for at least three years. There is a facility to carry back income tax relief to the previous tax year if the investor has unused SEIS capacity. Many fledgling tech businesses have benefitted from SEIS. Often, firms with few assets undertake a fundraising combining both SEIS and EIS, with SEIS covering the first £150,000 raised. What is SEIS? An SEIS company must have: • Gross assets of less than £200,000 at the time of the relevant investment. • No more than 25 employees at the time of the relevant investment. • Been trading for less than two years. SEIS gives investors even bigger tax breaks on subscribing cash for new shares in startups. With tax relief options on income tax, CGT and IHT, the EIS and SEIS could be the last of the great tax breaks. Adrian Walton Partner | Smith & Williamson | Business Tax | 020 7131 4180 Page 7 The Essential Guide to Tax Incentives for Fast Growth Businesses How owner-managers could benefit Many business owners do not realise EIS relief can be available to owner-managers as well as passive investors. It is possible to claim EIS or SEIS if a person owns less than or equal to 30% of the company’s equity – but not if they have ever owned more. With expert guidance, a business can be structured from the outset so those involved benefit fully from EIS and/or SEIS. For example, a startup comprising four people could be arranged with three individuals holding 30% each, and one unassociated person retaining 10%. That way, founders could be eligible for SEIS/EIS relief. Where companies can go wrong The rules around becoming an EIS and/or an SEIS qualifying company are complex. Some common errors include: Businesses try registering with HMRC themselves. Pre-clearance is complicated, so take expert advice. Companies issue EIS shares before investors have paid for them. Young tech businesses with few assets often get pre-clearance on EIS and SEIS schemes simultaneously. However, EIS and SEIS shares cannot be issued on the same day. The practicalities of the share issue must be documented properly, with Companies House forms completed and the company’s statutory register of members updated. For EIS purposes, if an investor is involved in the business, he or she can become a director only if appointed after the relevant EIS shares have been issued. If they become an employee, not a director, EIS/SEIS income tax relief is not available. Owner managers holding more than 30% of a company’s shares cannot claim EIS/SEIS income tax relief. A tech firm whose revenue stream is from licence fees or royalties from intellectual property only qualifies for EIS if most of the IP’s value was created by the company (or a qualifying subsidiary) itself. 1 2 3 4 5 6 7 Page 8 The Essential Guide to Tax Incentives for Fast Growth Businesses EMI share schemes are tax-efficient for both businesses and employees. The staff member pays no income tax or National Insurance when the option is exercised, as long as the shares are bought for at least their market value when granted. Plus, the company receives a corporation tax deduction when staff exercise their options. The first question is: does your business qualify? Use tax to incentivise your staff What is an EMI scheme? Tech founders are facing increased competition when it comes to hiring the right talent. Few startups have cash to pay big salaries, so share options have become a popular form of compensation. Offering workers a potential stake in an enterprise’s future growth via an Enterprise Management Incentives (EMI) share scheme can be an effective way to build a workforce and scale a business. The offer of share options can attract employees who recognise a fast-growth firm with great potential. It can also drive a team’s motivation to make the operation succeed. Increasingly, millennials drawn to the tech field expect an EMI scheme to be in place as an added incentive to stay with an organisation. The business must be operating in the UK and independent. The firm must have fewer than 250 full-time equivalent staff. An employee can only be granted options over shares up to a value of £250,000. No option holder must own or control more than 30% of the company. There are certain conditions a company – and the employee being awarded share options – must meet: The business should have no more than £30m of assets. Page 9 The Essential Guide to Tax Incentives for Fast Growth Businesses The employer must weigh up the advantages and disadvantages of EMI schemes, and consider what they want to achieve. Is the intention to help with recruitment? Incentivising senior management to create business growth may be a priority. Problems occur when these conversations do not take place at the outset, so think about all possible scenarios. The pros & cons of EMIs for tech firms Pros Increasingly, tech businesses want EMI schemes because they cannot recruit without one. EMIs can aid retention since employees offered share options feel invested in the business, whether they exercise their options immediately, or opt to later. Share options boost motivation, as someone being awarded an option typically has to meet measurable criteria before they are able to exercise their options. Scheme rules should maximise flexibility, specifying what is required from each individual. Companies can award options with no conditions attached, so employees can exercise and hold shares straightaway. For the employee, any growth in value from today’s date to the share’s sale is subject in most cases to a lower rate of tax (CGT and not to income tax). If the period from the award of the share option to the sale of the share is at least 12 months, any CGT also qualifies for Entrepreneurs’ Relief – thus reducing the rate of CGT payable. Businesses become eligible for a deduction on their corporation tax bill when staff members exercise their options. Many investors want to see an EMI scheme in place as it gives employees an incentive to create growth and value in the company’s shares. 1 4 5 6 2 3 Page 10 The Essential Guide to Tax Incentives for Fast Growth Businesses If a tech company wants to attract, reward, and incentivise staff, and it qualifies for an EMI share scheme, that will usually be the best option for the business and its employees. Cash bonuses give a person money today, but little incentive to work hard tomorrow. And while some business owners favour the simplicity of unapproved share options, they carry no major tax advantages. For tech businesses, the EMI share option costs nothing at the outset, but can be a way to reward sustained effort to take an enterprise to the next level. Incentivising staff through share schemes Cons Some companies let all staff participate in an EMI scheme, which risks the shares’ value becoming diluted. Staff members who exercised options early find their shares diminishing in value as more employees join and further shares are issued. Equally, if the company goes through a bad patch, the value of shares may drop. If options cannot be exercised until an exit event, employees are not materially committed to the business. Some companies insist senior employees exercise and pay for their shares for this reason. Startups might promise early joiners a percentage of the company, then fail to do the paperwork. This can prove expensive since shares worth their nominal value when the person joined often become more valuable later. The employee faces a big income tax bill due to the shares’ growth in value, or the business must pay a bonus to cover the individual’s tax. Some businesses leave the way open to minority shareholders uniting to prevent a future company sale by failing to include drag and tag along provisions in the shareholder agreement. Drag along rights allow a majority shareholder to force remaining minority shareholders to accept a third party offer to buy the business. Tag along rights protect minority shareholders, entitling them to participate in a majority shareholder’s sale of shares at the same time for the same price. An EMI scheme must be registered with HMRC, and the tax authorities must be notified of the option awards within 92 days of their being granted. Businesses must handle this extra administration but most of this process can be outsourced. 1 2 5 3 4 Whilst EMI offers fantastic tax breaks and flexibility for fast-growing tech companies, considered design and implementation is often required to make the most of these benefits. Inez Anderson Partner | Smith & Williamson Employment Tax & Incentives | 020 7131 4919  Page 11 The Essential Guide to Tax Incentives for Fast Growth Businesses Could you make R&D tax relief work for businesses? How does R&D tax credits relief work Research and development (R&D) tax relief has helped thousands of businesses since it was introduced in the UK more than 18 years ago, with almost £3bn claimed in 2016 alone. The tech industry has innovation at its heart, which puts it in prime position to benefit from these generous tax breaks. Yet, too few companies are taking advantage of the R&D scheme or they fail to claim their full entitlement. Pioneering tech firms could tap into billions of pounds of support available to help them with new developments and to grow their enterprises. HMRC asks that a business can demonstrate it is seeking a technological advance in an area of science and technology, and in doing so is tackling an area of technological uncertainty. Put simply, if a company is developing a new process, platform or piece of software, then that project is probably eligible. A common misconception many tech firms make is that R&D relief only applies to the development of a new pharmaceutical or the design of an engine component. In fact, the scheme covers a vast range of products, services, or business processes, with much of the work being done in Britain’s tech firms qualifying for the relief. Page 12 The Essential Guide to Tax Incentives for Fast Growth Businesses R&D relief only applies to businesses liable for corporation tax, so sole traders do not qualify. There are two types of relief available: Types of R&D relief Small and medium-sized enterprises (SME) R&D relief Broadly if a business has less than 500 staff and a turnover below €100m or a balance sheet total under €86m it qualifies for SME R&D relief. • SMEs can receive 230% relief on qualifying R&D costs. • If the business is loss-making, it can claim a 14.5% tax credit on surrendering losses created by the qualifying R&D activity. • This means the value of making a claim can be as much as 33% of the qualifying expenditure. 1 2 Research and Development Expenditure Credit (RDEC) Large companies exceeding SME thresholds can claim RDEC for R&D projects, a tax credit of 12% (11% prior to 1 January 2018) of qualifying expenditure. Crucially for many tech firms who are subcontracted by large businesses, they may be able to claim under the RDEC scheme. Page 13 The Essential Guide to Tax Incentives for Fast Growth Businesses • The cost of employment is often the largest element of a claim. Many young tech businesses are loss-making, and the cost of employing staff is often the biggest expense. Assessing which people have been involved in a project and how much of their time was spent on it is a key component of making a claim. • The cost of hiring external workers may also qualify if they worked on R&D. A proportion of subcontractors’ pay could be claimed back. • Consumable items - materials or equipment used in the R&D process, such as software licence costs – could also increase a claim. What qualifies for R&D tax relief What costs qualify for R&D tax credits • How has a project looked for an advance in science and technology? This may be by developing something new in a sector, improving upon what already exists, or devising a product, service or process to give the business a competitive edge in an innovative way. • The project(s) need to tackle areas of technological uncertainty. This means demonstrating to HMRC there has been an attempt to devise a solution to an issue or problem where no known solution exists. • Businesses must show their efforts create an advance in the overall field and not just for that individual enterprise. A company using an existing technology for the first time in its sector would be ineligible, for example. • The project does not need to be a success, it is the time and effort that counts. Equally, if the work is overtaken by new advances – a common occurrence in the tech world – R&D help could be available if the project was genuinely innovative at the time of development. • Two companies could be developing the same thing at the same time and both qualify for R&D relief, as long as each project was developing a new piece of technology which was not readily available in the market. Firstly, a business must identify which of its projects is eligible. Page 14 The Essential Guide to Tax Incentives for Fast Growth Businesses What businesses can get wrong The most common mistake is simply failing to realise a project qualifies for R&D tax relief. Other businesses want to avoid dealing with HMRC or resent the perceived time and resources involved. These entrepreneurs often have no idea the tax credit can be worth as much as a third of the expenditure on qualifying projects. Much of the work done by tech firms is eligible for R&D support, whether it is creating a new digital platform, improving hardware, or developing software to help existing systems work together. R&D credits are not just valuable to new, loss-making businesses, Businesses often make specific errors when approaching R&D: • Once an R&D claim has been submitted, some companies copy the same details the following year. HMRC will reject such a claim since there must be evidence of ongoing project development. • Grant funding can clash with an R&D claim. Specifically grants which qualify as notified EU state aid, as does the SME R&D relief scheme. This can shift R&D into the RDEC scheme, which has a big impact on the tax credit’s value. • Companies in need of money to undertake R&D often fail to realise advance pay-outs may be available from providers who will lend on the expectation of a successful claim. • Many companies ask their bookkeeper for R&D advice, but expert guidance is more likely to ensure a claim is robust. Some entrepreneurs do not know they can make backdated claims up to two years from the end of an accounting period. they can help profitable companies, too, by giving them a reduction in their corporation tax bills. The Government and HMRC are rewarding risk- taking with R&D tax breaks. And both are eager that more businesses use the reliefs for reinvestment, job creation, and business growth. R&D tax credits can be a vital source of working capital for tech businesses. Provided qualifying activities are undertaken, making a claim can reduce a company’s corporation tax liability (if profitable), or even result in a repayment back from HMRC if the company is loss- making. The value of this credit can be as much as one third of the qualifying expenditure for SMEs. We can help in ensuring that claims made are robust (and therefore minimising the risk of HMRC enquiry), whilst ensuring that the value of claims are maximised. There are certain challenges and pitfalls that must be avoided, and therefore taking the right advice is critical to ensure that businesses do not miss out on this valuable relief. Matt Watts Partner | Smith & Williamson | Business Tax | 020 7131 4790  Page 15 The Essential Guide to Tax Incentives for Fast Growth Businesses What is Entrepreneurs’ Relief? Entrepreneurs’ Relief is a popular tax break with tech firms, as it typically halves the amount of CGT paid on the sale of business assets, typically shares in a company. It is applicable to trading companies, which makes it popular across all sectors. The relief also has the merit of being less complicated than EIS or SEIS schemes, with fewer conditions attached. In fact, Entrepreneurs’ Relief is often used by those who, for whatever reason, fail to qualify for EIS or SEIS relief. In the tech sphere, it is also commonly used to reduce the tax liability of employees who have exercised Enterprise Management Incentive (EMI) share options. Entrepreneurs’ Relief: Helping you save tax on the sale of your business Entrepreneurs’ Relief reduces CGT on the sale of business assets by individuals – not companies – from the standard rate of 20% to just 10%. Each person has a limit of £10m in lifetime gains to utilise the relief, which can be on more than one asset. One condition is that any enterprise being sold must be a trading company, or the holding company of a trading group, rather than being engaged in a non-trading activity, such as holding or making investments. Most tech firms will qualify. Page 16 The Essential Guide to Tax Incentives for Fast Growth Businesses The first thing to establish is whether a person is eligible to make a claim; How can Entrepreneurs’ Relief be used? Business owners can introduce spouses or civil partners into their company at least a year ahead of a planned sale. The spouses of business owners will be entitled to claim relief if they satisfy all of the conditions in respect of shares they own in the company. A common scenario is a tech entrepreneur selling shares and claiming Entrepreneurs’ Relief when they own more than 30% of their company. This would make them ineligible for EIS and SEIS, which are more attractive in tax terms since they may carry a zero per cent CGT rate. Others typically claim Entrepreneurs’ Relief if errors were made in registering their companies with HMRC as an EIS or SEIS company, which disqualified them from claiming the more beneficial tax break. Either way, the tax advantages of Entrepreneurs’ Relief are considerable and it is well worth planning for business exits well in advance. 1 Year Selling shares Entrepreneurs’ Relief 5% • Someone disposing of shares in a trading company must hold at least 5% of the company’s total ordinary share capital and voting rights to qualify for Entrepreneurs’ Relief. They must have held those shares and those voting rights for at least a year immediately before the sale and must have been an employee or office holder in the business for a minimum of 12 months immediately prior to the sale. • If a sole trader or business partner is selling all or part of their business, they must have owned the business or their share of it for at least a year before selling. • As an exception, someone selling shares received through an EMI scheme can claim Entrepreneurs’ Relief even if he or she holds less than five per cent of the whole company and/or has not held the shares for at least one year prior to the disposal. However, that person must have been granted the option to buy the EMI shares at least a year before selling the relevant shares. The date of the disposal of the relevant assets is what matters. If shares are being sold today, it is necessary to go back 12 months to ensure that the conditions outlined above have been met over that period. But with a little forward planning it is possible to take full advantage of the CGT savings available. Page 17 The Essential Guide to Tax Incentives for Fast Growth Businesses Employees with EMI shares Entrepreneurs’ Relief particularly comes into its own when a tech business has an EMI scheme in place. Offering share options has become a popular element of compensation in the digital sector, and EMI schemes are the most tax-efficient way to offer equity rewards both for staff and the business. Participating employees can minimise their tax exposure by claiming Entrepreneurs’ Relief on the sale of their shares. A simple example shows how an employee exercising an EMI option and selling the relevant shares might benefit from Entrepreneurs’ Relief: £1 An employee is awarded an EMI option over shares today with a current market value of £5. £5 They buy the share at the agreed exercise price of £1. When they sell their shares – more than a year after the options were granted – they sell for £12 each, an £11 difference between the exercise price and the price at which the shares were sold. The employee pays income tax (and possibly national insurance) on £4 per share at the time the shares are acquired, the difference between the £5 the share was worth when granted and the £1 exercise price. CGT is paid on the share sale price minus the exercise price paid, minus the sum on which income tax was paid. That makes the capital gain £7, on which the employee only pays 10% CGT under the Entrepreneurs’ Relief scheme. £12 £7 CGT SHARE EXERCISE TOTAL PRICE PRICE SUM We are not just financial advisors. We provide a one-stop-shop of support services to meet the personal, financial and business needs of business owners, management teams and shareholders at all stages of the business lifecycle. If you’re an owner-manager, entrepreneur, adviser, or if you work with a scale-up business, we’d love to hear from you. Telephone | 0808 164 0100 Email | techfounders@smithandwilliamson.com Website | smithandwilliamson.com Twitter | @SmithWilliamson LinkedIn | Smith & Williamson Fergus Caheny | Partner | Smith & Williamson | 020 7131 4216 Our Expertise Events Diagnostic Insight Partnerships Our Scale-Up Programme Contact Us Our tailored networking and education events connect founders and their management teams with investors, experts and mentors. Technical, analytical or inspirational, we deliver powerful business intelligence to scale-ups and their leaders. Our strategic alliance network can help you fulfil your ambitions. Identify your business’s strengths and weaknesses and receive directions and recomendations on practical next steps. We champion the cause of entrepreneurs and growth businesses, connecting you with peers and networks to help you develop and scale. 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