Taking the time to find the right business structure may be low on the list of priorities for entrepreneurs starting up a new business. Any future sale or third-party investment can seem like a remote event, and entrepreneurs with start-up businesses have plenty of demands on their time.
However, by structuring the business as effectively as possible at an early stage, entrepreneurs can help maximise growth, attract diverse investment and ensure that as much value is retained as possible on sale.
The UK tax system offers numerous incentives and reliefs to help mitigate the tax burden for entrepreneurs and investors into start-up businesses. Whilst finding the right structure to accommodate the most relevant tax reliefs and incentives can be complex, this note outlines some of the main benefits and gives some examples of the sorts of cases where they may be relevant.
Entrepreneurs' Relief (ER)
What does it do?
ER is a long-established relief from capital gains tax targeted at entrepreneurs who are involved in the day-to-day running of their business's. ER reduces the rate of tax charged on a sale/IPO of a business from 20% to 10% and it is available for each individual's first £10m of qualifying capital gains. There are several strict conditions which must be met over a period of time to obtain ER, so it is important to structure for ER at an early stage in a business’ life.
The key conditions that must be satisfied in respect of shares held in a company are that for a period of at least 2 years prior to the sale of the shares:
- The company is a trading company (or the holding company of a trading group);
- The individual holds at least 5% of the company's ordinary share capital and can exercise at least 5% of its voting rights;
- The individual is entitled to 5% of the proceeds on a sale (or certain other entitlements); and
- The individual is an officer or employee (full or part time) of the company or group.
Mr Smith is starting a new software business. He is a director of the company and will be actively involved in its growth and key to its success. The business is owned by Mr Smith and his three business partners in equal shares.
Mr Smith should consider structuring his stake in the company to ensure it will qualify for ER on sale as early as possible. With the right structure, ER could reduce Mr Smith’s tax bill on sale by half.
Investors' Relief (IR)
What does it do?
IR is a newer form of capital gains tax relief modelled loosely on ER. However, whereas ER is targeted at those in a 'hands on' position running the business, IR is instead aimed at external investors who are not a paid officer or employee of the business (although IR is available for unpaid non-executive directors).
As with ER, IR reduces the rate of tax applicable to the gain on a sale/IPO from 20% to 10% and it applies to each investor's first £10m of qualifying capital gains. This £10m IR limit is separate to the £10m ER limit, so it can be used even after an entrepreneur has exhausted their ER allowance.
Ms Brown is an established entrepreneur and now acts as a 'business angel' to offer financial support and advice to new businesses. Whilst she is happy to act as an unpaid non-executive director to offer advice, she does not want to play a 'hands on' role in the business.
As an external investor, Ms Brown should consider whether IR is available for her prospective investment. IR is not subject to some of the strict conditions which can apply to ER, so she should be free to invest as much or as little as she wishes without a substantial restructuring of the business. By securing IR, Ms Brown could reduce her tax bill by half when she sells her investment.
Enterprise Investment Scheme (EIS)
What does it do?
EIS relief is an approved tax incentive which is designed to promote early stage equity investment in higher risk companies. The EIS regime is more highly regulated than ER and IR and care must be taken, both from the point of view of the individual investor and the business, to implement the right structure for the scheme.
A successful EIS structure can provide the following tax incentives for investors (subject to various conditions):
- They may deduct an amount equal to 30% of the money invested from their total UK income tax liability for the tax year, up to an annual limit of £1m (or £2m in the case of knowledge intensive companies, such as those whose trade mainly involves the development of intellectual property/software);
- if the above income tax relief is secured, any capital gain made on the disposal of the business is exempt from capital gains tax;
- if the business is sold at a loss, relief is given which can be used against either income profits or chargeable gains; and
- capital gains tax otherwise due on the sale or transfer of other assets may be deferred by investing the proceeds in an EIS business.
Mr Adams is a successful high-net worth investor who is looking to invest in high-risk businesses. He does not intend to play any active part in the business and is happy to put his capital at risk. He expects to have a significant income tax bill this year and he has also recently made some capital gains on another investment, which he is happy to reinvest.
Mr Adams should consider investing in a business which qualifies for EIS. By doing so, he can reduce his income tax liability for the year and also defer any tax due on his existing capital gains. If the business is a success, any future capital gains he makes when he sells out after 3 years would be fully exempt from capital gains tax.
Seed Enterprise Investment Scheme (SEIS)
What does it do?
As its name suggests, SEIS is a form of EIS which is targeted at even smaller (and riskier) start-up businesses, but which offers enhanced tax incentives.
A successful SEIS structure can provide the following tax reliefs for investors (again, subject to various conditions):
- They may deduct an amount equal to 50% of the sum invested from their total UK income tax liability (up to an annual investment limit of £100,000);
- Any unused annual investment limit may be carried back and used in the previous tax year;
- If income tax relief is secured, any subsequent capital gain on sale is exempt from capital gains tax;
- If the business is sold at a loss, relief is given against either income or chargeable gains tax; and
- capital gains tax otherwise due on the disposal of any asset may be exempt from tax if the gains are reinvested in SEIS shares.
Mr Adams' sister, Ms Adams, has had similar success with her investments. However, she has a greater appetite for risk and is looking for even higher risk investments than her brother. She does not intend to play any active part in the business and is happy to put her capital at significant risk by investing in start-ups.
Ms Adams should consider investing in a business which qualifies for SEIS. By doing so, she can reduce her income tax liability for the year in the same way as Mr Adams, but to an even greater extent. Ms Adams can also extinguish any existing capital gains tax charge she may otherwise face by reinvesting the profits into a SEIS business and she will benefit from complete tax exemption from any further gain she makes in the future when selling her SEIS investment.
Business Investment Relief (BIR)
What does it do?
BIR is available to certain non-UK domiciled investors. Broadly, the relief enables them to invest funds from overseas in UK private companies without incurring tax charges on bringing the funds into the UK. Both equity and debt investments can qualify for BIR.
Combining BIR with the other tax reliefs and incentives covered above can be a powerful combination for non-domiciled investors, potentially enabling both the initial investment and any capital growth to be realised tax-free (or subject to minimal tax).
Investments in listed companies, partnerships and sole traders are excluded from the relief. But otherwise most investments into private companies which trade in the UK (or which hold companies that trade in the UK) can qualify for BIR.
Ms Connor has recently moved to the UK but was born overseas and does not intend to stay in the UK over the longer term. She is not domiciled in the UK and claims the remittance basis of tax (so that she is normally only taxed in the UK on income and gains arising from the UK and not overseas).
Ms Connor recently sold her previous home outside the UK and has kept the proceeds in a non-UK bank account. A contact has identified a good investment opportunity in a UK company and Ms Connor would like to invest some of the sale proceeds from her house into the business.
She has previously been told that bringing the sale proceeds into the UK could trigger a UK tax charge as a ‘remittance’. However, if Ms Connor can benefit from BIR, this tax charge would not arise, and she could bring the proceeds into the UK tax-free to make the investment. She could also consider if the investment would qualify for any of the other reliefs and schemes outlined above, to further reduce her UK tax bill.
The Tax team at Farrer & Co can help design the most appropriate structure for your business, to help maximise its potential, incentivise investment and ensure as much value is retained as possible on sale. We can implement the structure, explain to all the participants how it works and make any required applications to HMRC, helping entrepreneurs focus on the day-to-day demands of growing a successful business.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, September 2019