High-tech start-ups face collateral damage in private equity crossfire
The UK will soon have a new scenario where day traders, stock market speculators and private equity investors who normally invest in trailing edge, post late stage companies will pay the same unified single capital gains tax as leading edge technology entrepreneurs, early-stage start-ups and their investors.
Initially, intended to bring private equity investors (PE) into the mainstream tax regime, the UK Chancellor of the Exchequer (finance minister for non UK readers), Alistair Darling, delivered his first pre-budget report in October 2007 with measures that will be a major blow to millions of small businesses and high-tech start-ups and their investors, who will now be caught in the PE crossfire.
This 'throwing the baby out with the bathwater' measure, together with the collapse of EIS, SFLG and VCT programmes is sending the wrong message to entrepreneurs. It will create serious collateral damage for the fledgling high-tech start-up ecosystems and their investors. This strategic error has created wholesale condemnation from affected parties. We capture some of the comments and highlight the dangers of losing the current momentum for entrepreneurship and start-ups that exists in the UK and start a new brain drain.
The abolition of the 10 percent CGT and replacement with an 18 percent unitary tax compounds the previously announced measures in the abolition of first £10,000 as tax free and additional income tax rises for SMEs. This together with the collapse of EIS and SFLG programmes is sending the wrong message to entrepreneurs.
Abolition of taper relief and an increase of 80%
From April 2008 this will be abolished in favour of a flat rate of capital gains tax of 18 percent. This represents an increase of 80 percent and is ‘totally unacceptable’, especially from a government that claims to be the champion of small businesses and entrepreneurs – according to The Federation of Small Businesses.
Chief among them was the announcement of the abolition of taper relief (inflation adjusted capital gains calculations) on capital gains tax (CGT). This relief allowed small business owners to sell up and pay only 10 percent CGT on the profit. Now day traders, market speculators, gamblers, options and futures traders and private equity investors will pay the same capital gains tax as leading edge technology entrepreneurs, early stage start-ups and their investors.
Early stage investment specialist E-Synergy has branded changes to capital gains tax rules a ‘blunt instrument’ that is inconsistent with the Government’s stated aim of creating an enterprise economy.
Andrew Stevenson, chief executive of E-Synergy, said the decision to scrap taper relief and impose a flat rate 18 per cent CGT regime also threatens the UK’s ability to nurture and develop its fledgling sustainable technology sector.
“This change is a very blunt instrument that will hit enterprising small businesses and investors willing to take higher risks much harder than private equity bankers doing large, lower risk deals,” he said. “The rewards for those involved in start-up and early stage businesses are mainly through capital gains, which puts them directly in the firing line.”
He said that the UK’s lead over the rest of Europe in securing investment for its fledgling technology companies is now under threat and attempts to close the gap to US levels of investment have been severely undermined.
“It is particularly bad news for the emerging industry sector of sustainable technology where the UK has the potential to lead the world,” he said. “That simply will not happen if enterprise and innovation in this exciting sector are strangled at birth.”
Let the brain drain begin: rush to sell out, exit and quit
There will be a rush on business sales before 6 April 2008, as business owners are set to be hit with an 80 percent increase on the tax they pay when disposing of their businesses, according to leading tax expert Grant Thornton.
Private equity under the quash
The abolition of taper relief and a new capital gains tax will also put massive pressure on the private equity industry, which is already feeling the sharp end of the credit crunch.
Grant Thornton corporate tax partner Stephen Quest said that the ‘across the board’ increase in capital gains was in effect an 80 percent rise in what is currently paid. It is also a major disincentive for private equity executives to take the risks they were currently taking, and a factor likely to negatively impact the industry's recruitment and retention rates.
The next 12 months are already set to be extremely difficult for buy-out firms, who have reported their most negative forward looking expectations ever in a survey carried out by Grant Thornton Corporate Finance, with the majority of private equity executives (63 percent) predicting a downturn in deal values.
Quest said PE firms would now be reassessing their present models, and even the competitiveness of remaining in the UK.
“This has certainly shifted the goal posts for private equity at a time when it has been predicted by those in the industry that the value of deals is set to fall considerably. Following this massive increase, we can only hope private equity firms remain open to taking the risks on underperforming businesses that they have done in the past, given the likelihood of more UK corporates experiencing financial pressure over the coming year as the credit shortage filters through the economy.”
“This is the most negative forecast we have ever seen from the private equity sector and a huge drop in confidence from just three months ago, and with the capital gains tax increase announced today, it seems the light at the end of the tunnel is an oncoming train," concluded Quest.
Raft of EU legislation will add to the PE woes
A less publicised aspect of the private equity tax debate was the raft of unfavourable tax implications for SMEs owned by private equity. Under current European legislation, small companies do not qualify for a raft of tax benefits if they are more than 50 percent owned by private equity houses, which survey respondents believed was affecting their ability to recruit quality management, foster research and development, and attract investment in these smaller companies.
One example is the Enterprise Management Incentive (EMI), which offers small businesses tax benefits for senior management, so that the UK management talent pool is not so concentrated in larger firms, but does not apply to private equity owned businesses. Another is R&D tax credits, which are very generous for smaller companies, while PE owned companies only qualify for the lesser tax benefits offered to large companies.
“At a time when we are on the verge of a recession, changes in the rate of CGT and removal of taper relief are likely to slow the economy down still further”, comments Beers & Partners. “This may discourage newly redundant entrepreneurs from going out to create new businesses which - because of the credit squeeze would require business angel investment. The Chancellor's changes to the CGT rate and taper relief at this time seem designed to reduce flow of new business start-ups and investment at exactly the moment when they should be encouraged.”
Don’t look at EIS for relief – it is on the verge of collapse
Although many have looked at the EIS (Enterprise Investment Scheme) as a possible way of alleviating the pain, where capital gains tax exemption of up to £400,000 per annum per investor is available, providing the investment is held for more than three years.
However, latest data indicates that EIS has collapsed from its own patchwork of the required paperwork and advisory fees. Hidden amongst the announcements were the latest data for EIS, which at its peak in 2000-01 drew £1,061 million in investments. It has been going down ever since – in FY03, it was £624 million. Provisional figures for FY04 show only £586 million and for FY05 it is still lower at £462 million. Recent figures for SFLG do not paint a rosy picture either – The Chilli will be covering this and how the overall strategy for entrepreneurship and enterprise is becoming unstuck in more detail at a later date.
This is yet another hammer blow to small businesses still reeling from the increase in their corporation tax bills announced in the last budget. The Federation of Small Businesses has been lobbying hard to get this outrageous decision reversed and is looking for help – there is already a petition on the Number 10 website and the FSB is keen to get as many signatures as possible – assuming many of The Chilli’s readers will want to support the campaign, they can visit the web site – click here.
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