Why the UK tech start-up eco-system is flying and what Australia can learn

Malcolm Turnbull – The new Prime Minister and an air of optimism

Since Malcolm Turnbull’s arrival in office it is hard to put value on the air of optimism and the spring in the step of innovators and entrepreneurs in the start-up and Fin-tech space. Who knows how this will translate into that extra piece of discretionary effort or focus that generates value and jobs for the Australian economy.

Items that were off the table or regarded as politically sensitive can now be openly discussed in the context of the potential revenue and jobs they will create.

It is in the context of this new environment that it now seems possible to talk about tax relief when it is provided as an incentive to help our entrepreneurs and innovators create the next big tech giant of tomorrow.

It is not to say that equity has gone out of the window, as it seems from all accounts that the Prime Minister is very much concerned about fairness but he also recognises that you need to create wealth first to have something to share.

Why should income earners, taxpayers and retirees part with their hard-earned cash to help small start-up ventures when start-ups statistics indicate that only 1 in 20 new ventures will be successful?

Well if the government is prepared to provide them with some incentive to do so then surely everyone has a chance to win.

Tax relief for investors in the UK

For over 20 years in the UK, tax relief has been available to encourage private investors to provide capital to unlisted companies. The aim being to provide businesses with funds that would otherwise be unavailable.

Today the Enterprise Investment Scheme (EIS)* and the Seed Enterprise Investment Scheme (SEIS)* offer a number of tax breaks to investors in qualifying trading companies.

To qualify under the EIS the company must have not more than 250 employees and gross assets not exceeding $30 million. For the SEIS the limit is 50 employees and gross assets not exceeding $400,000.

To encourage investment in EIS share issues, the investor receives income tax relief to the value of 30% of the amount invested of up to $2 million. The 30% of the $2 million ie $600,000 can be deducted from an individual’s income tax bill for the year!

For investment in SEIS share issues, the investor receives income tax relief at a generous 50% of the amount invested up to $200,000 ie a further potential deduction in their income tax liability for the year of $100,000.

If the shares in either the EIS or SEIS investment are held for 3 years and subsequently sold at a profit, the gain on sale is exempt from capital gains tax.

Where $100,000 is invested in SEIS shares and the shares double in value in 3 years to $200,000 it has effectively cost the investor $50,000 for a tax-free gain of $100,000.

Significant relief has on occasion led investors to make investments purely for tax reasons – otherwise known as the tax tail wagging the investment dog. Whilst no amount of tax incentive can turn a bad investment in to a good one, the additional loss relief available under the EIS and SEIS, illustrated below, can certainly soften the blow.

Losses offset against income tax – illustration
Assume – you invest $100,000 in SEIS shares, lose the entire investment and your marginal income tax rate is 45%.

Income tax relief on initial investment at 50% = $50,000 (reduction in tax bill for the year)
Net cost of $100,000 investment = $50,000 ($100,000 – income tax refund of $50,000)
When you dispose of the shares in 3 years’ time for $0 the loss on which tax relief is given is net of any income tax relief obtained when the investment was made ($100,000 – $50,000)
Loss relief = $50,000 x 45 % = $22,500
Your actual loss = $50,000 – $22,500 = $27,500
Total income tax relief = $72,500 (72.5 % of your investment)

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Equity based crowdfunding

Whilst these types of tax relief have been in place in the UK for over 20 years it is interesting to note the impact they have had on the relatively new equity based crowdfunding industry in the UK.

The UK equity crowdfunding market raised roughly $170m in 2014. It is dominated by two large players – Seedrs, who themselves received a $20m investment from investors including a Rothschild backed fund, and Crowdcube who as at the start of this month had raised $235m of capital to help 322 businesses.

By far the majority of companies in the UK who received funds through equity crowdfunding platforms have been eligible for EIS or SEIS relief. Many investors looking at the platforms are looking for homes for their annual EIS or SEIS allowances.

On speaking to equity crowdfunding platforms in the UK, it is clear that they value the UK Government’s support in the form of tax relief for investors and appreciate the sizeable impact it has had both on their business and the ventures raising funds on their platforms. The EIS and SEIS reliefs are driving significant traffic to the equity based crowdfunding platforms.

Here in Australia the Turnbull Government has highlighted the development of a crowd sourced equity funding market as an “urgent priority” with a legislative framework promised by the end of 2015.

At the same time the Government is actively engaged in the tax reform debate. One measure potentially worthy of consideration as a way to help mobilise innovation and move it from the debate stage to the operational stage might be to provide income tax incentives for those who buy shares in small unquoted trading companies.

Appropriately tested on its costs and benefits to Australians, this measure may have the potential to help entrepreneurs and small businesses as well as to help enhance the success of the future equity based crowdfunding market in Australia.

Note: for simplicity assumed exchange rate Aus $ 2: 1 GBP
*www.hmrc.gov.uk/eis, www.hmrc.gov.uk/seedeis

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