The best unknown tax secret
“Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”
Benjamin Franklin in a letter to Jean-Baptiste Leroy, 1789.
Now that I have shoehorned in a catchy blog title, let me explain the relevance of death and taxes. (Company) death and taxes are intertwined nicely in a dilemma created by the Seed Enterprise Investment Scheme, or SEIS for short.
How does SEIS work?
The basic premise is to encourage investment into SME’s. Shy away from the markets, and provide growth capital to startups.
Let’s run an example:
I hit the big time on a scratch card and pocket £100k. I make a SEIS investment into a start-up — it qualifies as it has less than 25 employees, and gross assets totaling less than £200k. I receive a shareholding of less than 30% and therefore am entitled to SEIS.
I am entitled to income tax relief totaling 50% of my investment. Therefore, the £100k investment that I made, really only costs me £50k post tax. In the event of me selling my shares for more than the purchase value, I will not pay Capital Gains Tax on the profits.
It gets better. Should the Company fail then I also qualify for loss relief equating to 45% of my risk capital. My risk capital is the £50k exposure I have post income tax relief. Therefore, if the Company fails, my £100k investment has only cost me a grand total of £27,500. Not a bad punt.
This is an undoubtedly generous scheme and it definitely works.
From the investor side — it’s a pretty sweet deal. Stick “Angel Investor” on your LinkedIn profile and bag a bit of experience and kudos. Who knows, it might return 30x — and if it doesn’t — well, it only cost you 27.5% in real terms.
For the UK economy, it is also fantastic. By making angel investing more attractive and accessible to ordinary Joes, it fosters a real innovative and entrepreneurial economy.
But what about the Company perspective…
5 years in and things have not progressed according to plan — your angel investor now has an interesting dilemma;
a) Roll up their sleeves and help the Company raise further cash to embark upon another 5 year cycle. They will suffer dilution as a result of this and therefore the holy grail of a 10X return quickly becomes 2X;
b) Let the Company fail — after all, they will pocket their SEIS Loss Relief, and limit the damage;
Going back to our earlier example.
This would give me a guaranteed return of £22.5k now — OR a 10% chance of £200k in 5 years time.
It’s a tough one.
Crossed wires. An inherent conflict of interest between SEIS and Founder shareholders. Founder shareholders will want to fight tooth and nail to make their sacrifices over 5 years worth it — but their angel investors have an incentive to fail.
Death and Taxes
Two inevitabilities of life — and here’s a third, Startups will fail.
But why offer a tax incentive for failure?
SEIS is an excellent scheme, but it could be better. Why not introduce a flat rate income tax relief provision of 60% for SEIS investments, and abolish loss relief? It would abolish the temptation to let the Company fold — yes, failure is good for an economy — but let us not encourage it.