Taxation of Spin-out companies

The Finance Act 2003 has caused considerable upheaval in the spin-out community in the way shares are treated for tax purposes. Designed to close tax loopholes which had cost the Treasury £1.4bn in lost income tax and national insurance, the Act had the unforeseen consequence of landing academics with potential tax liabilities even before they had started to generate cash.

As a result, several universities put their spinout activities on hold until the situation had been resolved. In May, UNICO, the universities’ companies association, and the Inland Revenue issued a joint memorandum of understanding which set out arrangements for avoiding up-front tax liabilities.

Outline

Tax will arise in situations where shares are acquired for less than their market value. Take a typical example: A university sets up a company and licenses some intellectual property to it. The founders pay 10p a share and at the same time a business angel invests at £10 a share. The Inland Revenue will assume there is a gain to the founders of £9.90 per share which will be taxed accordingly.

Two are essentially two alternatives:

1. The safe harbour approach

This has been put together in a memorandum of understanding between UNICO and The Inland Revenue. Essentially, the founders buy preference shares at a nominal value (say 1p a share), which can be converted to ordinary shares at the current market value. There will be no income tax either on the initial acquisition of the preference shares or when ordinary shares are issued to investors. Instead, tax will be due when the preference shares are converted to ordinary shares – typically on disposal.

Something else to bear in mind - by deferring the tax liability until disposal the founders will usually find themselves with a bigger tax bill - up to 48% income tax and national insurance as opposed to capital gains tax charged at a rate as little as 10%.

2. The buy early approach

Where the founders buy in very early on, the company will have negligible value and thus there will be no scope for up front tax charges to arise. This will involve some careful planning right at the start of a venture and won’t always fit in with universities’ spinout policies, which normally involves the university starting the process with the academics taking an equity stake afterwards.

The tax treatment will be different depending on whether the shares are deemed to have been obtained through employment (and thus liable to income tax and national insurance) or as investors and thus liable to capital gains tax. In general, if you are, or are likely to be, an employee, that’s how you will be treated for tax purposes.

There are also issues regarding the different valuations on shares arising from restrictions – something that is often put in place at the time venture capital is invested. This could include ‘bad leaver provisions’ and additional veto rights for major shareholders. Tax will be payable on the difference between the price paid (nominal amount) and the restricted value of the shares. This sounds good at first — the restrictions reduce the value of the shares and therefore the tax bill is less — except that it stores up a problem for the future. This is because, when restrictions are later lifted, the sudden rise in value of the shares at that point will be taxable, at least in part.

This should give you a very brief overview of the some of the issues involved. This is however a complex area and you will need to get professional advice to ensure your arrangements are correctly structured.

For further information on financial issues, please contact Chris Budleigh on 01372 378822 or email chris@psi-ense.co.uk

Grateful thanks to Gerry Jackson of Critchleys, Oxford and Sharon Keown of Smith & Williamson, Guildford, for their kind help in preparing this article.