CandidCapital

The 2008 UK Budget may have been a modest affair, but published with it were two documents with probably greater implications for the long-term performance of the innovation sector in the UK.

Many of you reading through the coverage of Alistair Darling’s first Budget, delivered on 12th March 2008, may have been reminded of Claud Cockburn’s famous (spoof?) entry for the prize of most dull but accurate headline: ‘Small Earthquake in Chile, Not Many Dead’.

The reasons for such modesty on Mr Darling’s part are varied. His critics, who proliferated after the Northern Rock fiasco, view him in much the same way as Churchill allegedly saw Clement Atlee, Britain’s first post-WWII prime minister: ‘A modest man, but then he has so much to be modest about.’ More to the point is the tightly limited room that any Chancellor of the Exchequer would have for manoeuvre given the macro-economic constraints he has inherited form his predecessor - and boss - and the extraordinary market turbulence of recent months.

Three weeks after the event, I’ve tried to distill those elements of the Budget that are most likely to impact on entrepreneurial and technology firms. I’ve also taken the opportunity to brush up on some enduring tax-related issues for entrepreneurs, such as the enterprise investment scheme and venture capital trusts.

But far more interesting than the Budget for the long-term health of the knowledge-based economy were two White Papers issued at the same time as the Budget: Enterprise: unlocking the UK’s Talent and Innovation Nation . I hope at least to whet your appetite enough to tempt to you to download the White Papers for yourself.

So first the Budget round-up and then the White Paper amuse bouches.

Capital Gains Tax

Not a surprise – not least because it was largely trailed in the controversial pre-Budget statement in September – was a move to impose a single 18% flat rate of CGT. This was originally promoted as a move towards simplicity, something the UK tax system urgently needs after 10 years of micro-management from Gordon Brown led to a doubling in size of the tax code.

Nevertheless, the Budget has achieved an unwanted biological miracle in giving us a CGT regime that is half pregnant. The flat rate remains – sort of – but so too does the complexity. In a nod to the time when New Labour still wooed start-ups and the self-employed, ‘entrepreneurs relief’ (I think there’s an apostrophe in there trying to get out) provides an exception from the general move to a flat 18% rate of capital gains tax: a lifetime allowance of £1 million of gains on business disposals to be taxed at only 10%.

The most concise summary I can make is as follows: the first £1 million of capital gains on the disposal of a business or several businesses by an individual (during her lifetime) will still be taxed at an effective rate of 10%. Indexation also comes to an end. The annual exempt amount for next year (2008/09) has been confirmed as £9,600.

I know of a handful of private businesses which accelerated their disposal plans to complete deals before 5th April 2008 so that the owners can still take advantage of business asset taper relief and the existing 10% (non-lifetime) rate.

Some assets, which previously qualified for taper relief, will not qualify for entrepreneurs’ relief: employee shareholders who own shares in non-trading companies or who do not own 5% of the ordinary shares and Enterprise Management Incentive option holders. The £1 million relief is obviously finite and unlikely to be enough to cover the value of a business built up during most of your working lifetime.

Just another stone in the psychological wall encouraging British entrepreneurs to limit their ambitions?

Enterprise Investment Scheme

One potentially helpful change that was partly lost amid the noise relating to CGT was the increase in the EIS investment threshold by £100,000 to £500,000.

So what is the EIS?

The HMRC website puts it succinctly: ‘The EIS is designed to help smaller higher-risk trading companies to raise finance by offering a range of tax reliefs to investors who purchase new shares in those companies.’ The basic criteria are as follows:

• All shares must be paid up in full, in cash, when they are issued.
• Shares must be 'full-risk' ordinary shares, with no preferential rights
• Investment can be directly into the company, or through an EIS Fund.
• Income tax relief is available to individuals who subscribe for shares in an EIS qualifying company.
• The relief is 20% of the cost of the shares, to be set against the individual’s income tax liability for the tax year in which the investment was made.
• Relief can be claimed up to a maximum of (now) £500,000 invested in such shares, giving a maximum tax reduction in any one year of £100,000

The capital gains tax reliefs are now obviously being withdrawn, but for further information see the full HMRC guidance on venture capital schemes

Corporation Tax

If the EIS changes were welcome for growth companies, small firms will be hit by the increase in the small companies rate from 20% to 21%. Mainstream corporation tax, paid on annual profits of more than £1.5 million, was cut from 30p to 28p in the pound, but the small companies rate will increase again to 22p in 2009. Anti-avoidance measures become more draconian.

Venture Capital Trusts

So far as I can see, the Budget only affects VCT rules peripherally, by imposing the same exclusion on shipbuilding and coal and steel production as qualifying trades as it did for the EIS (and, for that matter, the Corporate Venturing Scheme): companies whose business consists substantially of these activities will no longer qualify under these 3 schemes for any relief.

But just to make sure we are all on the same page, here is a brief summary of the VCT rules:

VCTs began life under Conservative Chancellor Ken Clarke in 1995 as an incentive to invest in smaller firms through a series of tax benefits by subscribing for new shares. Initially, this meant the ability to defer capital gains tax liability and 20% income tax rebate on initial investment and no tax to pay on income or gains from the trust.

But the rules have been revised a couple of times over the past dozen years. Stockmarket falls in 2000-2003 meant that few investors were tempted by a CGT shield. From April 2004 CGT deferral was scrapped BUT the Income Tax rebate was increased to 40%. Demand for VCTs went up.

So after 6 April 2006 the Income Tax rebate fell to 30%, the minimum holding period to qualify for the relief rose from three to five years and new limits were imposed on the size of companies in which VCTs may invest.

VCTs are collective investment listed on the Stock Exchange. At least 70% of funds raised by VCTs must be invested in ‘qualifying assets’ within three years. To qualify, assets must:
• be UK based trading companies
• with under 50 employees
• have gross assets below £7 million at the time of investment
• have raised no more than £2 million from venture capital schemes during the previous year.

Once again, HM Revenue & Customs has a usable guide, which explains the attraction for investors of VCTs, which I summarise as follows for first time readers:

Income tax reliefs include exemption from income tax on dividends from ordinary shares in VCTs ('dividend relief'), and 'income tax relief' at the rate of 30% of the amount subscribed for shares issued in the tax year 2006/07 for the tax year in which these 'eligible shares' were issued, provided that you subscribed for the shares on your own behalf, the shares were issued to you, and you hold them for at least five years. The income tax relief at 30% is available to be set against any income tax liability that is due, whether at the lower, basic or higher rate.

There are two Capital Gains Tax reliefs: you may not have to pay Capital Gains Tax on any gain you make when you dispose of your VCT shares. (This is called disposal relief). IF you invested in shares issued before 6 April 2004, you may be able to treat gains arising on disposals around the time your VCT shares are issued as postponed to a later year. (This is called deferral relief.)

You can get two of the reliefs, dividend relief and CGT exemption, for both newly issued shares and second-hand shares acquired, for example, through the Stock Exchange. But income tax relief (and, where the shares were issued before 6 April 2004, deferral relief) can be claimed only if you subscribe for new shares. You can get income tax relief for a tax year if shares in VCTs for which you subscribed up to a maximum of £200,000 are issued to you in the year (£100,000 for tax years before 2004/05).

My only additional comment is that the stock-market quotation for VCTs can be a little illusory in practice. You could buy and sell at any time, but you’d lose the up-front tax relief if you sold within three years. And poor liquidity in VCTs will constrain the share price, too.

Enterprise Management Incentive Schemes

Mixed messages on EMIs came out of this year’s Budget, perhaps reflecting a continuing desire in the Treasury to fine tune taxes and most other forms of regulation beyond the level of audibility accessible to the human ear.

One the one hand, the maximum individual option grant limit is increased from £100,000 to £120,000 with effect from when the Finance Act 2008 gains the Royal Assent.

On the other, to qualify a company must have fewer than 250 full-time employees. Part-time employees are to be converted to full-time employees (FTEs) by taking a ‘just and reasonable’ fraction for each part-time employee. Shipbuilding, coal and steel production will no longer qualify for EMI; I confess these are not sectors that have crossed my desk as investment opportunities for many years.

Now for a reminder of what the EMI is in the first place.

EMIs enable small firms to give share options with tax advantages to keep employees for recruitment and retention purposes, aligning the rewards to individuals better with the risks they could take compared with working for – say – a FTSE 100 firm.

The EMI regime is subject to a total share value of £3 million under EMI options to all employees. The shares must be in an independent trading company that has gross assets of no more than £30 million.

The grant of the option is tax-free and there will normally be no tax or National Insurance contributions (NICs) for the employee to pay when the option is exercised. There will normally be no NICs charge for the employer.

So if you are a qualifying beneficiary of an EMI scheme, you can receive shares tax (income and NIC) free and you only pay tax in the form of CGT on a disposal. But being an EMI option holder will not get you entrepreneurs’ relief, even though up until now you would have benefited from tape relief.

Small Firms Loan Guarantee Scheme

The Budget news was that the small firms loan guarantee scheme has been increased by £60m this year.

So what is the SFLGS?

It is aimed at early-stage businesses with good business plans and a funding requirement for which a loan would be otherwise be appropriate BUT which cannot obtain a conventional loan because it does not have assets to offer as security. The SFLG helps to by providing lenders with a government guarantee against default in given circumstances.

The SFLG is a joint venture between the Department for Business, Enterprise and Regulatory Reform (BERR) and a number of participating lenders (such as high-street banks), who administer the eligibility criteria and make the commercial decisions regarding borrowing.

This guarantee to the bank covers 75% of the eligible loan, for which the borrower pays a 2% premium on the outstanding balance of the loan to the BERR. Loans of up to £250,000 and with terms of up to ten years can be guaranteed. The SFLGS is available for qualifying UK businesses (some sectors and purposes are excluded) with an annual turnover of up to £5.6 million and which are up to five years old.

From the point of view of entrepreneurs, the SFLGS has been a success story, for obvious reasons. The Treasury has understandable reservations because it represents a potentially significant contingent liability. And it is an open secret in the trade that some banks have been … a little less rigorous in applying the criteria than others. It appears that the Treasury has overcome its own reservations by ensuring that the BERR audits the banks more strictly, and by limiting the funds available in any one year.

Non-Doms

Unlike many market-oriented members of the commentariat, I am profoundly sceptical about the value of non-domiciled residents to the UK economy and most ‘statistics’ in newspapers and elsewhere on their contribution are probably as sound as a bond issue collatoralised on sub-prime mortgages.

I’d be LESS sceptical if the broadsheets, when discussing the issue, headed each and every article with an explanation of their proprietor’s own tax affairs, just as I’d take newspaper criticism of FTSE chief executive pay-packets more seriously if each rag included details of how much its editor is paid.

But for the record, this is in summary what the Budget finally said about impoverished shipping tycoons living in Belgravia and oligarchs on their uppers in Hampstead: those who have spent at least 7 of the past 10 years in the UK will be charged a £30,000 annual levy for the privilege of not being taxed on offshore income and gains.

But several concessions were also made in the Budget:
• minors will not be required to pay the £30,000 levy to avoid paying UK tax on worldwide income and gains.
• gains and income from overseas trusts which relate to UK assets will not be taxed unless the assets are remitted into the UK.
• non-doms will not be required to disclose information about assets held within trusts as long as they have declared any taxable income or gains from them.
• those who pay national taxes on worldwide income can offset the £30,000 levy against any taxes paid in their home countries

I still suspect that non-doms are as relevant to innovation and entrepreneurship as private equity is to venture capital; but if you disagree, do declare your interest.

Innovation White Paper

One of my favourite anecdotes concerns the Polish cavalry general who was asked who he would fight first if the Germans and the Russians invaded his country at the same time, hardly a fanciful idea given the tumultuous history of Poland. ‘The Germans, of course,’ he said, ‘business before pleasure.’

So now - after the rather dull business of looking at how the Budget might impact on growth firms and reviewing some of the major schemes (EIS, VCT, SFLGs etc) of the past 15 years – turn to the relative pleasure of the two White Papers that came out as part of the Budget process.

First, the Innovation White Paper: Innovation Nation . It is issued by the relatively new Department for Innovation, Universities and Skills, created out the carve-up of the old DTI and Department for Education and Skills that took place when Gordon Brown shuffled the Cabinet chairs on becoming Prime Minister.

This little review of history is relevant to understanding the split personality of the White Paper. One the one hand, it is a solid, 90-page review of what is going on in areas as diverse as government funding for science, international markets, education and business finance. As such, I’d recommend it to any reader looking for a rapid induction into the subject.

But the serious work of the sector specialists in the DIUS also gives many signs having been edited by political commissars with an agenda of regionalism, inclusivity and ‘all shall have prizes’. I recently has cause to look up the Bank of England's 1996 report on tech-firm funding and was struck by how much policy at the time deferred to the Business Links, entities which barely get a look-in these days. More recently, the vehicle of choice for filling all policy gaps has been the Regional Development Agencies. I wonder - giving how much is notionally riding on their shoulders and how unevenly they respond to government expectations - how long it can be before they fall out of favour and into the limbo of desuetude: neither quite abolished nor yet fully functional?

And The Foreword by the Secretary of State (who is oddly photographed with collar and tie modestly akimbo) could have been written by Private Eye’s Rev J C Flannel:

‘We want to create an Innovation Nation because Britain can only prosper in a globalised economy if we unlock the talents of all our people … In all this there is an exciting challenge for business, public services, third sector organizations, towns and cities, universities and colleges. Government can foster innovation but only people can create an Innovation Nation’

Some contradiction, surely, between the first and last clauses? For all that, the good news is that the body of the White Paper makes much more serious reading and begins to consolidate work in the field initiated by Michael Heseltine as President of the Board of Trade in the mid-1990s and then carried forward by Peter Mandelson when he was at the DTI.

Most importantly of all, the DIUS White Paper explicitly builds on the most comprehensive recent review of the whole subject, Lord Sainsbury’s Race to the Top, issued in October 2007. Indeed, at the same time as issuing the White Paper, the DIUS published an assessment of progress: Implementing the ‘Race to the Top’. On its own account, ‘over 20 [of the original 72 recommendations] have already been implemented and the rest are in the process of implementation’

Entrepreneurship White Paper

The Sainsbury Review was a solid analysis of how Britain can compete in a globalised economy. But over and above that, what matters with strategy is that you stick with it, even as you modify it in the light of experience. Until recently, it often felt that each new innovation White Paper existed in isolation from its predecessors.

But just as the DIUS White Paper makes welcome, detailed reference to the Sainsbury Review, the joint HM Treasury/Department for Business Enterprise and Regulatory Reform's Enterprise: unlocking the Uk’s talent also builds on rather than ignores recent history. The Introduction in particular is a useful summary of policy over the past decade or more.

However, the White Paper also contains two intriguing new proposals.

First, a target mentioned in the Budget speech for small and medium-sized businesses to win 30% of public sector contracts in the next five years. To help meet this, public procurement rules will be changed: ‘The Government recognises that invoice and debt factoring is an important source of finance for businesses. The Office of Government Commerce will therefore remove the standard requirement for departmental consent from their model procurement clauses which will effect existing and new contracts.’ (Paragraph 4.33). This is as close as we might have hoped that government would go in implementing a scheme similar to the American SBIR program.

Secondly, recognising that the ‘US has 20 per cent more businesses per head than the UK. A significant proportion of this gap is explained by much lower rates of women’s entrepreneurial activity in the UK’ (paragraph 1.30), the government has made a ‘commitment of £12.5million for a capital fund focussed primarily on investing in womenled- businesses’. Details are still sparse, but this initiative will be taken with other measures for investment-readiness, especially for women entrepreneurs.

Give Thanks for a Small Earthquake

So all in all, perhaps having a small, non-lethal earthquake was not such a bad thing. If the Budget itself was uninspiring, the two White Papers of greatest interest to innovation and entrepreneurship show (even with their political slant) a welcome trend of building on the pioneering work of the past dozen years, rather than moving on to pastures new without learning from the past.

And specifically on access to finance, the DIUS White Paper notes (paragraphs 4.29-4.30) that the government ‘has now committed over £141 million to ECF funding with a further £150 million earmarked for future funds over the next 3 years…Since its inception, the EIS has raised over £6.1 billion and invested in over 14,000 small, high-risk companies, while VCTs have invested over £3.2 billion in over 1,400 companies.’

Not many killed, but quite a lot of additional investment levered in at a time when institutional investors are still deserting the early-stage market. The test will now be how well the government-backed funds perform over the long term and how successful they are in re-igniting private interest in the sector.

31 March 2008