Pitfalls of startup taxation

In our previous issue we mentioned that start-ups, these dark horses of business, are innovative companies that desperately need funding to promote their ideas and transform them into a final product. And that business angels, who are, in fact, private investors, come to their rescue and make these risky investments, and later on professional venture investors follow their lead.

But can we assume that difficulties await our young inventors and novice business people – not only in terms of creativity and later on while looking for funding, but also from the state and, in the first place, tax authorities?

You are absolutely right. At first sight, yes. If you read the press and manifests of various states in the sphere of tax policy and innovation, practically all countries are trying to make their tax policy extremely attractive for R&D and innovative companies, since only these companies in a short period of time can turn into multinational giants who hire thousands of workers and pay millions of dollars in taxes. It was this race for tax benefits that caused a series of tax scandals in the past, which we have already talked about, and has led to countermeasures on behalf of the OECD, which have found reflection in the BEPS Action plan.

Nowadays, providing beneficial tax regimes, the so-called IP BOX, is clearly regulated at the European level. However, this does not change the fact that all countries have a beneficial tax regime for innovative companies. Start-ups are either freed from income tax for the first few years of operation or have a very low tax rate.

And where’s the catch?

Regardless of jurisdiction, unpleasant surprise can await start-ups when tax authorities start the assessment of their stocks value. As soon as the start-up finds funding, the value of its stocks grows. For example, the company obtains funding which together with its own capital is $10 mln. The founders and investors who, for example, own 10% of this amount, turn out to be the owners of a virtual fortune of $1 mln. In other words, this problem affects the taxation of business people and initial investors (most often these are business angels) as physical persons. The stocks with a virtual value of $1 mln will entail a hefty tax order in jurisdictions which have wealth tax in addition to income tax.

But the value of their stocks is virtual, not real… Because companies invest their funding into developing a prototype and, in fact, their stocks are not yet backed up with sufficient profits so that they could have a value of $1 mln…

That’s the trick! Tax authorities of various countries can assess the stocks in different ways: according to their market or actual value… and start from different points in time. Besides, you should not forget that tax assessment of company’s value is also a basis for calculating taxes for the company itself.

I can only add that the problem of tax assessment of stocks value is linked to the problem of stock-options, thanks to which start-ups can employ specialists whom otherwise they would be unable to give high salaries.

Can you please explain your last example?

To employ talented people for a modest salary, start-ups offer stock-options to their staff. Stock options means the right to buy stocks in the future at a price significantly below the market. For example, an engineer agrees to work for a salary of $50,000 per year in exchange for the stocks-option which in future might cost $500,000. The problem will emerge right at that moment. If after 5 years the worker transforms this option into stocks, he will be taxed for the income of $550,000 that year. And he will have to pay a lot more taxes as compared to the situation if he received the same amount as a salary (in our example it’s $150,000 per year), to get the same amount of total income for the period of 5 years.

Why is there such a discrepancy between the desire of countries to get as many innovative companies and scandals related to beneficial tax regimes and such hidden tax pitfalls?

Tax rules in some countries cannot keep the pace with the development of technologies and changes in the economy. Hence the discrepancies and contradictions, as is the case with taxation of innovative companies. All jurisdictions are fighting for attracting such companies to their markets, so that they do their R&D activities, develop and hire workers from local people… But in some countries there are these distortions, I would call them “tax punishment for business people and initial investors”- I have given you the example of this.

We can also add here such tax burden as taxes on income from capital gain which is provided by business angels. In some leading jurisdictions this tax is lowered to the minimum or cancelled altogether, but in other countries, only if you can prove that this is not your professional activity (which is the case for business angels), then there is a chance to escape this tax… Otherwise, you end up with a tax order for tens or even hundreds of thousands dollars or euro.

I won’t name these jurisdictions where such things exist and flourish, but I can sadly state that tax authorities of some countries so far have not realized the importance of innovative companies for the economy, and are still bringing tax punishment on private investors and business people who invest their initial capital and without whom start-ups and their success would not be possible.

That’s why the assistance of a tax consultant, a specialist in intangible assets can be vital for a correct structure and a careful choice of a desired jurisdiction before the launch of a start-up.