In this second post in my series covering the budget recommendations that I coordinated at StartupIreland, I cover our recommendations to reform Ireland’s myriad of incentive schemes into a single coherent policy modelled after the United Kingdom’s successful SEIS scheme. In addition we recommend the introduction of UK-style Entrepreneur’s Relief on Capital Gains Tax.

This is the second post in the series “#StartupIreland Pre-Budget Submissions 2015″

First of all though, let’s get one major point of confusion out of the way. In Ireland’s Budget 2014, an “Entrepreneurs Relief” measure was introduced. It bears no significant similarity to its namesake, the UK’s “Entrepreneurs’ Relief” scheme (which we like). It also turns out to be riddled with enough problems that I’m quite sure that it has not influenced a single entrepreneur or investor in Ireland. Let’s be clear: in Ireland we do not have Entrepreneurs Relief. We have a bad scheme with a good name.

Recommendation: CGT for Entrepreneurs

Background

The rate of Capital Gains Tax (CGT) in Ireland stands as one of the highest in the world at 33% (up from 20% in 2008). Both the founders and investors behind startup companies hope to derive the majority of their long-term income from the disposal of their shares, which means that both of these groups feel that their anticipated taxes have increased by 65% in the last few years. For these people, an increased rate of CGT acts as a disincentive to investment. Every potential startup must now promise even greater returns to compensate for the higher taxation overhead, resulting in fewer potential entrepreneurs and investors taking the plunge. For those entrepreneurs and investors who take the plunge and are lucky enough to make a return, high CGT leaves them with less after-tax capital to reinvest in new startups.

In practice, the punitive CGT rate means that a lot of startup investment is now performed through complicated holding companies. This has the simultaneous effect of (a) deterring all but professional investors from making investments, and (b) deferring the collection of tax by the exchequer.

We understand that CGT is an essential form of wealth redistribution in society. However, we believe that the current high flat rate CGT stifles investment in innovation in Ireland, and reduces the overall tax take. A more progressive CGT structure is required.

The United Kingdom has demonstrated a way forward. Introduced in 2008, “Entrepreneurs’ Relief” provided a reduced 10% rate of CGT on the first £1M in capital gains earned by a proprietary director during his/her lifetime from the companies he/she creates. This scheme has been so successful that the lifetime limit was raised to £5M in 2010, and then to £10M in 2011.

Recommendation

Ireland should implement a progressive CGT scheme along the lines of the UK’s Entrepreneur Relief Scheme. The first €12.5M earned from startup investments by founders or private investors in startups should be taxed at a lower rate of 10%.

Recommendation: Consolidate SCS, EII and “Entrepreneurial Relief”

Background

The Employment and Investment Incentive (EII), Seed Capital Scheme (SCS) and Entrepreneurial Relief are the three major tax reliefs in place in Ireland to support startups. Unfortunately, the feedback from the community is that these schemes are not working in the intended way.

The EII scheme has not proven successful due to its complexity, the staging of tax relief over several years, a requirement that the company continues trading for 3 years (many startups succeed or fail faster than this), that employment levels increase over those 3 years, and various other restrictions.

The Seed Capital Scheme (SCS) permits founders to invest in their own startups and reclaim income tax from the previous 6 years against their investment. This scheme is suited to encouraging experienced staff from large companies to leave employment to start their own ventures. It is less useful to young entrepreneurs or serial entrepreneurs, who do not have the capital and tax history to benefit from the scheme.

Budget 2014 introduced the “Entrepreneurial Relief” measure (which has little similarity with the progressive CGT known as “Entrepreneurs’ Relief” in the UK). A better name for this relief would be “capital gains reinvestment relief”. The relief in its current structure is not of practical use to entrepreneurs or the majority of investors. The issues with it are more easily illustrated by the following example.

Say an entrepreneur sells her business to a US technology giant in 2015, after many years of hard work on a living wage. From the sale of shares, she makes a capital gain of €1M. She is still immediately liable for CGT at 33% and therefore has a net gain of €670K. To avail of full CGT relief, she must now reinvest the entire €670K in other qualifying startups. In the following years, should she make a net gain on her portfolio, then the CGT she is liable for can be reduced by half, to a maximum of €330K (the sum she was originally taxed on the proceeds from her own company in 2015).

Criticism

This relief does not incentivise the present-day behavior of the vast majority of entrepreneurs, who have not yet sold a company. Its influence is limited to the minority of entrepreneurs who have sold a business and are considering future investments. Even for this group, the scheme suffers from two major problems:

• The relief can only be accessed many years in the future, at least 3 years, but more probably on the 5 to 10 years timescale it takes for startup investments to mature.
• It is extremely unwise for an entrepreneur to reinvest all her capital into new startups. A wise entrepreneur will diversify, and will allocate only a fraction of her money for re-investing startups.

A More Realistic Example

A more realistic example is that the entrepreneur allocates 20% of her remaining 2015 capital (€134K) to startup investments. The best case scenario is that she makes an amazing 10X return only 3 years later. At this point she would receive €44K in CGT relief (€134K x 33%), reducing her effective 2015 CGT rate from 33% to 28%. Compared to the level of risk that she has taken on her new investments, this reward is both minimal and late, and will not significantly alter her investment behavior.

Comparison with the UK’s SEIS Scheme

The United Kingdom has introduced a scheme known as the Seed Enterprise Investment Scheme (SEIS). This unified scheme overlaps in purpose with Ireland’s EII, SCS and Entrepreneurial Relief schemes. It has already proven highly successful in its stated goal of “kickstarting the economy”.

SEIS allows private individuals to invest up to £100K per year into qualifying startups and receive the following simple benefits:

1. Upfront income tax relief of 50% of the amount invested. For example, if £100K is invested, personal tax liabilities can be immediately offset by £50K.

2. Full exemption from CGT payable on any gains made from these investments.

3. Any capital losses incurred from the investment can be offset against capital gains or income tax.

4. To encourage people to participate, individuals can reclaim 50% of capital gains tax paid on disposals of other assets, if they invest those proceeds into qualifying startups. This is similar to the Budget 2014 Entrepreneurial Relief scheme, but is claimable immediately instead of being contingent on the profitable future disposal of the new investment.

Recommendations

The EII Scheme, SCS and Entrepreneurial Relief should be replaced with a single coherent scheme that provides the powerful incentives offered by the UK’s SEIS. To maintain the key additional incentive of SCS, it should be possible for an entrepreneur who invests in a startup under the new scheme to receive relief on tax paid in previous years, not just the current year.

Coming in part 3… Employee Incentivisation

In the next part of this series I’ll post our recommendation on employee incentivation in private companies in Ireland. Startups generally consider employee ownership to be a key strategy for success, however there is currently no good way to implement a suitable scheme.

You can stay tuned by following me and StartupIreland on Twitter.