Taxing times for entrepreneurs

11 November 2007

Changes to capital gains tax proposed by the Chancellor last month could have a huge impact on small business owners, potentially affecting everything from hiring good people to attracting investors

Last month's pre-budget statement from the Chancellor of the Exchequer didn't go down well with small business advocates. If they come into effect from 1 April 2008, the proposed changes will significantly increase the capital gains tax (CGT) bill for those seeking to sell their equity in a business from 10 per cent to 18 per cent. The increase may also deter investors who, under the present regime, have been able to qualify for taper relief of ten per cent if they retain their shares in a business for more than two years.

The changes were initially portrayed as a means to redress the inequities of a tax system that enabled private equity bosses to pay far less tax than everyone else. But it soon became apparent that the measure announced by Alistair Darling would have a profound effect on entrepreneurs and small business owners.

A number of business lobbying groups have lined up to attack the measure, claiming it represents an 80 per cent tax hike on people seeking to sell their business or to cash in shares in a company after 1 April 2008. The Federation of Small Businesses (FSB), the British Chambers of Commerce, the CBI and Institute of Directors wrote a joint letter to the Chancellor calling on him to suspend his decision and enter into detailed discussions with business organisations to find an alternative way forward 'that averts serious damage to this country's entrepreneurial culture'.

The FSB also quotes case studies from its membership where the CGT bill they will face after April 2008 has increased significantly. One member's CGT will jump from £10,000 to £60,000 and another will have to pay an extra £42,000 CGT.

The changes to CGT will also have an effect on an investment landscape that is already beginning to feel the effects of the credit squeeze in the wake of the recent market ructions around subprime mortgage lending. John Cridland, deputy director-general of the CBI, argues there could be a 'reduction in investment in start-up and growing businesses'. That point was echoed by Dr Andrew Stevenson, chairman at g2i consortium member E-Synergy, who believes the changes will hurt small businesses and investors willing to take higher risks.

'The rewards for those involved in start-up and early stage businesses are more capital gains based which puts them directly in the firing line,' he says. Stevenson also believes it will be harder for start ups to recruit good managers to help them attract investment, given that equity forms an important component of compensation packages. The cost to start-ups will be higher if they have to pay a bigger salary or increase the equity stake to compensate for the higher CGT bill.

'The whole process is more costly,' Stevenson states. 'It's more risky, there are less returns and it will be more difficult to get people. It will have a very negative effect.' He suggests the change could also deter would-be entrepreneurs, especially those working for a larger company at a high salary who might normally be prepared to risk a lower salary in exchange for the rewards from a potential sale.

Neil Pamplin, corporate tax director at Grant Thornton, agrees that the changes are likely to make small and mid-sized companies and start-ups less attractive to investors. Business angels, for example, are now facing an 80 per cent increase in their tax bill.

The attractions of going for an AIM listing are also reduced because stocks no longer quality for taper relief, although they still qualify for inheritance tax relief.

Ironically, investors in larger listed companies have seen their CGT bill reduced from 40 to 18 per cent. And in a bizarre twist given the recent negative atmosphere around those with non-domiciled status, the change may actually encourage more people to elect to be treated as non-domiciled because gains made from foreign assets may be CGT-free.

Of course, the 80 per cent increase in CGT is relative to what was a very low rate. The increase to 18 per cent puts the UK back in the 15 to 20 per cent range common across Europe, and is still well below the 30 and 40 per cent rates that used to apply before Gordon Brown changed everything in 1998.

Nevertheless, Stevenson argues that the UK has gone from having one of the most attractive investment regimes to one of the least attractive. And Pamplin is also struggling to understand the change. '[The government] spent all this time and effort encouraging an entrepreneurial culture only to pull the rug from quite a fundamental driver and I don't think anybody has adequately explained the rationale for it,' he says.

By Billy MacInnes, Webster Buchanan Research