Where is the glamour?

Jun 11, 2018

Sunday Business Post, 10 June 2018
A considerable distance away from the cachet of a stock exchange listing and from the drama of an initial public offering, small companies use less glamorous tactics to raise money.

Companies most commonly raise money by bank borrowings, and small start up businesses always found that difficult.  The bank travails of the last decade made it even harder for businesses to borrow, so much so that the government felt obliged to set up a separate agency, the Credit Review Office, to deal with refusals to some commercial borrowing applications. 

In such a market, you’d expect that more companies would try to use the other traditional way of raising money by issuing shares, in effect, borrowing from their shareholders.  Investing in shares in a quoted company is one thing as there is a ready market for redeeming that shareholding.  But taking a punt in a privately quoted company is very different.

A Short Ego Trip

The late business guru Mark H. McCormack once observed that buying a minority shareholding in a private company is little more than a short ego trip for the investor.  The investment itself is high risk.  The return on the investment by way of dividend is often tiny.  And then there is the problem of how to redeem the investment, always assuming that adverse trading conditions or poor management haven't whittled it away to nothing.  Something to sweeten the deal is needed, otherwise the funding problem for small businesses will persist.  Hence the existence of the Employment and Investment Incentive Scheme (EIIS) and its first cousin, the Start Up Relief for Entrepreneurs (SURE).

EIIS works by bending one of the fundamental rules of taxation.  It blurs the distinction that is made between day-to-day business expenses which can be allowed to reduce taxable income, and the amounts spent on investing in capital (real estate, shares and the like) which don’t reduce taxable income.  In a nutshell it gives an investor an income tax break for the capital value they invest in the small start-up company.  The Exchequer shares in the risk the investor is taking by putting money into a privately held company. 

Because the Revenue Commissioners don't like risks much, there are lots of terms and conditions attaching to EIIS and SURE.  Chief among these are that the company must be a relative newcomer, relatively small, and the amounts that are invested should be relatively low.  The impact of these restrictions can be seen from the headline figures associated with the EIIS. 

There are well over 150,000 companies incorporated in Ireland but in 2016, only 261 companies raised funds by using the relief.   The total amount of all the investments was just over €100 million, and typically individual investors invested about €50,000.  The tax cost to the Exchequer in 2016 was estimated at just over €32 million.

Small but Reviewed

In the overall scheme of things, these are relatively small figures.  You'd expect them to be higher, given the difficulties that companies have in raising funds, and the attractiveness of the EIIS relief on offer for individuals.  In recent times over €7 billion has been collected in corporation tax each year and over €18 billion in income tax.  Against that backdrop, this particular tax incentive costs very little indeed, yet it is under official review at present.

All tax reliefs should be reviewed periodically.  If the property tax reliefs of the 80s and 90s taught us anything, it is that tax reliefs should not continue indefinitely otherwise they create distortions in the markets they were supposed to correct.  In the 1980s property tax reliefs were brought in for good reasons to address a shortage of decent moderate cost rented residential accommodation.  However when left unchecked, 20 years later, they contributed to the property bubble.  We can see from the amounts involved that the EIIS is not contributing to any kind of bubble.  So why is it under review?

The State Aid Thing

The answer may lie in EU's rules on state aid.  The EU state aid rules don't allow the government to provide selective benefits to particular companies or sectors.  Raising money using tax incentives is potentially an illegal state aid, so permission has to be sought from Brussels for schemes like EIIS to operate.  A problem has arisen in that the European rules no longer allow small companies which are in existence for more than 7 years to raise money within a tax incentive scheme.  Many companies which would otherwise qualify comfortably under the EIIS framework have been stymied by this requirement.

The reason for this European policy is unclear.  Policymakers are sometimes concerned about what they term “deadweight” – incentives of all types to promote activity which would occur anyway even without their existence.  Whatever the motivation, it has severely restricted the commercial usefulness of EIIS for companies in an expansion phase.

So the review currently underway is possibly not so much about individual tax savings, nor even about the amount the exchequer is foregoing on EIIS relief.  Perhaps the question is instead a political one.  We know from the Apple case just how difficult the EU state aid issue is for the government.  How far is Ireland is willing to push the boundaries of the EU state aid rules to provide a tax benefit for funding smaller indigenous industry?  The answer is unlikely to be glamorous.

Brian Keegan is Director of Public Policy and Taxation at Chartered Accountants Ireland