An assessment of SME tax reliefs

Aug 01, 2018
SMEs in the Republic of Ireland can access four major tax relief regimes, which is laudable, but there remains room for improvement in each.
 
Over the past few years, Ireland has introduced, expanded or streamlined many new tax reliefs and regimes with the stated aim of encouraging research and innovation, providing alternative sources of finance and improving the environment for entrepreneurship. While the government of the day will laud these new initiatives as being beneficial to Irish small- and medium-sized enterprise (SME), it is often the case that the initiatives are not taken up in any great numbers or are used primarily by multinationals operating in Ireland.

In this article, the author considers why these targeted tax incentives are not achieving the expected take-up among Irish SMEs – and what could be done to rectify this. Is it a question of education, perception or restrictions within the tax incentives themselves?

Employment and Investment Incentive Scheme

The Employment and Investment Incentive Scheme (EIIS) is an extremely important source of finance for start-up and early-stage SMEs as for many of these businesses, the friends and families of the business owners may be one of the few sources of finance available. The EIIS is a successor to the old Business Expansion Scheme (BES) and while it covers a larger variety of trading activities, it is less generous in the tax relief available. This is because, under the EIIS, the income tax relief is spread over two tranches – 30% relief in the year of investment and 10% after three years of trading. Furthermore, the second tranche of relief is not guaranteed and is dependent on the company increasing employee numbers during the investment period.

Compared to BES, lower numbers of companies have availed of the EIIS. This has been attributed to factors such as the spreading of income tax relief over four tax years and the €150,000 annual investment limit applicable to each EIIS investor. Unhelpfully, recent changes to the EIIS have further reduced the attraction of EIIS for SMEs. Finance Act 2015 incorporated the EU General Block Exemption Regulation (GBER) rules into EIIS legislation. Some of the most significant restrictions included in these provisions are:

  • The company must be trading for less than seven years. Where such a company has previously raised EIIS funding and wishes to raise a second round, the second round must have been envisaged in the business plan submitted for the first round – before the GBER rules were in force. To add insult to injury, Revenue has taken a very prescriptive approach in this regard; and
  • If the company has traded for more than seven years, it must be entering a new geographical market with a new product or service, or have previously raised EIIS/BES funding within the first seven years of trading.
More recently, Finance Act 2017 introduced new “connected party” rules, which make the tax relief unavailable to any investor and their associates (including relatives, which are broadly defined) who already hold shares in the company before EIIS funding is introduced. Previously, income tax relief was available to EIIS investors who held less than 30% of the company, and even this restriction was relaxed where the total value of the EIIS investment was less than €500,000. These new restrictions may neutralise the EIIS for many SMEs that are badly in need of this alternative source of funding.

Research & Development tax credit

While the lower and likely diminishing take-up of EIIS by SME companies can be attributed to stifling legislative restrictions, the same cannot be said of the Research & Development (R&D) 25% tax credit. The tax credit regime was significantly simplified with the removal of the “base year” and incremental allowable amounts from 1 January 2015. In addition, Finance Act 2012 introduced the concept of the qualifying company surrendering some or all of the R&D tax credit to a “key employee”.

The continuing concern for all companies claiming R&D tax credit (and SMEs in particular, as they have less resources to deal with penalties and interest in the event of getting it wrong) is the uncertainty around what exactly constitutes “qualifying” R&D activity. Some relief for small business on this issue was set out in Revenue’s eBrief 17/17. This stated that, where a small or micro enterprise is in receipt of Enterprise Ireland/IDA grants for its R&D activity and the value of the R&D tax credit claim in an accounting period is less than €50,000, Revenue will accept that the activities are “qualifying” under the relevant tax legislation. There is an acknowledgement that these thresholds are too low and will only give comfort in a small number of cases, but there is no indication that this concession will be expanded.

While the idea of the surrender of the R&D tax credit to key employees is a fine one, this aspect of the regime has had little take-up from SMEs. This is perhaps because the key employee must not be a director of, or have a “material interest” in, the company (i.e. hold at least 5% of the company’s shares). As SMEs typically have a small pool of overlapping shareholders, directors and key employees, most will breach this condition. Another issue that limits the incentive for R&D activity are the maximum spending caps in relation to outsourcing:

  • Outsourcing R&D work to third parties is restricted to 15% of the in-house R&D expenditure or €100,000 (whichever is greater); and
  • Outsourcing R&D work to universities is restricted to 5% of the in-house R&D expenditure or €100,000 (whichever is greater).
These limits contradict international best practice, which typically encourages collaboration between innovating businesses and/or education. They also disproportionately affect SMEs as, with fewer resources, a collaborative approach may be the only way for an SME to progress.

Knowledge Development Box

A relatively new incentive introduced in Finance Act 2015, and one that is not yet widely known about, is the Knowledge Development Box (KDB) regime, which complements the R&D tax credit and is the second phase of incentives around research and innovation. The R&D tax credit is available in respect of the spend on “qualifying R&D activities” while the KDB regime applies a reduced 6.25% corporation tax rate on profits arising from the exploitation of a “qualifying asset” derived from these same R&D activities.

While this regime is regarded by many as being targeted at multinationals, it is in fact Irish SMEs that may benefit the most from it. The KDB regime is most beneficial to companies that carry out most or all of their underlying R&D activities in Ireland, which of course would apply to Irish SMEs. There are also two aspects to the “qualifying asset” requirement that work for Irish SMEs:

  • Within the mainstream KDB regime, a “qualifying asset” includes inventions that are patented as well as computer programs. Irish tech companies that carry out their R&D activities in Ireland and are entitled to an R&D tax credit may therefore be entitled to the reduced 6.25% corporate tax rate on future profits; and
  • There is an SME-specific KDB regime, which applies to companies and groups with annual turnover not exceeding €50 million and KDB profits not exceeding €7.5 million. The definition of “qualifying asset” for these companies includes computer programs as well as novel or useful inventions that do not have to be patented.

Key Employee Engagement Programme

Finance Act 2017 saw the introduction of the KEEP scheme, which was presented as a tax-efficient way to incentivise key employees within SME companies. The scheme allows for the tax-free grant of share options to an employee (as long as the options are granted at market value), followed by capital gains tax (CGT) on gains arising on the ultimate sale of the shares by the employee.
As the KEEP scheme only commenced at the beginning of this year, there are several excessive legislative restrictions and practical issues. Many commentators and representative bodies have lobbied the Department of Finance and Revenue on these issues to make the new scheme fit-for-purpose. Some of the major issues include:

  • The requirement for a Revenue-agreed share valuation method, given that the scheme relates to shares in private companies often with no external market;
  • The practical issue of creating a market for these shares so that a KEEP employee has a method of selling the shares and realising a gain. Calls have been made to allow the employer company to buy back the KEEP shares and for the KEEP employee to secure CGT treatment on that buy-back by the buy-back being regarded as a “benefit” for the company’s trade;
  • Under the current rules, a “qualifying individual” must not hold more than 15% of the employer company shares. This restricts the usefulness of the KEEP scheme for SMEs which, as we noted earlier, will have a small pool of shareholders and key employees; and
  • Calls have been made to extend CGT entrepreneur relief on disposals of KEEP shares, thereby reducing the CGT on €1 million gains arising to 10%.

Conclusion

This article has focused on the four major tax regimes available to SMEs in the Republic of Ireland – EIIS, R&D tax credit, KDB regime and KEEP – and we have seen that some of these regimes are specifically targeted at SMEs.

While there is always more for practitioners to do in terms of educating clients on the availability of reliefs, many of the legislative changes and/or administrative practices within Revenue in recent years have reduced the effectiveness of these reliefs. It is a case of what the right hand giveth, the left hand taketh away.

With Brexit looming, this approach is damaging to Irish SMEs – which are the lifeblood of our economy – and does not sit with the Government’s stated aim of encouraging entrepreneurship in this country.

Kerri O'Connell FCA is Principal at Obvio Tax Services and author of Small and Expanding Businesses: Getting the Tax Right.