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How Changes to CGT Threaten the Future of UK Startups

| Henry Whorwood

The Office of Tax Simplification (OTS) recently published their first report reviewing Capital Gains Tax (CGT) titled Simplifying by Design. The Chancellor called for the review in July, primarily to look at the administrative difficulties associated with the tax. A second report is due to be published: the first looks at the principles of the tax, the second will look at technical and administrative issues.

As supporters of the entrepreneurial ecosystem, we always try to monitor the policy environment for entrepreneurs (and for startups and scaleups) and, wherever possible, provide data relevant to policy and interventions. We have not previously, however, objected outright to proposed changes, especially where data is lacking. 

But Simplifying by Design makes recommendations for changes to CGT under four main categories, one of which we think will have profound—and adverse—impacts on entrepreneurs and the businesses they run. Therefore, in a change from our usual broadcasting, we’re taking the opportunity today to elaborate on how and why this change is a catastrophically bad idea.

Simplifying by Design suggests that the Government should consider “whether employees and owner-managers’ rewards from personal labour (as distinct from capital investment) are treated consistently and, in particular consider taxing more of the share-based rewards arising from employment, and of the accumulated retained earnings in smaller companies, at Income Tax rates”. To translate: tax capital gains, including those generated by entrepreneurs from their own businesses, at income tax rates.

If implemented this would raise basic rate taxpayers’ CGT from 10% to 20%, and higher and additional rate taxpayers’ CGT from 20% to 40% and 45% respectively. The OTS also recommends reducing the tax-free annual allowance for CTG, currently at £12,300, to between £2,000 and £4,000. 

Finally, the OTS recommends replacing Business Asset Disposal Relief (formerly Entrepreneurs’ Relief) with a new, more restrictive scheme focussed around retirement. Business Asset Disposal Relief currently allows entrepreneurs to pay a lower CGT rate of 10% on the first £1m of proceeds from sale of their own company shares over their lifetime in recognition of the risk they have taken in building a business.

Taken in isolation, and couched in terms of creating equality between income tax payers and CGT payers, these changes may seem innocuous, indeed fair. But we believe they will have some serious unintended consequences for entrepreneurs, particularly those who lead fast-growth companies.

To understand why, we must consider how these entrepreneurs make money. Typically, they do so differently to a regular employee: through exit events (sale of their shares in the company they founded) rather than salary—an event that is a capital gain. These events are few and far between—often only when the company is sold, although occasionally through an earlier ‘secondary’ sale of shares along the way. An entrepreneur’s income is, therefore, extremely lumpy, and—crucially—will likely occur almost entirely in one single tax year. 

The current differences between income tax and CGT rates and reliefs accommodates this distinction well; its removal will lead to three main negative impacts—discouraging entrepreneurship in the UK; discouraging growth of entrepreneur-led companies; and discouraging investment into high-growth businesses.

Discouraging entrepreneurship as a career in the UK

1. Entrepreneurs will be taxed more heavily than employees

Entrepreneurs will pay top levels of marginal rate of income tax on the majority of their income since it occurs largely in a single tax year. This compares unfavourably to employees who are paid standard salaries. Take the following comparison which, for simplicity, ignores inflation and assumes current income tax arrangements stay in place:

An employee earning £80k per annum for ten years—£800k of gross income:
£80k p/a gross is £55,042 p/a net. 
Total net earnings over ten years are therefore £550,420. 
Effective tax rate of 31.2%.

Entrepreneur taking £30k per annum salary for ten years, then selling the company for £500k—£800k of gross income:
£30k p/a gross is £24,042 p/a net. 
Net earnings from salary over the first 9 years is £216,378.
Year ten income is £530k gross; £292,042 net (44.9% overall tax rate after accounting for NI). 
Total net earnings over ten years are therefore £508,420. 
Effective tax rate of 36.4%.

The entrepreneur ends up with a significantly higher effective tax rate despite risking ten years of their life building a business rather than taking a job somewhere. That is clearly the wrong signal to be sending.

2. There will be a perceived ‘nationalisation’ of entrepreneur-led companies

Any capital value created by an entrepreneur above £150k will eventually (on realisation) be taxed at the top marginal rate of income tax—currently 45%. In effect, this gives the Government a risk-free stake of up to 45% in all private entrepreneur-led companies. Or, to put it another way, it’s the equivalent of the Government taking 45% of an entrepreneur’s equity stake in their company into public hands. Again, we’d argue that is not the right signal to be sending at a time when private-sector led economic growth is critical.

3. The UK will be poorly positioned compared to international comparables

Implementing these proposals would give the UK the highest marginal CGT rate of any European country at 45% – beating Denmark’s current 42% – and higher too than the US. Many of the fastest-growing companies have no need to be legally or even physically located in the markets they are targeting; the entrepreneurs behind them even less so. Disadvantageous tax regimes for entrepreneurs compared to similar jurisdictions will drive entrepreneurs and their current (and future) companies abroad.

Discouraging growth of entrepreneur-led companies

1. It promotes payment of dividends (or salary) rather than reinvestment for growth

Entrepreneurs in profitable companies are faced with a constant decision as to whether to re-invest profits for company growth—often a risky move, certainly with no guarantees of return—or take dividends. As it currently stands the tax system incentivises entrepreneurs to re-invest, as capital growth is taxed at a lower rate than dividends. Under these new proposals, capital growth is taxed at a higher rate than dividend income. Entrepreneurs will therefore have no incentive to take the riskier reinvestment route.

Indeed, dividends aside, it’s even the case that an entrepreneur would be better off taking cash out as salary (removing it from the company’s investment pool) rather than reinvesting for capital growth. Not only is this less risky than reinvestment, but they’ll also benefit from an overall lower rate of tax (see example above).

In short, these proposals take no account of an entrepreneur taking the decision to reinvest for tomorrow rather than reward themselves today. They forget that foregone dividends or salary is a risky capital investment.

2. It will make it harder for entrepreneurial companies to attract and retain talent

Many entrepreneurial companies use equity options to attract key talent. This offsets the fact that they can’t compete with large, established organisations on salary alone, and ensures incentives are aligned between entrepreneurs and employees at these organisations. Most such options are issued under the Enterprise Management Incentive scheme under which employees have their gains on shares acquired through options taxed at capital gains tax rates, including benefitting from Business Asset Disposal Relief.

These proposals would massively increase the tax rate on such gains. That means that such options will become far less valuable as an incentive, risking both talent attraction and retention, and therefore slowing growth.

Discouraging investment into high-growth businesses

It will remove significant amounts of angel investment capital from the ecosystem

A large proportion of seed capital in the UK comes from angel investors who have made their cash by building and selling their own business. A massive tax hike on these sales will remove a significant proportion of discretionary seed capital from the ecosystem in short order. The same can be said for serial entrepreneurs—with less net proceeds post-sale of a company, it’s less likely they’ll be in the financial position to start their next company. The desirability of the circular nature of entrepreneurial capital has been well-studied—it’s circulating not just capital but also expertise back into the ecosystem. These proposals would significantly depress this much sought after feedback loop.

So what's the answer?

We are not the first to raise objections to these proposals. Lord Leigh, founder of Cavendish Corporate Finance penned an open letter to the Chancellor calling on him to “ensure that the entrepreneurial spirit in this country is recognised and encouraged, by keeping capital gains taxes at an appropriate level”. The Centre for Policy Studies’ Tom Clougherty said it “would deter investment and punish saving”.

Whilst we sympathise with the rationale behind some of the changes, particularly the (ab)use of the system by sole contractors to extract rolled up retained earnings at a low tax rate, we feel this one-size-fits-all change would have a significant adverse impact on the entrepreneurial ecosystem just at the time it is needed to power growth. The right thing to do is to ditch the change—at least where entrepreneurs and their businesses are concerned.

Want to help us lobby? Get in touch with us.

Toby Austin
Co-founder and CEO

Henry Whorwood
Head of Research and Consultancy

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