May 30, 2013
Companies with Small
Profits
B y R o b e rt G a u t — F r i e d F r a n k H a rr i s Shr i v e r & J a c o b s o n ( L o n d o n ) L L P a n d
S a r a h G a bb a i — F r i e d F r a n k H a rr i s Shr i v e r & J a c o b s o n ( L o n d o n ) L L P
This article summarises certain tax-favourable regimes that potentially apply to companies
with small profits.
Overview of Topic
1. Companies with small profits may qualify
as “micro, small or medium-sized enterprises” as defined under EU law. Under
the right circumstances, this allows such
companies to mitigate their corporation
tax liability by availing themselves of certain
reliefs or exemptions which use this definition as part of their eligibility criteria.
2. Companies with small profits also need
to raise finance, particularly in the early
phases. A number of regimes are aimed
at the tax-efficient raising of finance from
individuals, notably EIS and SEIS. EMI options are also frequently used to incentivise
employees on a tax-efficient basis. These
regimes do not require the company to
meet the EU law definition but instead
have their own threshold requirements for
the company in determining whether the
individual is entitled to tax relief under the
relevant rules.
Key Acts
Income Tax (Earnings and Pensions) Act
2003 (ITEPA 2003)
Income Tax Act 2007 (ITA 2007)
Corporation Tax Act 2009 (CTA 2009)
Corporation Tax Act 2010 (CTA 2010)
Taxation (International and Other) Provisions Act 2010 (TIOPA 2010)
reprint article
Key Subordinate Legislation
None.
Key Quasi-legislation
None.
Key European Union Legislation
Annex to Recommendation 2003/361
concerning the definition of micro, small and
medium-sized enterprises
Key Cases
None.
Key Texts
None.
Discussion of Detail
Introduction: Companies With Small Profits
1. This article identifies and summarises certain UK tax rules that are relevant for companies with small profits.
2. UK companies with small profits currently
attract a lower rate of corporation tax than
larger companies. To qualify for the “small
profits rate” (currently 20%), a company’s
taxable total profits must be £300,000 or
less; otherwise, a UK company is subject to
corporation tax at the main rate (currently
23%), with marginal relief being available
May 30, 2013
3.
4.
5.
6.
for taxable total profits of between £300,000 and
£1,500,000. However, the proposed reduction in
the main rate to 20% for accounting periods beginning on or after 1 April 2015 together with the
disappearance of marginal relief means that there
will soon be no distinction between companies
with small profits and larger companies as far as
rates and thresholds are concerned.
That said, certain exemptions, reliefs and taxfavourable regimes aimed at small companies will
continue to be available if they meet the relevant
criteria. A number of exemptions and reliefs are
available to companies falling within one of the
categories of “micro, small and medium-sized
enterprises” as defined under EU law (see Annex
to Recommendation 2003/361). In addition,
there are certain tax-favourable regimes aimed
at raising finance for small companies. These regimes do not specifically rely on the EU law definition but instead include financial and headcount
thresholds as part of their eligibility requirements.
Small companies may either satisfy the EU law
definition, or be eligible for one or more taxfavourable regimes aimed at small companies, or
both. Examples of exemptions or reliefs for small
companies which rely on the EU law definition
include the transfer pricing exemption (s.166
TIOPA 2010), the dividend income exemption
(s.931B CTA 2009) and, with some modifications, relief for expenditure on research and
development (R&D) and related tax credits
(Ch.2, Pt 13 CTA 2009).
Enterprise Management Incentive (EMI) share
options are a useful form of equity-based financing
which small companies can use to incentivise key
employees and executive directors as a means of
attracting and retaining their best talent. Also relevant is the potential for high-growth small companies to attract tax-efficient funding from individual
investors or “business angels” in the form of Enterprise Investment Scheme (EIS) or Seed Enterprise
Investment Scheme (SEIS) investments.
EIS and SEIS encourage alternative forms of finance which, given the relative scarcity of bank
lending in the current economic climate, are
bound to see an increased uptake, particularly given the significant tax breaks available to EIS/ SEIS
investors. Business angel investment networks
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often cite compliance with EIS or SEIS requirements as one of the key criteria for raising finance
through their networks. The tax rules affecting
EMI share options, EIS and SEIS reliefs do not specifically rely on the EU law definition but instead
rely on certain threshold requirements relating to
gross assets and headcount.
7. Special rules also apply to groups of small companies in the context of the debt cap and controlled foreign company (CFC) rules (Pt 7 and
9A of TIOPA respectively). Broadly, the debt cap
rules do not apply to groups consisting entirely
of micro, small and medium-sized enterprises as
defined under EU law (ss.261(1), 337 and 344
TIOPA 2010). Also, if a small company is a CFC
as defined in Pt 9A TIOPA 2010, a UK resident
parent may benefit from certain CFC entity level
exemptions, notably the low profits exemption
(Ch.12, Pt 9A TIOPA 2010) or the low profit margin exemption (Ch.13, Pt 9A TIOPA 2010) if the
relevant criteria is met. These detailed provisions
are beyond the scope of this article.
Transfer Pricing Exemption
1. Section 166 TIOPA 2010 provides that ss.147(3)
and (5) TIOPA 2010 do not apply in calculating
for any chargeable period the profits and losses of
a “potentially advantaged person” if that person
is a “small or medium-sized enterprise” (SME) as
defined under s.172 TIOPA 2010 (which crossrefers to the EU law definition), unless an exception applies.
2. Broadly, this means that if an SME is a party to
a non-arm’s length transaction, the profits and
losses of that SME for corporation tax purposes
will generally not be subject to a transfer pricing
adjustment. SMEs may also opt out of this exemption by making an irrevocable election to that effect (s.167(2) TIOPA 2010).
3. Exceptions to this exemption include a) where the
other party to the non-arm’s length transaction is
resident in a territory that has not concluded with
the UK a double tax treaty with a non-discrimination article (s.167(3) and s.173 TIOPA 2010);
or b) where HMRC has served a transfer pricing
notice on a medium-sized enterprise following
an enquiry into its tax return (s.168 TIOPA 2010)
or on a small enterprise that has entered into a
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non-arm’s length transaction which is taken into
account in calculating the “relevant IP profits”
under the “patent box” rules of Pt 8A CTA 2010
(s.167A TIOPA 2010). A transfer pricing notice
requires the SME to calculate its profits and losses
as if transfer pricing adjustments applied.
4. Small or medium-sized enterprises within large
groups generally do not benefit from the transfer
pricing exemption, since the staff headcount, annual turnover and annual balance sheet total of >
25% owners and > 51% controlling or controlled
entities, as well as those of the SME itself, are included in determining whether the SME threshold amounts are exceeded (see s.172 TIOPA
and art.4 of the Annex to Recommendation
2003/361).
Dividend Income Exemption
1. Under s.931B CTA 2009, dividends received by
small companies (as defined under s.931S CTA
2009, which cross-refers to the EU law definition)
will be exempt if:
a. the payer is resident either in the UK or in a territory that has concluded with the UK a double
tax treaty with a non-discrimination article;
b. the distribution is not of a kind mentioned in
para. E or F in s.1000(1) CTA 2010 (broadly,
in other words, the distribution must not exceed a reasonable commercial return for use
of the principal);
c. the payer does not get a deduction for the
distribution under the law of its territory of
residence; and
d. the distribution is not made as part of a tax advantage scheme (defined at s.931V CTA 2009).
2. This test is sometimes easier to satisfy in practice than the exemption for dividends received
by companies which are not small companies,
where the dividend must also fall within an exempt class (s.931D CTA 2009), in addition to
meeting the requirements of s.1000(1)(b) and
(c) above.
R&D Relief And Related Tax Credits
General Principles
1. Different types of R&D relief are available to
“small or medium-sized enterprises” as defined
at s.1119 CTA 2009 (SMEs) depending on
© 2013 thomson reuters
May 30, 2013
the circumstances in which they incur qualifying
R&D expenditure. Relief is available under Ch.2,
Pt 13 CTA 2009 (the SME Scheme) if the SME is
a going concern and incurs qualifying R&D expenditure on in-house or contracted out R&D in
support of its own trade, unless the expenditure is
subsidised or exceeds a EUR 7.5m cap, in which
case relief under Ch.4, Pt 13 is available. Relief under Ch.3, Pt 13 CTA 2009 is available if the SME
incurs qualifying R&D expenditure on in-house
or contracted out R&D as a sub-contractor for
another person.
2. To be eligible for any of these reliefs, an SME
must, amongst other things, meet the definition
of an SME under s.1119 CTA 2009 (which crossrefers to the EU law definition), as modified by
s.1120 CTA 2009. Under this section, the company’s employees must not exceed 500, turnover
must not exceed EUR 100m and its annual balance sheet total must not exceed EUR 86m. Also,
if the SME meets the EU threshold limits without
regard to its > 25% owners or > 50% controlling
or controlled entities, but those entities together
(not including the SME itself) exceed those
threshold limits in a given accounting period, the
SME will not qualify as a “small or medium-sized
enterprise” for the purposes of the R&D reliefs
even if it so qualifies in the following accounting
period (s.1120(2)-(6) CTA 2009).
3. “Qualifying R&D expenditure” in this context
includes, for example, staffing costs in respect
of employees (s.1123-4 CTA 2009) or externally
provided workers (s.1127-32 CTA 2009) who are
directly and actively engaged in relevant R&D; expenditure on computer software or consumable
or transformable materials which are employed
directly in relevant R&D (s.1125-6 CTA 2009);
and payments made to participants in a clinical
trial (s.1140 CTA 2009). “Relevant R&D” for
these purposes means R&D related to a trade
carried on by the company, or R&D from which
it is intended that a trade will be derived (s.1042
CTA 2009). “R&D” has the same meaning for corporation tax purposes as it does under UK GAAP
(s.1138 CTA 2010).
4. An SME may incur qualifying R&D expenditure
in conducting its own R&D activities in-house, or
in sponsoring or commissioning another person
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such as a charity, educational establishment or individual, to perform the R&D. This latter type of
expenditure is referred to in Pt 13 as “contracted
out R&D”. (See ss.1052-1053, 1066-1067 and
1077-1078 CTA 2009).
How R&D Relief Works
1. Under the SME Scheme, the SME may either
claim an enhanced corporation tax deduction
equal to 225% of the qualifying R&D expenditure (s.1044 CTA 2009) or, if the qualifying
R&D expenditure is incurred in a pre-trading
accounting period, it may elect to obtain relief
by way of a deemed trading loss equal to 225%
of the qualifying R&D expenditure (s.1045
CTA 2009).
2. A deemed trading loss under s.1045 CTA 2009
is effectively a form of “start-up” relief. If the
SME commences trading in the same period
for which the deemed trading loss is elected,
or in a later period, the deemed trading loss is
treated as carried forward to the next accounting period to the extent not already absorbed by
current period profits or by way of group relief
(s.1048(3), (4) CTA 2009). It cannot be carried
back unless the SME was entitled to elect for a
deemed trading loss in that preceding period
(s.1048(2) CTA 2009).
3. Where an enhanced corporation tax deduction
creates or increases a trading loss, or the SME
elects for a deemed trading loss, the SME can
claim an R&D tax credit based on the unrelieved
portion of that loss (or deemed loss) at the applicable rate (11% for expenditure incurred on or after 1 April 2012). However, if the SME claims an
R&D tax credit in respect of an elected deemed
trading loss, any losses carried forward are treated as reduced by the unrelieved portion thereof
(s.1048(5), s.1062 CTA 2009). In other words,
the SME is effectively precluded from carrying
forward the deemed trading loss. For accounting periods ending before 1 April 2012, an R&D
tax credit could be claimed on the lesser of the
unrelieved portion of the loss, or the total PAYE
and NIC liabilities for that accounting period
(s.1058(1)).
4. Relief will not be available under Ch.2 if, broadly, the total R&D relief claimed under Ch.2 in
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respect of expenditure attributable to an R&D
project would exceed EUR 7.5m (see Ch.8, Pt 13
CTA 2009), or if the qualifying R&D expenditure
is subsidised, whether by way of Commissionapproved State aid or otherwise (s.1138 CTA
2009). Instead, the SME should be able to claim
a corporation tax deduction equal to 130% of the
qualifying R&D expenditure in accordance with
Ch.4, Pt 13 (s.1068 CTA 2009).
5. If R&D is subcontracted to an SME by another
person (see s.1065 CTA 2009), the SME may
claim an enhanced corporation tax deduction
equal to 130% of the qualifying R&D expenditure
(s.1063 CTA 2009) in accordance with Ch.3. No
tax credits can be claimed under Ch.3 or Ch.4, Pt
13 CTA 2009.
6. The Government is proposing an above-the-line
tax credit for qualifying R&D expenditure incurred on or after 1 April 2013 by SMEs who do
not qualify for the SME Scheme, as well as for
large companies. This is intended to be optional
until 1 April 2016, from when it will be mandatory. Further details can be found in draft legislation, currently in Sch.14 of the Finance (no. 2)
Bill 2013.
Enterprise Management Incentives (EMI Options)
1. EMI share options are a form of incentive to allow key employees to participate in the equity of
a “qualifying company” (as defined in Pt 3, Sch.5
ITEPA 2003) free of income tax, provided they
exercise their EMI share options within 10 years
of the option grant date. Under the draft Finance
(No. 2) Bill 2013, Sch.23, shares acquired pursuant to an exercise of an EMI share option will
attract entrepreneur’s relief if sold on or after 6
April 2013, provided certain conditions are met.
2. Under the EMI code (as defined in s.527(3) ITEPA 2003), companies with fewer than 250 employees and gross assets not exceeding £30 million
may grant tax advantaged options (EMI Options)
over shares worth up to £250,000 as at the option
grant date to each eligible employee, subject to a
total value of £3m in respect of shares over which
unexercised EMI Options have been granted,
provided that certain other criteria under the EMI
code is met.
© 2013 Thomson Reuters
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3. Such criteria includes the need for the underlying shares to consist of ordinary, nonredeemable
shares, and for the company to be carrying on a
“qualifying trade” (which includes the exploitation
of IP or other intangibles, dealing in goods in the
course of anordinary trade of wholesale or retail distribution, and related R&D activities -paras 15-19,
Sch.5 ITEPA 2003) and to be independent (that is,
not controlled by another company -para.9, Sch.5
ITEPA 2003). Employees must work a minimum
of 25 hours a week, and must not hold more than
30% of the company’s share capital (paras 25-30,
Sch.5 ITEPA 2003) in order to be eligible for the
EMI Option scheme. The scheme must also be approved by HMRC (Pt 7, Sch.5 ITEPA 2003).
4. The company cannot get a tax deduction for the
costs of setting up the EMI scheme(Business Income Manual (BIM) 44015 and 44020) but it can
for any incidental costs of running the scheme
(BIM 44025). In addition, the company is entitled
to corporation tax deductions under Ch.3, Pt 12
CTA 2009 when employees acquire shares on exercise of their EMI Options (ss.1018-1019 CTA
2009). Broadly, the deductions match the difference between the market value of the shares when
acquired and the amount that the employee pays
for them (Employee Share Schemes Unit Manual
(ESSUM) 57900).
5. When share options (including EMI Options) are
exercised, the company will get a corporation tax
deduction equal to the market value of the shares
when they are acquired, less any consideration
given for the option and/or the shares (s.1018
CTA 2009, ESSUM57900).
6. If the employee exercises an EMI Option and
acquires restricted or convertible shares at forless than their market value as at the option
grant date, the company gets relief for both
theamount of the discount and the amount that
would have been charged to tax but for the EMI
code (ESSUM57900).
7. Additional corporation tax relief is available if a
subsequent chargeable event under s.426ITEPA
2003 occurs in relation to restricted shares acquired post-exercise (Ch.4, Pt 12 CTA 2009) or if
a chargeable event under s.438 ITEPA occurs in relation to convertible sharesacquired post-exercise
(Ch.6, Pt 12 CTA 2009).
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May 30, 2013
Enterprise Investment Scheme (EIS)
1. EIS is a valuable relief for individual business angels looking to invest in small companies.Under
EIS, income tax relief at 30% of share subscription proceeds of up to £1m (for taxyears 2011-12
and subsequent tax years) will be available under
Pt 5 Income Tax Act 2007 (EIS relief), provided
certain criteria are met. EIS relief is subject to a
3-year “lock-in” period from the share issue date
(s.159 and s.256 ITA 2007), during which EIS
relief may be withdrawn or reduced if any of the
circumstances listed in Ch.6, Pt 5 ITA 2007 occur during that period (for example, if the EIS
shares are sold). EIS shares can be sold free of
capital gains tax if sold after the expiry of the
3-year “lock-in” period (s.150A(2) TCGA 1992),
and a deferral relief can be claimed if EIS shares
are sold and the investor re-invests in further
EIS shares (Sch.5B, TCGA 1992).
2. In order to be eligible for EIS, the individual must
be a “qualifying investor” (Ch.2, Pt 5 ITA 2007),
the issuing company must be a “qualifying company” (Ch.4, Pt 5 ITA 2007) and certain requirements must be met with respect to the shares issued (Ch.3, Pt 5 ITA 2007). The eligibility criteria
are complex, the main provisions of which are
briefly summarized below.
3. To be a qualifying company, the company must
not have more than 250 full-time employees at
the time of share issue (s.186A ITA 2007), and its
gross assets must not exceed £15m immediately
before the share issue and £16m immediately afterwards (s.186 ITA 2007).The company must
also be independent (that is, not controlled by
another company- s.185ITA 2007), have a UK
permanent establishment (s.180A ITA 2007),
must not be in financial difficulty (s.180B ITA
2007) and must not be listed on a recognised
stock exchange (s.184ITA 2007). During the
3-year “lock-in” period the company must be
trading (s.181 ITA 2007)and must neither be a
51% subsidiary nor under the control of another
company (s.185 ITA 2007).
4. As for the shares, the company must not raise
more than £5m (for shares issued on or after 6
April 2012) from other EIS, SEIS or VCT investors during the 12-month period leading up to the
share issue (s.173A ITA 2007). Once the finance
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has been raised, all of the money raised must, within 2 years from the issue date, be employed wholly
for the purposes of a“qualifying business activity”
(e.g. the licensing of IP or other intangibles, or
dealing in goods in the course of an ordinary trade
of wholesale or retail distribution, or related R&D
activities) which the SME must have been carrying on for at least 4 months ending on or after
the issue date (s.175-6 ITA 2007). In addition, the
shares issued must be fully paid up and must not
contain present or future rights to “preferential”
dividends (s.173 ITA 2007). Also, the shares must
not be issued in connection with “disqualifying arrangements” which broadly are arrangements in
which one of the main purposes is to secure that
a qualifyingbusiness activity is placed under an EIS
or SEIS wrapper (s.178A ITA 2007).
5. To be a qualifying investor, the investor must be
an individual subject to income tax. He or she
must not be an employee of the issuing company
at any time during 3-year lock-in period or the 2
years prior to the share issue, but may be a director (even if the director is also an employee) as
long as he or she does not receive excessive payments during that period (e.g. payments which
do not represent necessary and reasonable
remuneration forservices rendered, or reasonable commercial returns on debt or equity capital) (ss.163,167-8 ITA 2007). Any shares held,
whether directly or indirectly, must not exceed
30% ofthe company’s ordinary share capital
(s.170 ITA 2007), and any loans held must not
be“linked” loans (being loans that would not
have been made at all, or which would not havebeen made on the same terms but for the existence of the EIS shares) (s.164 ITA 2007).
The investor must also invest for genuine commercial reasons and not for tax avoidance purposes (s.165 ITA 2007), and must not enter into any
arrangements for ineligible persons to subscribe
for EIS shares (s.171 ITA 2007).
Seed Enterprise Investment Scheme (SEIS)
1. The Seed Enterprise Investment Scheme was
introduced in the 2011 Budget with a view
to encouraging investment in small high-risk
start-ups. It is effective for shares issued on or
after 6 April 2012 but before 6 April 2017, so
the scheme has limited availability.
2. The Seed Enterprise Investment Scheme works
in a broadly similar way to EIS, except that the
maximum investment and financial and headcount thresholds are much lower. Income tax
relief at 50% of share subscription proceeds of
up to £100,000 is available under Pt 5A Income
Tax Act 2007. The qualifying investor and
qualifying company criteria, and the requirements relating to the shares, are broadly similar to those of EIS except that under the SEIS
the company’s gross assets must not exceed
£200,000 immediately before the shares are issued, it must have less than 25 employees at the
time of issue, and it must not raise more than
£150,000 from the issue.
3. The Finance (No. 2) Bill 2013 (s.55-6) proposes
to limit SEIS re-investment relief to 50% ofthe
original gain for tax years 2013-14 onwards.
Analysis
KEY AREAS OF COMPLEXITY OR UNCERTAINTY
None.
LATEST DEVELOPMENTS
None.
POSSIBLE FUTURE DEVELOPMENTS
Proposals for an above-the-line (ATL) tax credit for
qualifying R&D expenditure
Finance (No. 2) Bill (introduced 28 March 2013)
HUMAN RIGHTS
None.
EUROPEAN UNION ASPECTS
None.
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