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Taxation and Start-ups Financing

Friday 27 May 2011, by Bernard Zimmern

The role of taxation in business creation is often considered minor, history, temperament, entrepreneurial, bureaucratic obstacles, labor law, etc. being judged more important.
The story of President Reagan, on the contrary, shows that taxation is a key factor, as it was able to stop the entrepreneurial spirit of Americans, considered internationally as among the most enterprising. In 1986, the President erases all the loopholes (tax incentives), including those that encouraged to invest in business creation, in order to reduce the maximum tax rate on income from some 50% to 28%. This brought down the numbers of start-ups births; they restart 8 years later when President Clinton, after his election, restores these loopholes. This example is all the more a proof of the influence of taxation on financing start-ups, that it was not a statistical coincidence: in articles published by The Wall Street Journal, financial experts of the West Coast had warned Reagan of the negative impact of this reform,.
To understand how to attract money toward start-ups, we have to account that, from a century ago, profits that offset losses have been reduced by a coefficient of about 2, by rising income and payroll taxes, which did hardly exist in the early twentieth century, while the risks associated with business creation remained substantially the same. Indeed, the marginal income tax rate in the U.S., even under George Bush, is close to 50%: 38% plus state tax on income in most states, close to 10%. But the percentage of new companies that have disappeared after 5 years has not changed since data on this figure exist and has stayed around 50%.
Americans have therefore set up in 1958 a tax measure that, to balance these profit drop, symmetrically reduces the risk by half. How? By the Federal government paying for half of the losses if they occur. The Sub-Chapter S acts like an insurance and is the source of the extraordinary development of Business Angels in the U.S. But it is interesting to note that the losses incurred by the Treasury under SubS are 3.5 times lower than the gains. A ratio found also in a study on French enterprises newly created.
Article 30 of the LME law of August 2008 has created a French Sub-Chapter S, the SCT, the “Société de capitaux transparente fiscalement”, through Article 239 bis AB of the tax code (CGI). But it has been almost eviscerated by DLF, the French Treasury tax division, who preferred to protect the success of 20 years of tax fight i.e. “tunneling” income, allowing losses to be deductible only from gains in the same category of income tax return and not from the overall taxpayer income.
England used other devices than the US, e.g. the Enterprise Investment Scheme, EIS, introduced in 1994 but already, before, exemptions from taxation on capital gains. According to the latest figures published by the Internal Revenue, in 2010, the EIS benefited to 11,000 investors, the exemptions from capital gains to 35,000.
In France, the history of tax incentives for investments in creating new businesses raises questions regarding the understanding of these mechanisms in France and could itself justify the creation of our website.
As we have seen ("financing the creation of business"), this funding:
• Is not achieved by mutual funds
• Is achieved only through direct investment.
• for high growth firms, the most significant for employment, is dependent upon independent Business Angels, those able, two or three of them together, to raise € 500,000.
The first tax incentive for investment in business creation enacted in France is the introduction in 1994 of “Avantage Madelin”, the same year as the English EIS with comparable mechanisms: a deduction of income tax of 20% of the money invested in new companies in England, 25% in France. This incentive, in England, was complemented by the cancellation of the tax on capital gains after 3 years holding. But, from the outset, differences are significant between the two countries, involving both the deduction limits and the conditions required to benefit from those incentives.
The ceiling was set at 40,000 francs in France for a household or a tax deduction of 10,000 francs, a little less than 2,000 euros. A witness at the meeting where two “inspecteurs des Finances” made the decision on that ceiling, reported that the model for it was that this reduction be equivalent to the tax incentives granted to add a toilet to a home.
This ceiling was progressively increased to 40,000 euros for a household, and a carry-over 5 years was added, that allows to invest up to € 200,000 a year and then nothing on the next 4 years. Thanks to the intervention of MP Nicolas Forissier, in 2008, an increase to 100,000 € without carryover was added.
This ceiling should be compared to that of the EIS which, from the start, has been set at £ 300,000 for a household and climbed steadily to £ 1 million (and has been increased in 2011 to £ 2 million). But simultaneously, as conditions to the tax benefit, the British imposed that the investment be a direct investment (not through a mutual fund) and that this investment be made in risky businesses, hence excluding rental businesses, real estate, etc. Opposite to that policy, Bercy [1] extended the tax advantage to mutual funds (FCPI and FIP) and placed no limit on the nature of the business so the tax benefit could be used to create wine cellars or cigar cellars, or to finance wind turbine and solar panels whose revenues are guaranteed by the government. It was not until the 2011 budget law that, partly at the suggestion of iFRAP, Bercy took model on the British to limit the beneficiaries of Avantage Madelin.
The combination of a low ceiling –that do not induce direct investment- and the possibility of the tax benefits through mutual funds, led to 55% of Avantage Madelin be invested into through these funds. (See breakdown of tax benefits for 2008).
Upon the arrival of the Sarkozy government in 2007, it was hoped that it would implement the mechanism pushed by the same Nicolas Sarkozy, Minister of Finance, in 2004, that had been voted by the Senate Finance Committee at the initiative of its Rapporteur, Philippe Marini: from the ISF [2] to be paid, an exemption of 25% of investments in SMEs, up to 200,000 euros, i.e.50,000 €. But if the deduction ceiling (50,000 €) was kept in 2007, the rate of exemption was 100 % and the ceiling was hence no more 200,000 € but… 50,000! The intervention of “Conseil d’Etat” [3], ruling it would be unconstitutional, reduced the rate of deduction from 100% to 75%. The aim of the Sarkozy government was obviously not to encourage new businesses but to make a hole in the wealth tax that it did not dare to remove.
SMEs and PECs: France behind Brussels
When a government creates tax loopholes, it is important that the beneficiaries of the loopholes are well identified to give the measure its full effect. For years, advocates of small businesses believed that the SMEs were the businesses that need tax benefits. The SME is defined by the European Union as companies with fewer than 250 employees and less than 50 million turnover or 43 million total assets.
But businesses of that size are usually out of seed funding problems, although they nearly always need capital. Aware of this difficulty, the Brussels Commission initially created smaller categories: PECs (Small Business Companies, less than 50 employees and less than 10 million turnover or total assets), micro-enterprise (less than 10 employees and 2 million turnover or total assets), and then pushed the national tax laws [4] to favor investment in PEC by the "Guidelines for investment in SMEs" published on 18 / 8 / 2006; in its Chapter 4, the EU grants indeed an almost automatic approval for tax benefits directed to PECs, while the benefits granted to SMEs require a special negotiation which can take months.
This idea is interesting as tax incentives cannot extract investments from individuals into start-ups, for a national total over a few billion €. This is an important amount if it goes to start-ups, but has no measurable effect if it is diluted on SMEs which, by themselves, have already net profits of €80 billion.
England understood very early the interest in limiting the EIS to small companies and placed the ceiling in company beneficiaries having assets below 7 million pounds before capital increase.
France is beginning to become aware of this issue but has missed the window when creating the ISF-SME (“ISF-TEPA”) in 2007.
The return of tax incentives for the Treasury
All tax incentives for investment in start-ups are seen by officials as a budget cost to the Treasury, and in times of scarcity, loopholes tend to be reduced or eliminated.
This is not apparently the policy of the Gracious Majesty’s government; in his 2011 budget, the Cameron government is to increase the ceiling of IR deduction under EIS from £ 1 million for a couple, to £ 2 million and the deduction rate from 20% to 30%. Nor is it the Obama’s government policy: a law signed in September 2010 just exempt from the tax on capital gains equity investment made by individuals in companies of less than $ 50 million in capital.
The reason is that these tax benefits are also extremely profitable for the Treasury.
In the United States, the taxable profits for Subchapter S represent about 3.5 times the losses deductible by the shareholders of these companies. A study on the profits and losses of new companies in France gives the same ratio.
Even the return of VAT paid by new businesses shows that Advantage Madelin (25%) is paid by the VAT in their first 3 months of existence; so, it does not cost anything to the Treasury as VAT comes back immediately whereas Avantage Madelin is deducted the following year from tax reports; and following VAT payments reimburses more than 20 times in 10 years the initial tax cost.
These results have been criticized with the following arguments:
• The VAT revenue generated by new businesses would be offset by lost VAT on competing businesses that have to reduce activity or fold. A statistical study using data from the U.S. Census shows that this assumption does not stand.
• A significant amount of capital raised under Avantage Madelin is invested in companies without turnover or less than the tax threshold (€ 73,500) that pay no VAT. This seems indeed correct because the capital raised for these companies without VAT is about double the amounts invested in companies with taxable turnover; and further analysis shows that this is indeed the consequence of investment into holding companies and real estate companies. This comes from the laxity of French tax law which, until 2011 budget law, did not care of excluding activities without risk or lack transparency, just put ceilings that made the tax incentives inefficient.
If tax incentives are considered as a budget cost inside in a static budget, the chances of France taking measures that increase business start-ups with employees and job creation are very thin.
It seems essential that the French government and Bercy give more importance in their static budgets to returns for the Treasury of tax incentives, do a thorough review of fiscal measures, what they cost but what they also bring back to the Treasury, not to mention behavioral changes that would result from significant changes like increasing ceilings and open themselves to dynamic budgeting.
[1] The French Treasury
[2] Wealth tax
[3] Supreme court for administrative issues and legal adviser to the French government
[4] Tax laws in EEC are the responsibility of each nation eventhough they have to comply with EEC rules