Tax Proposals will Shrink Capital Available for Startups

Business begets business. Successful entrepreneurs invest profits from their business in new ventures. These “angel investors”, and the critical role they play in the innovation landscape, are not well understood by policy makers. Instead of amplifying their nascent contributions, the new tax proposals may keep them at bay. This is because the proposals will make it unattractive for angels to use business income to invest in new startup ventures.

More than one billion dollars was put to work by angels in new ventures in Canada last year. A substantial portion of this funding for startups was done through private corporations. According to a NACO (National Angel Capital Organization) survey of 189 angels, 88% invest through a corporation. In B.C. for example, angels are encouraged to invest in startups through private corporations that issue tax credits to their investors.

Beyond family and friends, most startups get their financial backing from angels before being of interest to Venture Capitalists (VCs). In Silicon Valley that’s how the Facebooks and Googles get started: first, family and friends, then angels and then VCs for those firms showing exceptional potential. More than 600 Canadian companies attracted $3.2 billion in venture capital last year – the most since 2001. In comparison, angels invested in thousands of companies.

What is overlooked in the current heated debate about tax fairness, is that family investors and angel investors could have a lot less capital to invest in new businesses if they are forced to withdraw cash from their companies and invest personally. Under today’s rules, whether or not an angel investor uses his company to invest, the total amount of tax paid is exactly the same. There is absolutely no tax advantage in using a company.

For example, if I take $100k out of my company, I will have just over $50k to invest in an entrepreneurial startup. But, if my company invests in the startup, it will have $100K. Or, I can invest $50K in two startups. If the startup produces a two times payout, and I then cash in, the amount of tax paid is the same in both cases. The difference is that more capital is available to startups when a company makes the investment.

The proposed tax changes are designed to reduce the return to the corporate investor so that he will be no better off than a salaried employee who is paid $100K and then has only $50K (after-tax) to invest. But, is this fair to the entrepreneur who’s struggling to raise capital? And where’s the incentive to the angel investor?

The changes will discourage business owners from investing corporate profits in passive asset classes such as mutual funds and real estate by increasing the corporate taxes. This will have unintended consequences for angel investors who use corporate profits to invest in new ventures. By the way, angel investments usually require a lot of mentoring and are hardly “passive”. It would not be a pretty picture if half of this source of capital suddenly disappeared.

Under current rules, when an angel invests in a startup and realizes a capital gain, the tax rate is 26% (varies by province). If an angel invests using a corporation and then personally takes all the funds out, the corporation pays a tax on its gain and the investor pays a tax on the dividends received. The combined tax rate is the same 26%. That’s what’s meant by tax integration. The investor is no better or worse off in terms of dollars ultimately pocketed.

The new rules suggest that, when using a corporation to make “passive” investments, the combined tax rate will more than double to 56%. If the investor is a relative of the entrepreneur, the tax rate could be as much as 72% on interest income. Why 56%? This rate makes the total payout to the corporate owner identical to what he’d get if he withdrew corporate profit, paid tax and then invested it personally. This removes the incentive to use a corporation. It also removes a lot of investment capital. Incidentally, by not using a corporation, tax revenues will also be reduced!

Policy makers should think about the impact this will have on entrepreneurs and innovation in Canada and not take a broad brush approach to reduce the payouts on all corporate investments. Instead of trapping all forms of investment, consideration should be given, and exemptions made, for those who invest in active, growing businesses.

For those not familiar with the business of early stage investing, a doubling in five years equates to a 15% IRR. That sounds good but a more likely outcome is a zero return. Indeed, most startups fail. Getting 15% on one deal and 0% on many others, does not exactly entice investors. For this reason, angels must invest in a large portfolio of companies. It also takes a long time – more than 10 years – for startups to payoff. Patience should be rewarded. Using a corporation to achieve this, goes a long way towards keeping them in the game.

If anything, more incentives – not hurdles – are needed to ensure that entrepreneurs can access capital from private investors and their companies. Government supports incubators and accelerators to launch companies and it supports Venture Capitalists with the VCAP program but there’s a widening gap between accelerators and VC’s that’s filled largely by Angels and this gap must be reduced if we believe in commercializing Canadian innovation.

Hopefully, new tax policy will be crafted to encourage corporate owners to use business profits to become angels and invest in startups!

For More Information on the Tax proposals: http://mikevolker.com/small-business-tax-proposals/

Listen to: My Interview with Business in Vancouver on 29Sep2017.

 

 

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