The recent report by the Office of Tax Simplification (OTS)[i] recommends a range of policy adjustments to simplify the administration of the capital gains tax (CGT) and remove biases and distortions of behaviours.[ii] One of the recommendations suggests to align CGT and income tax (recommendation 1), in particular for owner-managers who may have a choice whether they derive their income as dividends or capital accumulation within the business. The recommendation to treat owner-managers similarly to external investors in the business has a potential to create large differences in effective tax rates between these groups, which is likely to stifle entrepreneurship and innovation by reducing founders’ incentives to start and build a business.
While superficially similar with respect to share ownership, owner-managers of start-ups accrue capital gains mainly when they sell the business, whereas external investors typically invest in a number of firms and at a higher frequency. External investors can carry forward losses from their portfolio investment, but entrepreneurs will typically not have any capital losses to carry forward, because founding a company is like a one-off bet. Ordinary portfolio investors will have gains and losses, and on average the losses will balance the gains (except for a risk-adjusted expected average return). For the entrepreneur, there is no averaging of losses and gains because she only has one investment. In the extreme, the ordinary investor’s CGT will be near zero if portfolio gains equal losses, while the entrepreneur’s CGT will be the maximum rate of 45% on a single successful exit from the business.
Another way to see this unequal treatment of founders and external investors is to compare an external investor’s portfolio to a set of entrepreneurs who each hold a single (large) stake in one of the external investor’s portfolio companies. If some of the firms go bust, the external investor can offset these losses against gains in other portfolio companies. The entrepreneur holding a stake in one of the failed businesses, however, will have no gains to offset. Carrying forward capital losses will only be feasible to the extent that the entrepreneur founds and successfully exits other start-ups. But even in this case, losses will typically be minimal, as they mostly consist of the founder’s time spent building the business.
Treating founders in the same way as external investors will essentially cut the founder’s upside in half without compensation on the downside of the return distribution. Investments in seed and early-stage investments have distributions with heavy tails, which means that most of the gains will come from a small number of start-ups. In venture capital funds, which average a number of such investments and thus have much less heavy-tailed distributions than individual investments, the variation of returns is infinite with heavy tails for both gains and losses.[iii] If the upside is artificially curtailed by increasing CGT for entrepreneurs or limiting the business asset disposal relief, seed/early-stage investment will become much less profitable. Taxing the small number of extremely successful start-ups at the full rate creates an asymmetry because of the inability of founders to offset this single gain against past losses. Founders who fail to achieve a successful exit will keep sitting on losses that cannot be used to offset future gains. Founders will find that their gross gains are taxed, while external investors pay CGT only on their net gains. The overall effect can be seen as an entrepreneurship tax that favours diversified investors over highly focused (and highly committed) founders.
How can a fair treatment of all investors be achieved? Founders who sell their business for a modest gain (up to a lifetime limit of £1 million) can currently use the business asset disposal relief to reduce their tax burden to 10% in the event of a sale. The OTS argues that the current business asset disposal relief is an ineffective incentive for investment and should be re-targeted towards business owners who retire. In particular, it suggests to consider:[iv]
- increasing the minimum shareholding to perhaps 25%, so that the relief goes to owner-managers rather than to a broader class of employees
- increasing the holding period to perhaps 10 years, to ensure the relief only goes to people who have built up their businesses over time
- reintroducing an age limit, perhaps linked to the age limits in pension freedoms, to reflect the intention that it mainly benefit those who are retiring.
If these suggestions were implemented, the effective tax burden for entrepreneurs would increase. For entrepreneurs, business asset disposal relief is not only useful as a retirement device but crucial for ensuring fair effective taxation compared with external investors. Differences in effective tax rates between the two groups are caused by a relative under-diversification of founders. To tackle these differences, under-diversification could be made a criterion for business asset disposal relief. If founders’ main asset is their business, and if they cannot offset gains from disposing of this asset against past losses (i.e. as a serial entrepreneur), then relief should be granted. These two conditions would specifically target founders and exclude portfolio investors who typically hold more than a single large investment, removing a potential for distorted decision-making by founders and external investors.
[i] OTS (2020), Capital Gains Tax review first report: Simplifying by design. Available at: https://www.gov.uk/government/publications/ots-capital-gains-tax-review-simplifying-by-design.
[ii] For a discussion of implications on entrepreneurship, see https://www.beauhurst.com/blog/cgt-changes-threaten-uk-startups.
[iv] OTS (2020), p. 89.