16 August 2021
Regular fundraising rounds are something you quickly become used to when working with early stage spin out companies in the life sciences sector. For these businesses, the main focus is on ensuring a cash flow that remains available to support the development and commercialisation of their ideas.
Perhaps equally important to such companies is the availability of R&D tax credits. For Small and Medium Sized Enterprises (SMEs1) these offer a tax credit of approximately £33 for every £100 invested in qualifying costs. In many cases, a company can retain access to these SME R&D tax credits and continue to raise funds. However, there can be a very real risk of losing access to the SME tax credit. The impact in most cases, is that the company is only eligible to claim under the Large company (RDEC) scheme, providing a net benefit of around £10 per £100 invested, although in some cases, R&D tax credits may not be accessible at all.
Loss of SME status
One of the more common issues is where a fundraise leads to an individual shareholder holding a shareholding of greater than 25 per cent, or 50 per cent. The assessment of a company’s size is complex, but generally, where a shareholder (that is not a venture capital or institutional investor) holds greater than 25 per cent but less than 50 per cent, a similar proportion of their other investments must be aggregated in assessing size. Where the shareholding (to include venture capital and institutional investors) exceeds 50 per cent, it will typically mean that the investor and all of its other controlling holdings must be aggregated.
A simple example would be a large biotech taking a 30 per cent share in a spin out. Whilst the spin out may be an SME when looked at on its own, this would likely mean needing to include 30 per cent of the large biotech’s size and aggregating it with that of the spin out. If that exceeds the SME threshold, the spin out would not be eligible to claim SME R&D tax credits.
Another example would be a private equity fund taking a 51 per cent interest in a spin out. The outcome will be case specific, but could again result in the need for an aggregation of the fund’s other controlled investments which in turn may result in the spin out exceeding the SME threshold, and no longer being eligible to claim SME R&D tax credits.
An additional sting in the tail is that if such a change occurs through investment, it takes immediate effect for that accounting period, so that if the investment falls mid-way through an accounting period, the impact will be effective for the whole accounting period.
Grants and subsidies
Grants and subsidies is another complex topic. Where an R&D project is in receipt of a subsidy directly, or indirectly, from another party (whether this is a grant, a subsidy, or a contribution), it will impact the amount of expenditure that can be claimed as eligible for SME R&D tax credits.
Looking specifically at grants, whether the grant is an EU state aid (notifiable, or de minimus), will also impact on the amount of expenditure that can be claimed as eligible for SME R&D tax credits. In the worst-case scenario, receipt of a small grant (say £1,000), could rule out the ability to claim SME tax credits on the whole project, for which total expenditure may have been, for example, £100,000.
As such, early awareness of the issue is essential, so that management can make informed decisions.
Whilst this article has focussed on R&D tax credits, there are a number of other incentives and reliefs that can be jeopardised by a fundraising or investment event. This includes but is not limited to Enterprise Investment Scheme (EIS), Seed Enterprise Investment Scheme (SEIS), or Enterprise Management Incentive Schemes (EMI) – all of which have varying conditions by reference to autonomy, change of control, or group size.
What to do?
Tax advisors are often guilty of missing the bigger commercial picture – in this case, the company’s need to remain cash solvent to fund its continuing existence.
Fortunately, in most cases, by discussing any risks with the company well in advance, it is possible to assess any potential issues, and then to make informed decisions based on what is more beneficial to the company – in some cases it may be forgoing a particular grant opportunity – in others, it may be accepting that the R&D tax credit will reduce. Either way, planning early avoids nasty shocks to cash flow forecasting (or in the case of the other issues noted, unhappy investors that have lost their EIS relief on their investment!).
An SME is an enterprise with fewer than 500 employees, and either turnover of less than €100m or gross assets of less than €86m. Where the enterprise is not autonomous (i.e. it has shareholders holding greater than 25 per cent), an assessment is necessary to determine what level of aggregation of shareholders may be required in determining the size of the group before applying it to the SME definition.
1An SME is an enterprise with fewer than 500 employees, and either turnover of less than €100m or gross assets of less than €86m. Where the enterprise is not autonomous (i.e. it has shareholders holding greater than 25 per cent), an assessment is necessary to determine what level of aggregation of shareholders may be required in determining the size of the group before applying it to the SME definition.