The government is perversely incentivising corporate debt

Tim Ward
For a small business, the costs of raising equity represent a huge percentage of the funds raised (Source: Getty)
Sometimes attitudes are so entrenched that we go about our business and daily lives and never question them. And for me, there’s one particular facet of the world of corporate funding that is not questioned enough – the imbalance in the government’s treatment of equity and debt. It is not only harmful to the interests of growth companies and therefore the wider economy, but also completely illogical. Why is it that the costs to a business of borrowing money are tax-deductible while the same benefit is not available to companies raising permanent equity finance?

One can understand the government’s lack of enthusiasm for extending tax breaks at a time of austerity. But it should be possible for ministers to stand back and see the benefit of promoting positive change and avoiding the obstruction to growth caused by failing to act on this illogical situation.

The government argues that lowering the rate of corporation tax encourages economic growth. The government tells us that there is too much debt in the economy. Yet it seems to be unwilling to encourage a transfer of capital from temporary bank finance to permanent equity capital. This is contradictory.

Everyone acknowledges that the value of growth companies to the British economy is as vast as their potential. The UK’s nearly 2,000 small and mid-size quoted businesses represent 85 per cent of all public companies. They employ 1.4m people – almost 5.5 per cent of total private sector employment. It’s time the government acted to ensure that their potential is fulfilled on behalf of the UK economy, particularly as these companies can contribute more to future employment and export growth than any other sector.

Our research shows that 19 other European countries have some form of tax relief for the costs of raising equity, highlighting the UK’s outlying position on this. The European Commission has also announced in its Capital Markets Union Action Plan that it intends to further address the imbalance in the tax treatment of raising equity versus debt. Alone in Europe (again), we must cope with an unlevel playing field.

For a small or mid-size company, the costs of raising equity represent a huge percentage of funds raised – sometimes 5 to 10 per cent – and this can be a major disincentive to listing on a public equity market. The current tax arrangement distorts this process even more.

In our fragile but somewhat optimistic climate, the government should be encouraging growth companies to raise long-term, permanent equity capital rather than short-term debt that the banks could call in at any point. The cost to the Exchequer of doing this is estimated to be just £80m a year.

There’s another consideration. The UK economy has been transformed by wider share ownership. For more than a generation, it’s been possible for an ordinary person to invest in UK companies without being considered a tycoon. Most people now realise their continued financial security depends on the health of Quoted Britain Plc, whether through pensions or other pooled investments. This link between permanent equity investment and the wider community can only be distorted by the continuation of the debt versus equity anomaly.

There is another measure we would like the chancellor to consider. He can encourage wider employee share ownership and align employee and management goals in driving economic growth by removing the arbitrary 5 per cent threshold for Entrepreneurs’ Relief on capital gains tax in respect of shares held by employees and officers. Currently, only officers or employees who own more than 5 per cent of a company are able to benefit from the reduced capital gains tax rate of 10 per cent on disposal.

Any cost to the Exchequer would be at least partially funded by employees exercising unapproved share options – generating a large income tax and national insurance receipt for the Treasury – as they attempt to qualify for a 12-month share holding period, which the Quoted Companies Alliance is proposing.

If he wants to be really ambitious, the chancellor could do even more by expanding Entrepreneurs’ Relief from just officers and employees to long-term SME investors, thereby including all stakeholders who make a meaningful and important contribution to growing businesses. It would also encourage new investors who are willing to be in it for the long term and contribute to the growth of a company, rather than those who want to make a short-term trade or gain.

Through these simple measures, the chancellor has the ability to encourage a switch from debt to equity and promote a long-term attitude towards equity investment. Both of these seem to me to be at the heart of the government’s agenda. It is time to prove that the heart is beating.

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