Looking to set up a start-up?
People create start-ups because of the passion they have for their project, the excitement of innovating, the allure of working on their own terms, and the prospect of high reward.
People rarely get involved in start-ups, or any venture, because of a love for paperwork and bureaucracy – and let’s face it, tax is probably the least sexy part of running a start-up! Founders already have a lot on their plate as it is without having to worry about all the documents they have to lodge with the Australian Taxation Office (ATO) or what they can do now to minimise a hypothetical tax liability in the distant future…which might never eventuate.
When starting a business, many founders assume tax is not a concern for their start-up because they are not yet making money or paying income tax. However, the inconvenient truth is that tax compliance and planning are critical aspects of carrying on any venture. Start-ups are no exception to this, but thinking about tax matters is often overlooked in a start-up environment.
Success in any business venture requires a proactive approach to tax compliance and tax planning. In most cases, this proactive approach by a start-up can increase enterprise value and assist founders in securing critical investment.
‘My start-up doesn’t pay tax yet, so why should I care?’
Good tax compliance and planning sets a venture up for success through:
- maximising future after-tax profits and enterprise value
- attracting and incentivising potential investment
- taking advantage of tax concessions and incentives
- signalling responsible governance practices to existing and potential investors
Many of the activities that contribute to good tax compliance and planning practices compliment other facets of a successful venture – such as good financial record keeping, proper cash flow budgeting, and incentivising and retaining key employees.
The compounding effects of these activities are much more likely to lead to a successful venture. The investment in proper advice and services also provides peace of mind that allows founders to focus on innovating and building their business.
‘What happens if I just ignore it?’
Ignoring a company’s tax obligations can significantly impede success.
Poor tax compliance could result in:
- financial penalties (which can be thousands of dollars)
- personal liability for directors for the company’s tax liabilities
- a review or audit by the ATO which takes time and attention away from productive activities
Furthermore, a bad standing with the ATO can signal to investors that founders will not be responsible with their money; thereby deterring investment.
Tax due diligence is frequently carried out by investors on target investments to ensure there are no skeletons in the closet. For example, most investors would be uneasy about investing in a start-up that has several years of outstanding tax returns, unpaid employment tax liabilities, and an ongoing dispute with the ATO over excessive R&D tax incentive claims. Any adverse findings uncovered through a tax due diligence review may reduce the enterprise’s value, which could result in having to give away more equity to investors.
Lastly, to ensure their interests are looked after, investors who are investing a significant amount of money will often push for a board position with the start-up. Start-ups may also wish to appoint key strategic advisers or personnel to the board. However, smart individuals would think twice about becoming a director of a company when doing so exposes their own personal assets due to outstanding tax debts and lodgements. Poor tax governance and practises will impede board appointments and could result in a start-up missing out on funding or recruiting talent.
‘Can’t I just deal with it or fix it later?’
Tax does not only become an issue once a start-up is profitable. Simply ignoring what will happen to a decent chunk of future profits can significantly erode the future value of a start-up. Ensuring a tax-effective legal structure is in place and understanding how income and profits will be taxed is imperative to ensuring the long-term success of a venture.
It pays to get proper advice from a qualified and competent adviser at the genesis of a new venture – or as soon as practically possible. Not doing so is short-sighted.
Ideally, tax planning should be done before a formal legal structure is put in place. This is because the longer it is left, the more expensive it is to remedy a poor structure – resulting in hefty professional fees and potential tax and duty liabilities.
This is particularly important when a start-up has an international flavour – for example, to ensure that income and profits are not subject to double taxation in multiple tax jurisdictions.
‘But my mate told me to do it this way…’
When deciding on a structure, or any tax issue for that matter, founders may be tempted to rely on advice from a mate or colleague. You might think you are saving a couple of bucks by relying on what your mate told you over a couple of beers – they got advice from their accountant so it should be good for you, right?
Unfortunately, there is no ‘one-size-fits-all approach' to structuring and what works for one venture might not work for another.
Example 1: Running a business through a discretionary trust
For example, your mate might run their cabinet carpentry business through a discretionary trust because of the flexibility in making distributions to family members and minimising tax. However, a discretionary trust would not be a suitable vehicle for a start-up because it does not easily accommodate for investors and is not an eligible vehicle for the R&D tax incentive. Rather, the commercial objectives (e.g.: access to the R&D tax incentive, flexibility in the distribution of profits, etc.) could be achieved through a number of alternative structures. The most appropriate structure will depend on a number of other factors – including how the start-up will commercialise its intellectual property or sell its products and services.
Example 2: Is a company always best?
Another example is that you might have a few mates who have various start-ups, and they might all operate them through companies. Based on their advice you set up your start-up through a company. However, your start-up involves the licensing of software to organisations in the United States, for which you receive royalties. Those royalty payments are subject to withholding tax, where tax is withheld by the licensee and remitted to the US tax authorities on your company’s behalf. While your company may receive a tax offset in Australia for the US taxes paid, those offsets are non-refundable and so your company will not get any benefit in an income year that it makes a loss (i.e.: since it does not have any Australian income tax to offset against).
In any case, this represents a permanent cost to the company and its shareholders even when making a profit because companies are not able to frank dividends in respect of foreign taxes. So, in this instance, a structure that allows a flow-through of the tax offsets might be more appropriate – such as a unit trust which allows its unit holders to take advantage of the foreign income tax offset.
The appropriateness of the structure would depend on many other factors and competent advice would consider all of those factors. Ultimately, you may decide that a company will still be appropriate for your situation (for any number of reasons) and that the tax inefficiency is therefore merely a cost of doing business in the United States.
In any case, wouldn’t you prefer to make an informed decision after weighing up the pros and cons of the various options?
It is imperative that founders, or any business owner for that matter, only rely on advice that they have received from a suitably qualified and experienced professional – whether that is a lawyer, a tax adviser or an accountant. Not only will they get advice tailored to their specific situation, and that is appropriate to their start-up, but getting advice from a professional also acts as an insurance policy in the unlikely event that the advice was wrong. A founder who suffers a financial detriment due to bad advice would be much more willing to make a claim on their adviser’s professional indemnity insurance than suing their mate.
‘Getting advice sounds expensive…’
The unfortunate truth is that getting good advice from suitably qualified and competent advisers is usually not cheap. However, the economic cost of not getting advice, or relying on what your mate told you over those beers, often exceeds the cost of getting proper advice (that is tax-deductible in most cases).
For example, the economic cost of not getting advice can include:
- penalties and interest on shortfalls in tax
- paying more tax than you otherwise should
- professional fees, tax and duty on restructures to remedy improper structures
- professional fees in dealing with an audit or review by the ATO
- missing out on tax concessions, grants and incentives (which is as good as throwing away money)
- missing out on securing investment funds
In most instances, good advice can prevent money from leaving your pocket, and in some circumstances can put money in your pocket.
Getting advice allows founders to free up time to focus their time and energy on their business. It can put them at ease knowing they are covered and have put in place the best structure that can scale with the business.
For the same reason that you would not use a homemade or cheap lifejacket when setting sail in unknown territory, you should always get advice from a qualified and experienced adviser.
Tax advice can put cash back into your pocket
Getting good tax advice can provide much value to a start-up by putting cash back into your pocket.
For example, an adviser can assist a company in preparing an application for the R&D tax incentive program that can (in some circumstances) return 43.5 cents in cash for every dollar of eligible spend. However, following a flurry of recent ATO audit and AusIndustry review activity, start-ups should be mindful about not overclaiming the R&D tax incentive with ineligible activities and expenditure as this could result in penalties and interest charges – on top of repaying the excess claim. Therefore, it’s important to only engage with experienced and reputable advisers, and not be overly aggressive with claims.
It is typical in the industry for advisers to charge a ‘success fee’ percentage of the rebate. This negates the start-up’s risk of spending more on fees than what they will get refunded through a rebate. If your adviser does, you should make sure there is a ceiling on the fee so the adviser is not incentivised to overclaim – since this has been a contributing factor to the emergence of some reckless advisers over the years.
For example, try to have your fee arrangement structured to be the lesser of X% of the rebate or $Y. On the other hand, some advisers will charge a fixed fee for the claim and advice and, while such fees could be less than a fee charged on a ‘success fee’ basis, it obviously comes at a risk that you spend more in adviser fees than what you receive as a rebate.
Furthermore, advisers can provide advice on a company’s eligibility as an ‘early stage innovation company’ (ESIC) which can provide significant tax incentives for eligible investors. A company that is able to confirm to potential investors that it’s an ESIC may find it easier to raise capital, as investors are incentivised to invest through potential entitlement to a 20% rebate and capital gains tax exemption on their investment.
A culture of obtaining tax advice from qualified professionals instils a culture of good tax governance in an organisation. This signals to potential investors that the founders and the board of a start-up are financially astute and may encourage investment by putting investors at ease that their money will be dealt with responsibly and wisely.
As part of their due diligence, interested investors may ask for copies of tax documents, ask questions about the start-up’s legal structure, and make reasonable enquiries about other financial and tax matters. Having this information available, and understanding it when asked about it, can be the difference between securing that investment or having to spend another few months trying hopefully to raise capital.
Tax advice can prevent money from leaving your pocket
Getting tax advice can prevent money from leaving your pocket through a number of means.
This includes advice around:
- structuring to minimise potential tax exposure and reduce or prevent double taxation
- deferring tax liabilities to assist with managing cashflow
- putting in place an effective employee share scheme (ESS)
Most start-ups are cash poor. To attract and maintain talented employees and key personnel, start-ups may wish to provide employees with equity in the company. This has the dual effect of reducing remuneration that is paid as cash and aligning the interests of employees with that of the founders by giving them ‘skin in the game’.
There are significant tax concessions available to employees of start-ups who participate in qualifying ESSs. Competent advisers can provide advice to companies on establishing and maintaining ESSs that are tax effective to both the start-up and its employees (such as minimising and deferring income tax liabilities).
Founders should not fall into the trap of having ‘handshake’ arrangements with employees and contractors for equity remuneration that are not quickly translated into formal contractual arrangements. Not only are there legal risks associated with this approach, but delays in putting in place the correct documentation for ESSs can result in increased tax liabilities for both employees and employers. This is because the market value of the shares may increase between the time that an arrangement is agreed on and when the ESS interests are actually issued.
Many founders of start-ups come from tech backgrounds and sometimes have little understanding of tax and financial matters. This is probably a broader reflection of our education system, which arguably does not provide adequate credence to financial and tax literacy.
However, a poor understanding of the tax system can result in misguided actions in carrying out a start-up’s tax affairs, which may have severe financial consequences. This is why it pays to both educate yourself on tax and engage with skilled professionals for advice.
Throughout my career I’ve heard numerous highly educated people involved in start-ups state that they were considering purchasing some equipment, incurring an expense, or carrying out some activity because of the ‘tax write-off’ or ‘tax benefit’. The truth is that tax should only ever be a secondary consideration compared to the true commercial value of a transaction or arrangement. There is no sense in paying $1 to get back 30 cents if it’s not a practical business decision.
Similarly, some founders might relocate overseas (e.g.: to the United States) to work on their start-ups or set up a foreign subsidiary or holding company, without considering the tax outcomes of their actions – such as the tax residency of the founder and the overseas company, and what it means.
While tax considerations are secondary to the commercial rationale of any decision, making informed decisions will require a knowledge of the tax system and how it relates to you and your business.
This is why it is imperative for founders to ensure they have a good grasp on the fundamentals of taxation. Misguided understanding of taxation leads to improper business decisions.
If in doubt, ask a professional. Make sure you seek professional advice when making any big decision – whether it be what structure to use, what the tax implications are of issuing capital to investors or employees, how you will be taxed on the sale of your shares or assets, and so on.
Seeking education and knowledge is an investment in yourself and in your business.
Want more information on the best tax considerations for setting up a start-up?
Contact RSM to discuss it with one of our trusted accountants and advisers.