UK Startup compnay and third party as creditor OR owner

[carpman]

Hi all,

First post and possibly some dumb questions:

I'm drafting a Term Sheet (Agreement) for an odd business relationship and tax (at the corporate and individual level) will play a part in how that relationship is defined in contract:

Some context may be helpful:

Normally you have an entrepreneur (who has the idea) and they seek venture capital from a third party (who has the money). However, in our case, we have:

An entrepreneur (who has the capital, the motivation but not the idea) and has promised a substantial share of equity to the third party who has the solution to the entrepreneur's business problem (thus the third party has the idea, but not the money).

Both parties will share control, however only the "entrepreneur" will manage operations. The third party doesn't want to be part of the company but does want quarterly payments out of the business (if you need more details on this let me know).

So my problem is how to position the third party (as shareholder, creditor, licensor etc.), and what are the tax and legal implications of such positionings.

I can treat the third party as a creditor who sells the idea to the entrepreneur (company) and the company thus has a debt to repay. The problem here is, the debt is variable (in that it's linked to the performance of the company and its valuation upon the third party's exit). Is that a problem?

Can the repayment of a debt (not interest, but the principal) be treated by the company as an expense and be written off against revenues (income) and thus reduce taxable profit?
i.e. can the paying down of a liability be netted against revenues pre-corporation tax.

If the third party receives such "repayments" are they treated as regular income, or is income from the sale of an idea (IP) treated differently? If the third party was a company in say, Singapore, would this be legal and also liable for corporation tax in Singapore?

That will do for now.

If anyone can shed some light on these issues I'd be most grateful.

Many thanks,

C.

 

[Snorbenz]

Sounds to me like a shareholder situation is the way to go. The ideas man would then be entitled to a dividend commensurate with his shareholding and would declare the dividend on his self assessment tax return.

However, dividends are only payable when profits are made and after corporation tax is paid, so it's entirely possible that the ideas man could receive no money at all for a year or two, while the money man could be taking a salary (which will bring down Corporation tax liability). You could set it up as no salary / dividends only but this will increase corp tax liability.

 

[carpman]

Many thanks for the reply Snorbenz.
Before I go into why the straight shareholder model is not ideal, I have a couple of questions:

1. Can you/someone tell me how the repayment of debt principal would / can be treated by an accountant. i.e. can the repayment of a liablility be netted against revenues to reduce taxable profits?

2. Can a shareholder also be a creditor? Is there any conflict? Are there legal or tax implications?


The straightforward shareholder method is not ideal for a number of reasons, here are 2:

1) There would be only 2 shareholders (ideas man + entrepreneur) and it's my understanding that if a dividend is paid then it must be paid to all shareholders.

2) As you point out, dividends are paid after tax, and I'm trying to reduce the company's tax burden.


Many thanks again, and all input greatly appreciated.

C.

 

[carpman]

quick related question

If a company is buying back its shares is that treated the same tax-wise as paying down debt principal?

Thanks,

C,

 

[mackwaa]

1. Can you/someone tell me how the repayment of debt principal would / can be treated by an accountant. i.e. can the repayment of a liablility be netted against revenues to reduce taxable profits?

You've quite a few complex issues here...

Only the interest can be claimed for tax purposes in the company

But then the Idea's man would have to declare this interest as income in their personal tax return. So as a collective you are no better off.

You might think about making the loan reasonably large (to claim more interest and less principal) but then you will probably get caught under transfer pricing rules.

2. Can a shareholder also be a creditor? Is there any conflict? Are there legal or tax implications?

A shareholder can be a creditor. And no conflict of interest provided the company is a closed company.

The straightforward shareholder method is not ideal for a number of reasons, here are 2:

1) There would be only 2 shareholders (ideas man + entrepreneur) and it's my understanding that if a dividend is paid then it must be paid to all shareholders.

2) As you point out, dividends are paid after tax, and I'm trying to reduce the company's tax burden.

1. Correct although you may want to split them into ordinary shares and preference shares.

2. The dividend paid would be imputed (ie the tax paid on the company earnings is included in the dividend) so the ideas man would declare the dividend in his personal name and claim the imputation credit to offset the tax payable. So shouldn't make much difference (depending on the tax bracket of the individual)

 

[carpman]

Thanks for the response mackwaa, and sorry for the delay in replying. I'd somewhat given up on this thread (prematurely as it turns out).

Well, I've spent some fruitful time over at the UK business forums (tax and then legal sub-forums). Below I've posted an outline of the issue and a summary outlining how we are thinking of proceeding (perhaps others may find it useful/interesting):

Here's a rough outline of the relationship:

We have 2 parties -

1. Entrepreneur (has capital + Operational Skills + Motivation)
2. Third Party (owns the Solution without which Entrepreneur's business won't function)

• Entrepreneur offers Third Party (let's say 50% share in company to keep it simple and an equal say in the operations of the business)
• Third Party agrees but on condition that a) they are not a direct part of the business, and b) that they receive financial compensation on a quarterly basis.
• Both parties want said payments to be netted against revenues (i.e. before corporation tax).

From here on in I'm going to call the Entrepreneur the Company.

So we have the Company and the Third Party. Essentially what we're doing is:

"Capitalizing an intangible asset" (The Solution) whose value is uncertain until derived from an equity valuation (when Third Party decides to exit relationship) against which the Company makes incremental payments to the Third Party in the form of a consulting fee (which, in essence, is indexed to the performance of the company).


METHOD

• 50% of shares are offered up as collateral against payment of the full consulting fee.
• The collateral agreement states that the control (voting rights etc) the Third Party will exercise is commensurate with that of a party holding 50% of the shares of the Company.
• If the Company defaults on the payment (or violates its contractual obligations with the Third Party) the Third Party gets to own ("forecloses on") 50% of the shares.
• Once the consulting fee is fully paid the Company gets back those shares put up as collateral.

An agreement such as: "Pledge of Shares of Stock as Collateral Security" allows the Pledgor (the Company) the right to receive a dividend etc .... but we will write into such an agreement that as part of the pledge the Pledgor (the Company) gives over voting rights. So we can use the collateral agreement as a method to manage control.

By doing it this way we should by-pass Capital Gains issues, as once the fee is paid the collateral (Shareholding) is RETAINED rather than BOUGHT BACK (which would incur Capital Gains). And since the Company is only paying a fee (rather than buying back its shares) not only does the Third Party avoid Capital Gains tax, but a fee can be netted against profits, thus reducing the Company's Corporation Tax.


The agreements I think we're going to need for this are:

1) NDA
2) Term Sheet
3) Pledge of Shares of Stock as Collateral Security (for UK law)
4) Shareholders Agreement
5) An invoice/consulting agreement with pretty clear terms and conditions setting out precisely the valuation method


My questions:

1) Is there anything in the "Method" outlined above that won't work?
2) Is there anything specific to UK Law that would make such an arrangement problematic?


Any help on this greatly appreciated.

C.