One of the critical decisions when raising finance is the form in which the finance is supplied to your company. (Note: The following text is subject to change at anytime.)
In general, there are two different ways that finance can be acquired:
- Issuing shares (share capital)
- Creating debenture or loan notes (loan capital)
The following are the tax and legal implications for both methods:
SHARE CAPITAL
Share capital can take many forms depending upon the rights and restrictions attached to the shares in question the rules for which are set out in the Memorandum and Articles of the Company available online from the public record at the Companies Registration Office.
Preference share capital may have preferential rights to receive profits available for distribution, but may have restricted voting rights. The more familiar form of share capital is 'equity capital' or Ordinary Share Capital.
DEBENTURE LOAN CAPITAL
Like share capital, loan capital can take many different forms depending upon the rights and obligations attached to the loan . Loans are normally secured by way of a fixed or floating charge but can also be unsecured. The most common form of loan capital is the debenture loan which is secured by way of fixed or floating charge over the assets of the company.
A number of essential legal and taxation differences are involved in the company's decision as to which form of security to issue and one should seek full legal and accounting advice.
Financing Alternatives
In addition to the traditional equity financing options, there are others available to your company. The availability of such alternatives will depend on both the asset and tax profiles of your company.
Through careful structuring, it may be possible to raise finance in a way that maximises and accelerates tax deductions that will result in lower-cost financing. There are many different variations of such financing structures and it is important that you consider these tax-based alternatives when raising finance.
Share Capital v Loan Capital
The following are the comparative differences between the two forms of finance:
a) Capital Repayment
A shareholder is an owner of the company. Consequently, upon liquidation debts are repaid to debenture holders in advance of shareholders. Shareholders have no direct interest in specific assets of the company. A loan holder is a creditor. Upon liquidation, debts are repaid in advance of shareholders. Where a loan is secured by a charge, a loan holder has a direct interest in the company's assets whereas a shareholder has none.
b) Tax Deductions
Dividends on shares are not tax deductible. In general, interest that a company pays on a debenture is tax deductible. However, interest paid on certain types of loans (e.g. where interest fluctuates with profits) may be treated as distributions and therefore no tax deduction will be received by the company. It is important to review the loan documentation in this regard.
c) Income Returns
Depend on company performances. Right to the payment of a fixed interest rate on investment which is payable irrespective of whether the company has made profits or not.
d) Buy Back Ability
Some restrictions may apply on companies purchasing own shares. A company may redeem its own loan notes. Redeemed loan notes may be reissued.
e) Corporate Governance
Voting shareholders can attend meetings, vote and inspect the company's accounts. Cannot attend meetings, vote and inspect the company's accounts.
f) Capital Gains Tax
Investment as shares will give a base cost for any future capital gains tax calculations on a disposal of the company and its shares. Loan capital does not give a base cost for capital gains tax purposes.
g) Capital Duty
Capital duty at 0.5% (down from 1% in 2004) is payable on the value of shares issued. However, capital duty does not apply when a company is unlimited. No capital duty on execution of a loan note.
Cash Extraction Premium paid to shareholders by a company on the redemption of share capital will be liable to either Capital Gains tax or Income tax (depending on circumstances).
Repayment of loan can be a tax efficient way of extracting profits.
OTHER FORMS OF FINANCE
Option 1: Sale and Lease Back of High Depreciation Equipment
Where a company has assets with a short 'useful life' (e.g. computer equipment, certain machinery, etc.), it may be possible to enter into an agreement with the bank to raise finance based on these assets. Such financing can enable the maximising and accelerating the tax deductions thus reducingthe overall cost of borrowing.
In general terms, under a sale and lease back arrangement, the company sells the assets to the bank at fair market value (which should be significantly less than the original purchase price). Immediately, the company will enter into a lease agreement with the bank for the same assets.
The overall effect is that the company gets an amount of cash, up front, which will equal the fair market value of the equipment sold to the bank.
The finance repayments will be effected through the lease payments.
Careful structuring will significantly increase and accelerate the tax deductions available (greater tax deductions that a simple loan agreement), which in turn will decrease the cost of financing.
Option 2: Lease and Lease Back
Again this solution uses existing assets to raise finance and through careful structuring the tax deduction can be increased enabling a significant reduction in the cost of finance. In this scenario instead of selling the assets to the bank, the assets are leased to the bank for an upfront lease payment from the bank/financial institution. If structured properly, the lease and lease back arrangement can give rise to significantly higher tax deductions than even the sale and lease back. This will ultimately help reduce (or even eliminate) the cost of the finance.
Other Potential Sources of Funds
Equity Investment - The principals in the new venture should consider what level of funding they can provide. While this may cause financial strain for individuals, it will be important to show potential debt investors that the management team is fully committed to the project. Individuals may also be entitled to preferential tax treatment for any equity investment in the new venture.
Traditional Bank Financing - Commercial term loans may be organised by approaching major banks. The banks will secure the loan via a combination of directors' guarantees and security over major assets such as land or equipment. The banks will evaluate the management team and their business plan to assess the level of credit they will extend and the risk premium to be charged. In a start-up operation most banks will adopt an ultra-conservative approach and may limit their share of financing to match equity investments. It is likely that financing facilities will be reviewed on a regular basis and may be withdrawn or limited if business plan targets are not met.
Venture Capital - Specialist venture capital firms will consider the merits of the business plan in assessing any investment in this project. The Venture Capital firms will structure the financing arrangements to safeguard their investment and create potential for the Venture Capital firm.
The VC firms will generally place less covenants around their financing so that there are fewer restrictions on the operation with regard to raising additional debt. However, they will structure their funding to provide them with maximum benefit from an equity interest. The key to negotiating efficient venture capital investment is to limit the element of equity granted while recognising the value of the funding from the Ventur Capital.
Private Placement - High net-worth individuals will consider the merits of a privately arranged investment in the proposed operation. The flexibility of this form of funding can be advantageous because it can be structured to meet the objectives of both parties. The individuals targeted for investment purposes may be treated as sleeping partners or they may be invited to join the new operation if their particular skill sets complement the current management team. The key consideration for a private investor will be striking the right balance between risk and return. They will wish to see robust cash flow projections incorporating capital repayment.
Fund Managers - Investment fund managers hold allocations of funds for direct investment in particular industries. Most fund managers will fund small, speculative infrastructure projects. This form of financing will be short-term and expensive. The fund manager will look to recover financing within two to three years and will expect returns in excess of their standard yield.
Project Finance - Investment banks and commercial banks will consider treating the capital element of the funding required as project finance. They will then advance funds at each particular stage of the build programme subject to specified criteria.
FIXMYTAX.com have advisors with direct relationships with all providers of finance which include main stream banks, commercial banks, venture capitalist, enterprise boards and building societies.
If you require finance for your business, please contact us and we will arrange an initial assessment of your requirements.
If you require more information please consult your tax advisor or email us at tax@fixmytax.com.
