Besides commercial and legal challenges, start-ups and their investors should also consider the tax aspects of their venture. By bearing in mind the following points, major tax pitfalls can be avoided and tax benefits used. This article focuses on Austrian tax law and on individual investors (eg angel investors). Since tax systems in other jurisdictions contain similar rules, these principles may also be relevant for start-ups and their investors in other countries.
Making the right choice for using tax losses
Prior to the initial phase, expenses related to the future business are deductible for income tax and VAT purposes as pre-business expenses. Initial business losses may also immediately be used with the right choice of legal form.
Corporations, including limited liability companies, are separate taxable entities. That may result in double taxation at the corporate level (currently 25 %) and – in case of distributions – at the investor level (27.5 %), adding up to 45.625 %. Losses are trapped at the corporate level.
In contrast, partnerships are tax-transparent entities. Profits are directly attributed to the partners and subject to progressive tax rates from 0 % to 55 % at the partner level. Partners may immediately deduct losses, eg from employment income.
Usually a limited partnership will be established first, because it allows partners to deduct start-up losses. In addition, partners enjoy lower progressive tax rates while profits remain low. When profits skyrocket, the business (and unused losses) may be transferred tax-neutral to a corporation, thereby benefiting from a reduced tax rate of 25 % / 45.625 % (avoiding taxation up to 55 %).
Picking the wrong means of investment
Start-ups chronically lack funding. Therefore, investments by investors or employees are essential. However, not all investments are tax-efficient. Tax law generally distinguishes between investments in the form of partnerships, equity or debt.
Partnerships, such as atypical silent partnerships, may confer tax benefits as outlined above, but also tax risks. If not adequately planned, their establishment may even trigger income tax on the business's unrealised capital gains.
Equity investments into corporations via shares and comparable rights, such as equity participation rights, results in income that is currently subject to a tax rate of 27.5 % (after corporate income taxes, ie 25 %). However, if employees are granted participations in the profits of the start-up and may not dispose of their profit participations as ordinary owners, income from such participations may be treated as employment income subject to progressive tax rates, and possibly social contributions.
Debt in the form of loans or other debt instruments, such as silent partnerships, results in interest deductible at the business level and subject to progressive tax rates from 0 % to 55 %. In this case, any expenses at the investor level are deductible, while expenses related to equity instruments subject to a 27.5 % tax rate are not.
Going abroad with your (tax) eyes closed
Expanding the business abroad may increase opportunity, but also entails tax risks. Prior to entering a foreign jurisdiction, proper tax planning is essential.
Sending or employing workforce abroad may already trigger foreign taxes. In particular, activities abroad could result in income subject to taxes in that country. In addition, delivering goods or providing services abroad generally changes the VAT treatment of such supplies and may make tax registration abroad necessary.
Setting up a foreign subsidiary also raises additional risks. Corporations are subject to local taxes. All transactions between parent and subsidiary must be made at arm's length in order to avoid any tax surprises. Dividends to the parent may be subject to local withholding tax. Directors of the subsidiary must generally act in that country in order to avoid exit taxation or compliance risks.
Exit without proper tax planning
For many investors a successful exit is the final step. To increase the chances of success, an exit preferably should be tax-optimised. The taxation of capital gains triggered by such an exit depends on whether shares in a corporation (via a share deal) or the business as such (via an asset deal) are sold.
An asset deal by a corporation results in capital gains subject to 25 % corporate income tax. If the business is held through a partnership, however, capital gains are subject to progressive income tax rates from 0 % to 55 %. Only in this case are benefits available to reduce the tax exposure under certain circumstances (including a EUR 7,300 tax-free amount or the distribution of capital gains over a period of three years). Transaction costs generally reduce capital gains while VAT on such costs may also be deductible as input VAT.
A sale of shares by the investor results in capital gains subject to income tax of 27.5 %. Tax exposure in an exit may be reduced by selling shares in the corporation indirectly through a holding company at a 25 % corporate income tax rate. The holding company may reduce capital gains by deducting transactions costs, which would not be the case if the investor sells the shares directly. There is a special tax exemption for capital gains from the sale of shares in a foreign corporation (minimum 10 % holding for at least one year). In case of an indirect sale through a holding company, distributing proceeds to investors again triggers 27.5 % income tax. Share deals are generally exempt from VAT and VAT on related transaction costs is therefore not deductible as input VAT.
The exit structuring will thus have to be carefully planned and executed.