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Crowdfunding – watch out for the VAT

SINCE the 2008 crash, small businesses have found it hard to generate investment from traditional sources. Though the government’s rhetoric has been about the necessity for the financial sector of supporting new enterprise (and it is true that there has been a staggering increase in the numbers of entrepreneurial start-ups in the last few years), banks have been struggling with contradictory imperatives in managing this issue.

On the one hand, they have been savaged for irresponsible lending, and told to rebuild balance sheets; on the other, criticised for their failure to assist emerging SMEs – who are frequently very risky investments.

Hence the gap between the expectations of small businesses, and the practical reality of what banks can do for them. As a consequence, some smaller firms are returning to the most ancient form of borrowing: the family loan. But this method has its limits. Apart from the requirement of a family infrastructure, there is also – in most families – a limit to the resource that can be thrown at the pet projects of the new generation. (These things are relative, however; Donald Trump got going with what he considers a ‘small loan’ of $1m (£665,000) from his father). There is also the risk of endless strife should things go wrong.

At the opposite end of the novelty spectrum is crowdfunding. Rather than depending on a particular institution (like a bank), or on a defined group of people (such as a family), crowdfunding harnesses the internet and social media’s capacity to engage with vast swathes of individuals on a quasi-personal level. By exponentially increasing the number of potential investors for a particular venture, and lowering the bars to contribution, crowdfunding reduces the risk to individuals who want to support an enterprise. It represents, in principle, a step forward for popular capitalism.

Unfortunately, and as with the complexities around European e-commerce that I have discussed in previous articles, the indirect tax system may become an unintended brake on this new technology enabled lending framework. Getting the VAT wrong when operating a crowdfunding model could end up negating any benefits gained from the use of crowdfunding: there are risks of penalties, interest payments and bad publicity – which can be fatal for new enterprises.

To date, HMRC has not issued any UK guidance on VAT and crowdsourcing, but the European Commission’s VAT Committee has done; and although it should be remembered that these views will not be binding on HMRC, it provides some useful pointers on the VAT treatment to apply.

Crowdfunding can be implemented in two general ways. The first model sees a business ask investors for contributions to help fund it, and, in return, it will provide them with goods or services. For example, in return for their contribution a start-up brewery might provide investors with an amount of beer (with the amount given depending on the value of the contribution).

Because the business is giving the investor a good in return for the contribution, that income is subject to VAT (pending the business already being VAT registered or upon it crossing the registration threshold).

What this would mean for a UK business is that, assuming the goods are subject to 20% UK VAT, 1/6th of the investor’s contribution will immediately be lost to the taxman. There may be some way to mitigate this (such as classing the good as a gift or sample) but to do that would require some work (read cost) by the business. This reduction in investment therefore must be factored into the businesses investment plan.

The second crowdfunding model differs from the first in that investors receive securities (shares or bonds, for example) or some form of intellectual property rights that will lead to a cut of future profits. The latter IP option is again likely to result in the contribution being subject to VAT, with the same consequences as outlined above.

Securities are different though, because they are often treated as being exempt from VAT. This means that any contributions would escape VAT, allowing the business to retain all of its contribution.

Nonetheless, and perhaps unsurprisingly, there is a corresponding downside to the securities route: which is that VAT costs that relate to exempt transactions are irrecoverable. So, although VAT may be saved on income received, it may also be lost on general costs. Tax authorities give with one hand but take with the other.

Potential crowdfunders need to consider these issues before committing to the process. It would also be sensible to check whether the platform being used to host the crowdfund will charge VAT as well; if it does, then the question of how to recover that cost also arises.

Better to confront the issues early, than face the wrath of a cash strapped tax authority later down the line.

Nicholas Hallam is chief executive of VAT consultancy Accordance

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Philip Hammond