UK spin-outs feel pinch of tax ruling?

The number of university spin-outs has slowed markedly in the last year. The main reason for this is last year’s amendment to the Finance Act which is deterring the involvement of academics in these businesses. Before July 2003 academics who took a stake in a business set up by their university to commercialise research they had produced were charged only on capital gains. This was payable after selling shares. The changes to the Finance Act mean they now have to pay income tax based on the value ascribed to their shares as a result of first round investment. And this charge is incurred before the academic has necessarily sold any of his or her stake. Angela Sormani reports.

Professor Mike Wright of Nottingham University Business School underlines the importance of the involvement of the academic in recent research undertaken and funded by the Economic and Social Research Council. He says: “The clearest factor which promotes spin-outs is the commitment of the originating academic to commercialising his or her technology. Universities should provide greater career support and entrepreneurial training to those academics that wish to participate in the commercialisation of their academic research in order to gain their commitment to the commercialisation process in some form. Otherwise the tacit knowledge necessary to make the technology function in the marketplace is likely to be missing.”

The amendments to the Finance Act were designed to close tax loopholes, which cost the Inland Revenue tax and National Insurance on £1.4bn per annum. As a result, universities across the UK have put spin-out activity on hold as it became clear that founder academics were at risk of having to pay income tax on shares issued before having the cash with which to pay.

Jeremy Smith of law firm Dickinson Dees, says: “The changes introduced by last year’s Finance Act have left academics with a dilemma where both the solutions available to them are relatively unattractive. They can either accept that they will be taxed on the initial value of their shares in the spin-out company, which, given the difficulties in valuing shares in technology companies, leaves them facing an uncertain tax liability at a time when they are unlikely to have the cash resources to fund the liability. Or, alternatively, the spin-out company can be structured in such a way that academics can avoid any initial tax liability, but at a considerable cost – an effective tax rate of around 48% of sale proceeds!” And so when academics often give up their university posts in order to become involved in a business that is, by its very nature, risky, it is hardly surprising that the Government is finding it difficult to persuade them to continue to spin-out businesses.

In spite of this, government support for the commercial exploitation of university research has been strong, particularly from the Department of Trade and Industry, which has invested over £350m since 1999 to encourage enterprise activity. And at a time when academics are starting to recognise the benefits of commercialisation, it is unfortunate that the introduction of tougher tax rules on shares held by academics has stopped the incorporation of spin-outs.

Data on spin-out numbers over the years has not been routinely collected in the UK until recently. There is good commercialisation data in the US available from the Association of University Technology Managers (AUTM). In the UK, UNICO (the University Companies Association), an organisation representing British universities has been conducting a commercialisation activity survey based on the established AUTM model for the past three years. The report is based on the results of a survey conducted by Nottingham University Business School (NUBS) – see news this issue for further information. Figures for 2003 have not yet been released, but it is thought they will be down on 2002’s figure on the back of the changes in last year’s Finance Act. This is undoubtedly a disappointment for industry professionals active in the sector, who witnessed a boom in activity in 2002, when UK universities were completing more technology licence agreements than US universities (per unit of research funding) and spinning out nearly twice as many new companies (per unit of research funding).

While commentators agree that spin-out activity slowed in 2003, the year 2002 was characterised significant government support for universities through the Higher Education Innovation fund (HEIF), the University Challenge Seed Funds (UCSFs) and Science Enterprise Centres. This government support had also attracted significant interest from university administrators, who appeared to have knowledge and technology transfer higher up their agendas before the amendments to the tax rules.

The Higher Education Innovation Fund 2 Programme has also recently committed £187m to universities for investment from 2004-2006. However this looks likely to be spread thinly across the sector and the funding requirement for new initiatives risks leaving current successful programmes under-funded.

While efforts are being made by UNICO and the Inland Revenue to soften the impact of the legislation, academics are still considered to be at a considerable disadvantage compared to other entrepreneurs.

Tim Cook, managing director at Isis Innovation, the technology transfer business of the University of Oxford, said: “An unfortunate by-product of this reform last year was that academics who started up companies and were rewarded shares for their contribution to the development of intellectual property would have had to find several thousands of pounds before they had even sold their shares.” And there is no doubt the implications of the changes have had a marked effect on spin-out activity. Oxford University, for example has had a ten-month dearth of spin-out activity, according to Cook.

He adds: “It is a shame because the Government has done a lot to promote university spin-outs, but with this reform has shot itself in the foot. As a result Oxford University has only produced two spin-outs in the last year, compared to eight the previous year.”

But it is hoped this is only a temporary stagnation of activity and that university spin-outs are set to start-up again.

During the last year, UNICO has been working hard with the Inland Revenue to identify a mechanism which incentivises academics to work within the new law. The organisation has engaged in extensive dialogue with the Inland Revenue to provide tax certainty for academics, their universities and their advisors.

Dr Tony Raven of the University of Southampton, who has been leading the negotiations on behalf of UNICO, said: ‘We are pleased that we have been able to work in partnership with the Inland Revenue to produce this safe harbour under which our academics can again start to commercialise their research through spin-out companies.”

But more has to be done. Founder academics still remain at a significant tax disadvantage compared to other stakeholders in a spin-out, such as financial investors and outside managers and further discussion with the Revenue is required to level the playing field. Tim Cook agrees: “UNICO has found a partial solution, but it is still not a satisfactory solution. The whole scenario has completely turned off the academics and this is reflected in the drop in spin-outs from the universities.”