University spin-out companies

United Kingdom

The pre-budget report on 2 December 2004 contained some good news for academics participating in a "spin-out" company set up to develop a commercial application of a scientific discovery. Prior to 2003 it was fairly common for academics and the university or other not-for-profit research institution that the academic worked for to set up a new company and transfer the relevant intellectual property rights to that company with a view to obtaining venture capital backing for the spin-out company to develop the relevant technology. If the spin-out was successful, the academic could exit from the venture by selling his shares and paying capital gains tax.

During 2003, however, such spin-out transactions virtually ground to a halt. This followed the "Schedule 22 legislation" (as contained in Part 7 of the Income Tax (Earnings and Pensions) Act 2003). The Inland Revenue's position was that, when the research institution transferred the IP to the spin-out company, income tax and national insurance arose for the academic (and an employer's national insurance charge arose for the employing institution). The income tax and national insurance arose under the "undervalue" legislation if the IP was transferred before the academic acquired his spin-out shares or under the "special benefit" legislation if the intellectual property transfer was after the share acquisition. To the extent that the venture capital investors paid a higher price for shares in the spin-out company at first round financing than the academics (who paid a nominal price), the Inland Revenue sought to charge income tax. This was obviously disastrous for the academic; a significant income tax charge arose at a time when there was no cash to pay the tax bill (and, indeed, there never would be any cash unless the spin-out was successful)! Some structures have been negotiated with the Inland Revenue (for instance the UNICO structure involving convertible preference shares) that avoid a tax charge in the early stages of a spin-out company transaction. However, such structures still subject any "profit" when the academic exits the spin-out structure to income tax and national insurance. If the academic is also required to bear the cost of employer's national insurance the effective tax rate is over 48 per cent.

The Chancellor has announced that legislation will be introduced in Finance Bill 2005 so that income tax and national insurance charges will not arise when IP is transferred to the spin-out company. The Chancellor has also confirmed that if venture capital funding is introduced to the spin-out once the IP is in place, this will not, of itself, trigger a special benefit income tax charge. This legislation will cover transfers of IP taking place on or after 2 December 2004. Whilst this measure is generally welcome, careful structuring will still be needed to make sure that any venture capital funding is introduced at the right stage otherwise income tax and national insurance charges could still arise. It is hoped that the overall result of the proposed legislation is that an academic will be able to exit from a university spin-out company by selling shares and paying capital gains tax (thereby benefiting from favourable rates of taper relief).

The intention is that the legislation will have various carve-outs. The most significant disadvantage revealed by the Inland Revenue press release is that the legislation will only cover spin-outs where the intellectual property is transferred by a university or other educational, learning or research establishment whose activities are substantially publicly funded and who use IP-sharing agreements; it will NOT cover spin-outs controlled or funded by a person who carries on activities for profit (and there will be anti-avoidance measures to prevent the legislation being abused by commercial organisations). Overall, this is good news for university spin-outs although we await sight of the detailed legislation (due at the end of January 2005). There is an ongoing consultation process and representations can be made to the Inland Revenue up to 10 February 2005.

Please contact Mark Nichols at [email protected] or on +44 (0)20 7367 2051, Alison Hughes at [email protected] or on +44 (0)20 7367 2862, Toby Locke at [email protected] or on +44 (0)20 7367 2411 or Anika Chandra at [email protected] or on +44 (0)20 7367 3798 for advice relating to Schedule 22 or other tax issues relating to employee incentive arrangements. Please contact Charles Waddell at [email protected] or on +44 (0)20 7367 3602 for general advice relating to spin-out companies.