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Equity crowdfunding is an efficient and fast-growing means of channelling private capital to start-up companies. In New Zealand, progressive and innovative regulation and a syndication model have contributed to this growth. These developments may, however, be handicapped by tax policy on research and development (R&D), which confers tax preferences on particular firms that are not available to other firms. Swayed by the possibility of accessing specific tax incentives, investors may make suboptimal investment choices.

Equity crowdfunding and the tax system

From a fundraising company’s perspective, equity crowdfunding is a mechanism for raising equity capital by selling the company’s shares to many new investors (a ‘crowd’) through an intermediary (a ‘crowdfunding platform’).

Equity crowdfunding broadens investment opportunities for small investors and fundraising opportunities for companies seeking relatively small investments. While crowdfunding is innovative as way of investing, it is not reserved to investing in companies that are themselves innovative and therefore attract R&D tax incentives. Crowdfunding investors face high income risk because fundraising entities are usually start-ups or loss-making companies.

Government, through a national tax system, can share income risk with the investor not only by incentivising initial investment and income distribution, but also by incentivising disposal of the investment. In both cases, investors are encouraged to undertake the investment risk and provide their contributions to a fundraising company. Tax incentives for initial investment and income distribution subsidise the cost of investment and, therefore, increase its value to an investor. These incentives may stimulate investments in start-ups because they reward new capital instead of creating windfall gains for existing investors. Tax incentives for disposal of the investment may stimulate investors to support development and growth of the investee firm, job creation and productive innovation.

New Zealand has a well-developed depreciation regime, including accelerated depreciation for certain items. It also incentivises investment in innovation through R&D deductible expenditure, R&D tax loss credits, and R&D tax credits. These tax incentives are available to R&D-oriented fundraising companies. These incentives may therefore nudge investors towards incentives-eligible fundraising companies over incentives-free fundraising companies.

Implications

Crowdfunding is a group activity. Two abilities of a crowd are critical for building enduring business and to choosing a prospective investee through an equity crowdfunding process: the ability to identify companies with a profit-making potential; and an ability to monitor the performance of crowdfunded companies. Tax incentives do not affect the monitoring ability of the crowd but may affect the crowd’s screening ability by distracting investors.

If only innovative companies were to seek funds through crowdfunding, there would be no distraction for a crowd, and all fundraising companies would compete for funds on an equal basis. However, when innovative companies compete for funds with non-innovative companies, the crowd is distracted and prevented from picking a winner from the entire pool of fundraising companies.

Investment in innovative companies does not guarantee a return on investments. Moreover, such investments can be riskier than investments in non-innovative companies, if innovative businesses fail more often than other businesses.

Generally, tax incentives may limit the equity of the system, particularly since high-income enterprises may extract most benefits from tax credits. Furthermore, if a business is innovative, government shares investment risk through general and specific tax incentives.

Options for reform

New Zealand’s income tax system aims to be ‘broad base, low rate’; the efficiency and equity principles that inform this system provide a sound argument against tax incentives.

R&D tax incentives may contribute to the development of an innovative spirit in the business community. However, encouragement of innovative behaviour through tax incentives should be distinguished from encouragement of group investments through equity crowdfunding. Otherwise, the encouragement of innovation through tax incentives will undermine a primary purpose of equity crowdfunding (raising equity capital from a crowd and providing investment opportunities to a large number of small investors) and make it both less efficient and less fair.

Fundraising companies should be able to compete for investments on an equal footing, so that the crowd is able to pick a real ‘winner’. Ringfencing equity crowdfunding from R&D tax incentives could help to reach this policy goal and maintain the state’s participation in risk-undertaking that New Zealand’s light-handed crowdfunding regulations and its tax legislation have created.

As politically implausible as it may be, a tax levied on contributions made after a crowdfunding project had reached its funding goal would internalise overfunding externalities such as those caused by overshadowing other crowdfunding projects.

R&D tax incentives and light-handed crowdfunding regulations help companies to improve their cash flows. However, the interplay between these two regimes may create a double competitive advantage to innovative companies at the expense of non-innovative companies.

To even out cash-improvement opportunities for non-innovative businesses, government could compensate these businesses for disadvantages that specific tax incentives, such as the R&D tax loss credit and R&D tax credit create. Such compensation could be effected by restricting certain advantages to non-innovative businesses. Ringfencing equity crowdfunding to non-innovative businesses (and businesses that opted out of the R&D tax incentives) or a specific tax levied on recipients of specific R&D tax incentives could create this ‘compensatory’ advantage and, therefore, equalise opportunities for innovative and non-innovative businesses to improve their cash flows.

 

This blog is based on: Plekhanova, V & Barrett, J 2020, ‘Equity crowdfunding in New Zealand: The role of income tax incentives’, Journal of the Australasian Tax Teachers Association, vol. 15, no. 1, pp. 142-164.

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