Taxing Premium on New Shares Drains Startups

Jan 11 , 2020
By Million Kibret

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A 2019 directive by the Finance Ministry subjects income derived by companies from the issuance of shares in excess of their par value. Diverging from a number of positive steps taken by the ministries of Revenues and Finance in the past two years, this directive harms startups, writes Million Kibret (million.kibret@bdo-ea.com), managing partner at BDO Consulting Plc.

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Investors across the planet have various levels of risk appetite. Some love to start from scratch, breaking the ground and toiling through all the grueling stages of investment from blueprint to construction, installation, production and marketing. Others prefer those ventures which have already been transformed from problem kids into cash cows by their founders who took the courage to roll up their sleeves not only to write strategies and business plans, but also to get their hands dirty at construction sites and factory floors.

Everything has a price though. Those investors, whose preference is for low hanging fruit, invest in the ripe ventures, which are already up and running. These investors pay those passionate founders or their companies dearly for their hardworking days, sleepless nights, immense patience and unwavering persistence. Such payments in compensation of turning a venture from mere passion at heart and sketch on paper to gigantic machines on the ground, humming with the production of economic goods and services can, end up directly with the individual founders, who preferred to call it a day to enjoy the dividend of their many years of hard work and perseverance.

In such cases, the incoming investors would buy the shares of the companies from the founders at a premium. These shares are financial assets in the hands of the founders and when transferred from person to person at premium, they attract capital gains taxes on the amount of premium, a practice widely accepted and enforced across the globe.

On the other hand, the founders can also choose for the investment from the incoming investors to be injected into the company rather than to their personal pockets. In choosing this approach, the founders’ intention is attracting additional investment for the growth of their enterprises by deferring their personal short-term gains.

This approach results in additional investment to the company to be utilized for expansion of physical production facilities, to build capacities at various levels and to boost working capital in order to enable the enterprise to procure required inputs for the production process.

Generally, investing in an ongoing company involves conducting business valuation, where financial experts use internationally accepted valuation methodologies to arrive at fair values of the businesses. In most of the cases, the total net enterprise value of ongoing businesses exceeds their book value, which is mainly based on accounting books built using historical costs of physical assets. The excess of enterprise value obtained from the business valuation exercise over the book values results in premiums to be injected into the companies by incoming investors on top of par values of the shares of the companies.

Investment in this approach therefore results in two categories of capital for companies: additional paid-up capital by issuing fresh shares at par value to the incoming shareholders and premiums or capital reserves to the company, as the incoming shareholders’ total investment exceeds the total face value of the shares issued to them. Both of these items are additional investments into the company. In such cases, individual founders and other existing investors of the company do not receive direct personal financial profits.

The 1960 Ethiopian Commercial Code states that shares may be issued at a price greater than their par value and the difference shall be known as premium. When an extraordinary general meeting has approved such an increase, the premiums may be transferred to a reserve fund, according to another part of the Code.

Moreover, International Financial Reporting Standards (IFRS) state that equity capital and reserves be presented disaggregated into classes such as paid-in capital, share premium and reserves, denoting the fact that premiums received on the issue of shares are apart of capital accounts of a company.

The Ethiopian income tax proclamation that came into effect in July 2016 clearly states that gains obtained on sales or the transfer of shares is subject to a 30pc income tax. This provision clearly refers to shareholders disposing of existing shares they own rather than premiums arising from issuance of new shares by companies.

With Ethiopia’s long history of statehood, taxation by the governing bodies is not alien to the country. However, modern taxation practices are yet to be widely accepted by all economic players in the country. To this effect the Ethiopian ministries of Revenues and Finance have been continuously trying to implement and promote modern tax practices through improvement and modernization of tax filing and payment systems and by promoting public awareness of tax laws, regulations and practices.

The recent activities by the Ministry of Revenues to implement electronic tax filing and payment systems, enabling tax payers to settle their tax obligations from the comfort of their desks, is  a commendable effort and is expected to improve the country’s position on the global chart of ease of doing business.

The Ministries have also been engaged in issuing directives aimed at clarifying tax proclamations and regulations. These directives being issued by the ministries of Revenues and Finance have significantly helped taxpayers and tax professionals to clarify application of various provisions in the tax laws.

One of these was a directive issued by the Finance Ministry on July 2019 on income tax applicable on the transfer of capital items. However, an article of the directive, which states that income derived by companies from the issuance of shares in excess of the par value of the shares to be subject to income tax, has sent a shock wave through the investment community.

One major way of attracting foreign investment is directly channeling capital into companies which are already up and running. Investors injecting capital into the existing companies usually pay premiums to the companies. The amount of premiums paid into existing companies can be larger than the face value of the shares due to the rising business values of the companies.

This helps in capturing the unrecorded business value of our local companies, resulting in a significant amount of FDI into local enterprises to be invested in the form of premiums or capital reserves. The other major advantage of this approach is using investors’ capital for the growth of local companies rather than external debt, which will be returned back to the foreign lenders in hard currency, thus draining our meager reserves of hard currency.

However, an article in the directive results in the taxation of such premiums, which, in effect, will be taxation on investment capital. This provision, already alarming the investment community, might lead future investors to resort to partly injecting their funds for growth of companies in the form of shareholder loans if premiums are to be taxed. The effect of this will be poorly capitalized and highly indebted local companies. Founders and existing shareholders of investee companies may also prefer to pocket premiums from incoming investors rather than allowing the premiums to be used for future growth of the companies, as there will be no tax incentives in capitalising the premiums.

Many young entrepreneurs are tirelessly exerting their youthful energy on startup ventures, anticipating to attract angel investors and venture capitalists to value their enterprises and to become the next Facebook or Uber. When the angel investors value their enterprises, a significant portion of the valuation can end up being premiums and only a small amount of the total new investment may be granted to the incoming investors in the form of share capital. This enables the founders of these startups to have majority shareholding, resulting in an upper hand to the founders in managing the enterprises. Taxation levied on such premiums could dwarf these young enterprises by preventing them from taking off the ground.

A quick review of the current practices in the fellow Eastern African countries of Kenya, Uganda and Rwanda confirms that share premiums in these countries are classified in the capital account and no taxes are applicable. The new directive by the Finance Ministry puts Ethiopia at a disadvantage in terms of attracting the much coveted FDI compared to our peer group within Sub-saharan Africa.

As the country is gradually developing capital markets, investors coming in the form of venture capital and private equity funds are expected to play a significant role in investment into the economy. These investors generally operate by injecting funds in the form of share capital and premiums. Their primary objective is growing the respective local companies. The issue of taxation on premiums will significantly slash their growth funds and is tantamount to killing the goose that lays the golden eggs.

The Ethiopian government is being praised worldwide for the pragmatic efforts being exerted to ease doing business in Ethiopia and to improve the investment environment. The draft investment law plans to privatise major government-owned enterprises and the current tax reform activities can be cited as some of initiatives widely expected to attract foreign direct investment. However, implications of taxing premium on new shares may have adverse effects on the country’s efforts to attract global investors.

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PUBLISHED ON Jan 11,2020 [ VOL 20 , NO 1028]

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