Venture capitalists invest in companies that are high risk and high growth with the expectation they achieve a return on their money either by the sale of the company or by offering to sell shares in the company to the public.

Equity funding tends to come in various rounds, often starting with "family and friends" (funding from the founders and their family and friends) and "seed" or "business angel" finance (funding from wealthy individuals) and (hopefully) moving on to more substantial investment rounds where established venture capital ("VC") investors participate.  The first of these rounds is usually termed the Series A round and further investment rounds (often up to Series D) are common before companies are large enough to look to sale or IPO opportunities.

Investments into high growth companies by established VC investors typically involve the issue of share capital, on preferred terms with rights to convert into ordinary shares.  The rationale behind this form of investment being that: (i) it provides the VC with downside protection (it will get its money back first on a liquidation of the company); (ii) it provides an upside should the company do well (i.e. the shares they initially bought are now worth considerably more); and (iii) it is recognised that most early stage companies do not have cash flow strong enough to support debt finance.

In recent years however, there has been a steady growth in debt provision by VC and specialist venture debt lenders into VC backed companies from Series A round funding onwards.  These lenders provide debt funding to start up companies in circumstances where banks and other commercial lenders will either not lend money, or would require personal security from the founders.  The rationale for such debt investment is that it allows VC investors to leverage their equity finance whilst minimising dilution of the equity investors and founders.

The form of this lending usually depends upon the nature of the lender:

  • VC investors often provide bridge financing.  This may be from existing or prospective investors in the company, to finance the company until its next investment round.  This debt is usually: (i) convertible (together with accrued interest) into the class of shares of the company to be issued on the next investment round (often at a discount), (ii) repayable if the investment round does not happen by a fixed future date, and (iii) unsecured.
  • Specialist venture debt lenders are more likely to provide (i) secured funding (secured on the assets of the company), or (ii) funding based on leasing assets to the company1.  Because of the risks inherent in this type of lending, venture debt lenders tend to expect an "equity-kicker" in the form of warrants or options over a proportion of the equity share capital of the company, to provide upside benefits should the company be sold or IPO.

This article looks at the UK tax issues that venture debt lenders and VCs advancing debt finance should consider and, in particular, considers the tax treatment of interest on such debt and the tax effects of any equity-kicker.  

Corporation Tax Treatment of Interest

Tax deductibility of interest for the borrower may not be a key concern (as it would be on a leveraged buyout) as, for many early stage VC investments, it will be many years before the company is profitable. 

However, there will be companies that are looking to turn to profit quickly who will be looking at the deductibility of interest payments and utilisation of early stage deferred tax assets.  There will also be lenders and investors who will be taxed on interest income when they would not have been taxed on distributions and will want to see symmetry of treatment. 

Transfer pricing and thin capitalisation are unlikely to be major concerns as the company is likely to qualify for the exemption for SMEs2. Similarly the UK debt cap rules are unlikely to apply as (i) the rules apply to groups and many VC investments are into solus companies; and (ii) the rules require a "large" (i.e. non SME) worldwide group.

What will often be a concern however, is the equity nature of the investment in the round.  Interest payments are non-deductible distributions where securities are convertible into share capital unless the securities are listed on a recognised stock exchange or reasonably comparable to such listed securities.  Similarly, interest payments are treated as distributions where the security is connected with shares in the company (specifically through a stapled stock arrangement).  

These provisions should not create any issue where the creditor is a UK tax resident company as distribution treatment under these provisions does not apply where the interest is received by such a company.  However, many of the funds providing venture debt are structured as limited partnerships which are transparent for UK tax purposes and one would therefore look through the fund to a mix of investors – some of whom may be UK corporates – but many of whom will be non UK resident or exempt from tax (e.g. pension funds). 

Cautious advisers have in the past sought to structurally separate warrants from debt by issuing warrants out of a different company from the borrower.  The above rules would then very clearly not apply.  However, provided that the debt and warrant instruments are separate instruments which can be separately assigned and are not effectively a single arrangement, then structural separation should not be necessary to achieve tax deductibility of the interest.  This is as well for the early stage company that would not want to incur the costs of multiple holding companies.

Even if interest payments are deductible, the interest will not be deductible until actually paid (as compared to the usual rule of allowing interest deductions on an accruals basis) in certain circumstances.   One of the circumstances in which interest is not deductible until paid is where a close company3 pays interest to a lender which is also a participator in the company in a capacity other than that of lender (this will generally be the case with a warrant holder as the warrant provides an entitlement to acquire shares in the company).  The company will not obtain a tax deduction for interest paid to the participator (or certain connected persons) until paid if the interest is paid more than 12 months after the accounting period in which it accrues.  Exceptions to this rule apply however where:

  1. the participator is a company which is not resident in a non-qualifying territory or not effectively managed in a non-taxing non-qualifying territory (broadly speaking a non qualifying territory is a tax haven);
  2. the debtor is an SME, the lender is a CIS limited partnership (i.e. a limited partnership that is a collective investment scheme or that would be a collective investment scheme if it were not a body corporate) and no member of the partnership is resident in a non-qualifying territory; or
  3. the debtor is a CIS-based close company (i.e. a company that would not be close but for the attribution of the rights and powers of partners in a CIS limited partnership to the other partners) which is also an SME and the lender is not resident in a non-qualifying territory.

Withholding Tax

Interest payments will be subject to deduction of tax at source in the UK at 20% unless an exemption applies (e.g. payments to a UK tax resident company) or where a double tax treaty applies to reduce the rate.  More sophisticated structures for mitigating withholding taxes – such as using quoted Eurobonds – will not be appropriate due to cost constraint.

The effect of the EU Savings Directive will need to be considered by the company and VC fund to the extent payments of interest are made to EU resident individuals.

Tax Treatment of Warrants

As well as providing a concern to the tax treatment of interest payments under venture debt, the tax treatment of warrants will need to be considered in their own right. 

The derivative contracts legislation is unlikely to apply to most warrants issued by investee companies as they tend not to be cash settled so should be treated as equity instruments (and not derivative financial instruments) for the purposes of the derivative contract rules. 

The issue of a warrant by a company will, however, be a disposal of an asset (i.e. the warrant itself) for the purposes of corporation tax on chargeable gains.  As the company will have no base cost in the warrant a chargeable gain may arise equal to the amount received or deemed to be received for the issue of the warrant.  In the case of venture debt, no consideration will typically be given for the warrant as it will be issued in conjunction with the lending.  In this case there is no actual consideration for the warrant.  However where the issue of a warrant is not on arm's length terms (which is likely to be the case where issued for no consideration), any gain will be calculated by reference to the market value of the warrants on issue.  

Where the warrant is subsequently exercised, the issue of the warrant and the issue of the shares are treated as one transaction. Therefore, if the warrant is then exercised, no disposal by the company will be treated as having taken place on issue.  Where tax has been paid on issue, a repayment of the tax should then be available on exercise.  Where there is not a significant gap between grant and exercise (e.g. where the exercise takes place before the tax return for the period in which the issue takes place needs to be filed), any "gain" on issue effectively ceases to be chargeable.

Convertible Debt

Convertible debt is often seen in venture backed companies as it may be used by equity investors in certain circumstances – e.g. as a means of bridge finance pending further equity investors being found.

A convertible debt will fall within the UK loan relationship rules for the investee company and as such one would expect interest to be deductible on an accounting basis.  However, as seen above, interest on convertible debt which is not listed or comparable to listed securities will, unless paid to a company within the charge to corporation tax, be treated as a distribution for UK tax purposes and therefore not tax deductible.  Therefore, if the convertible cannot be made on terms which are comparable to a listed security, there may be a significant tax mis-match where interest is taxable in the hands of the recipient investor.  Where interest is deductible anti-avoidance rules, including the late paid interest rules will need to be considered.

The tax rules on convertible debt are also complicated where the investee company accounts for the debt under IFRS or modified UK GAAP (i.e. FRS 26) as a separate host contract and embedded derivative or equity instrument.  Most VC investee companies will account under old UK GAAP without showing the embedded derivative as a separate liability.  However, the accounting treatment in this respect will need to be considered as and when IFRS for SMEs is implemented as this standard provides for bifurcation of convertible debt into a host contract and equity element.  Under the ASB's current proposals, small companies (which would be most VC investments) would not need to apply IFRS for SMEs but could account under the financial reporting standards for smaller enterprises ("FRSSE").  As FRSSE does not contain FRS 26, the status quo should be maintained for the time being for most start up companies. 


1.  Venture leasing is now less common in the UK following the introduction of the "long funding lease" regime whereby capital allowances on such leases are claimed by the lessee rather than the lessor.  This effectively means that the benefit of the capital allowances is lost – or greatly reduced (given that most early stage lessee companies would not make profits for a number of years).

2.  The definition of SME (i.e. small or medium-sized enterprise) follows Commission Recommendation 2003/361/EC (being an entity which together with certain partner or linked enterprises employs fewer than 250 persons, has an annual turnover not exceeding EUR50 million and/or an annual balance sheet not exceeding EUR43 million).  Consideration will need to be given as to whether the VC and its portfolio companies constitute partner or linked enterprises for these rules.

3.  Broadly speaking, one under the control of five or fewer participators and their associates.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.