We need to look after the EU’s economic backbone in SMEs

This week’s Summer Economic Statement explains that a total package of €1.05 billion is being provided for in Budget 2023 on the tax side. That’s double the amount set in the original strategy and, as it says, “reflects the need to adjust the parameters given the higher-than-assumed inflation”. It also states that it will focus on the need to adjust income tax bands and credits so that workers are not ‘dragged’ into higher levels of taxation by virtue of wage inflation. This is welcome.

On a separate but related matter, the European Commission recently published its “Annual Report on Taxation 2022”. It weighs in at almost 160 pages and covers a broad spectrum from recent EU tax reforms, the green transition, the digital transition as well as discussing a global framework for the taxation of multinational enterprises. The section on tax incentives for SMEs is of note.

According to the European definition, small and mid-size enterprises (SMEs) are companies, which employ fewer than 250 persons and have an annual turnover up to €50 million, and/or an annual balance sheet up to €43 million.

While we may disagree with the EU on certain tax measures from time to time (remember CCCTB and more disagreements are below), we can’t disagree with the report when it says that “SMEs are the backbone of Europe's economy”. You’ll recall that when we signed up to the OECD deal on Global taxation (shorthand for the 15% corporation tax rate) the Minister for Finance and Chair of the Eurogroup, Paschal Donohoe, said in a press release that “The Government values the role of SMEs and microenterprises in our economy and as creators of employment throughout Ireland. Balancing our enterprise policy between foreign direct investment, SMEs, export-only businesses and non-exporting indigenous firms is an important policy consideration. … Our statutory 12.5% tax rate will continue to apply to the vast majority of businesses in Ireland given they operate below the €750m threshold set out in the agreement”. Agreement was secured with the EU on this matter and so we agree on the EU’s “backbone” analogy.

The EU Commission’s report notes that there are two main reasons supporting the provision of tax incentives to SMEs. The first is that “there are market failures that affect SMEs”. The second is that the “tax system has a disproportionately negative impact on SMEs”. The report explains one market failure argument in favour of incentives is that SMEs generate positive spill-over benefits for the economy. These benefits “could include innovation that can be applied elsewhere and can have a positive impact in the growth of the economy” aka “creators of employment” as noted by the Minister earlier.

The Commission notes possible benefits including labour training and the upgrading of skills that can be applied afterwards to other businesses. Therefore, SME tax incentives could encourage higher levels of investment in these activities. Myron Scholes (Nobel prizewinning economist) and others once wrote: "Success is achieved when the tax rules subsidise activities that benefit society as a whole more than they benefit the individuals engaging in the activities ...". Once again, we agree.

The report continues that due to market failures affecting SMEs, some find it more difficult than larger enterprises to obtain external finance e.g., the survey on the access to finance of enterprises (SAFE) found that between 2009-2019, the percentage of firms that perceived access to finance as their main problem was consistently higher for SMEs than for large companies. Against this background, tax incentives could reduce SMEs’ need for external finance by helping them maintain a higher proportion of their earnings.

One of the solutions to this would be an amended version of EU’s proposal for the Debt Equity Bias Reduction Allowances (Debra) which I’ve previously written about in these pages. That allows for a notional deduction on equity finance such that the SME’s earnings are not used up paying interest. That “give” is reduced by the “take” in Debra’s currently proposed restriction on financing so more work needed here before we can agree on this proposed solution.

Further, making it easier to access equity finance through the Employment and Investment Incentive Scheme (EIIS) would play a part here. Allowing SMEs give tax incentivised share options to its employees through an enhanced Key Employee Engagement Programme (KEEP) would allow SME’s retain cash in the business while incentivising employees with real skin in the SME’s gain.

Another reason cited for promoting SME tax incentives is that tax systems pose disadvantages to SMEs. The report gives the examples of high compliance costs and the sci-fi sounding “Asymmetric treatment of profit and losses”: It explains the latter as meaning profits are taxed when they occur (a cheque is written at that time) while losses are “normally not refunded” but carried forward to reduce future income. The report notes that this might affect SMEs that often face liquidity problems especially in their early development stages. Consequently, the report notes that “Under this argument, the possibility to refund losses at the time they occur or to use them to offset other income may be justified; as are refunds for tax credits provided to SMEs”. It’s also why many organisations are asking for excess R&D credits to be refunded over one year instead of over three years which is currently law.

The EU takes a balanced approach and looks at what they call “the significant criticisms” of tax incentives. For example, citing IMF 2016 research it says that tax incentives can affect the growth of SMEs by creating disincentives for them to grow beyond a certain size to remain eligible for special tax treatment. I suppose not all sweet shops want to be the next Willy Wonka but then again some may look toward unicorn status irrespective of the tax code. The report says that incentives might encourage companies to break-up into smaller ones to take advantage of tax benefits which undermines companies’ possibility of growing and to take advantage of the economies of scale. You can see their point on that one and when we’ve brought in tax reliefs there is accompanying anti-avoidance legislation to stop such activity. Therefore, we have ways with dealing with these issues because the key here is to develop the economic backbone.

Budget 2023 is now even closer than previously understood so let’s do everything we can to incentivise the SME sector.


Please note this article first featured in the Business Post on Sunday 11 July 2022 and was re-published kindly with their permission on our website.