Tax and Regulatory Breaks for Startups
Addendum to Postponomics: Kishida Punts On Startups and Income Redistribution
This addendum explains some of the tax and regulatory breaks which were referred to in Postponomics: Kishida Punts On Startups and Income Redistribution, but which there was no space to detail.
Double-Taxation on Limited Liability Companies (LLCs): When a corporation earns profits, that corporation is taxed. Then, the shareholders who receive dividends from those profits pay personal income taxes. So, those dividends are subject to double taxation. In LLCs in the US and in many other OECD countries, the profits pass through to the owners without being taxed at the company level. Taxes are only paid by the owners as part of their income tax. So, there is no double taxation. At the same time, as with a full corporation, the personal property of the owners cannot be taken if the LLC defaults.
The recognition of the LLC on the federal level unleashed a flurry of new firm creation with 59% of “high-growth innovative enterprises” in the US in 2013 having been created in the 5 years after 1988, and another 27% during 1993-2013.
In Japan, the Ministry of Economy, Trade, and Industry (METI), successfully pushed an LLC law through the Diet in 2006, but the MOF used its regulatory power to block the LLC from having the tax advantages that LLCs—or their equivalent—enjoy elsewhere. Reflexively, the Ministry of Finance (MOF) argued that Japan could not afford to lose the revenue, without factoring in the enhanced tax receipts stemming from a pro-growth LLC system. In Japan, METI again tried to authorize LLCs without double taxation, but the MOF once again blocked it.
METI made no effort to remedy this lapse in the current negotiations with the MOF.
Open Innovation Tax Incentive: The purpose is to incentivize large corporations to collaborate in innovation with new, imaginative companies, mainly by buying shares in them, or even wholly acquiring them. The measure, introduced in 2020, gives big companies tax credits for such investments, but only through March 2022. It is not clear how hard METI worked to make this permanent, or expand it, or broaden its use. Nor is it clear how well the system has worked so far. In any case, the Five-Year contains a very vague mention of the issue. “To promote M&A [i.e., the purchase of venture firms by big companies], which is an exit strategy for startups to grow significantly under the umbrella of a business company, the open innovation promotion tax system will be limited to those that particularly contribute to the growth of startups, and the acquisition of existing issued shares will also be taxed. In doing so, the government will adopt sufficiently effective tax measures.” To promote partnership in cases where the big company does not acquire shares, the Plan says: “In addition, regarding the R&D tax system, we will expand preferential treatment when collaborating with startups.” It is unclear if and when it will adopt such preferential treatment or how big and impactful it will be.
Stock Options for Employees: In the US and Europe, startups in the early stages that cannot afford to pay competitive salaries for very skilled employees can still attract them by offering stock options. If the company succeeds, these can become very valuable to the employee. For a variety of reasons, use of them is very cumbersome in Japan. The Five-Year Plan proposes assorted measures to make them easier for both the employer and employees. I would need to speak to some entrepreneurs to assess how well this will work.
Government Procurement From Innovative Startups: Procurement by the national and local governments amounts to about 16% of GDP, a huge market. For a long time, the government has set aside part of that procurement for small and medium-sized companies (SMEs) and in 2015 the government create a “set aside” for companies less than ten years. But it applies only to national government purchases, about a third of all procurement. In 2018, it raised the goal to 3% of national contracts but has never come close. Moreover, some of this procurement has been for “me too” products like desks. A reformer involved in the Five-Year Plan said he and his colleagues were pushing to raise the goal to 10% and improve the quality of purchases, but that did not happen. Instead, the Plan just stated: “We will expand procurement from startups and quickly expand the contract ratio to 3% or more.” In short, the government simply promised to reach a goal it set years ago and never met without explaining what it would do differently.