In response to the announcement of the Government’s National Innovation and Science Agenda (NISA) on 7 December 2015 and the release of the discussion paper in February 2016 (Discussion Paper), the Government introduced the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (the Bill) on 16 March 2016. The Discussion Paper estimated that over 4500 start-ups are missing out on equity finance each year, and this is resulting in a lack of innovative end-product goods and services.
The Bill lapsed due to prorogation on 15 April 2016. It was restored on 2 May 2016 and on 5 May 2016 the Bill received Royal Assent to become an Act.
The changes ushered in by this new legislation affect early stage investors and small businesses alike. Here, Partners Justin Byrne and Hayden Delaney answer some of the key questions around eligibility requirements, offset and exemption mechanisms, and the potential impact on your business.
Cognisant of stakeholder concerns, the Government drafted the Bill in order to provide tax concessions in two ways:
- by inserting a new Subdivision 360-A termed ‘tax incentives for early stage investors in innovation companies’, which sets out the circumstances when an investor qualifies for the tax offset and the modifications to the CGT treatment of eligible investments; and
- amending the early stage venture capital limited partnership (ESVCLP) and venture capital limited partnership (VCLP) regimes within the Venture Capital Act 2002 (VCA) and Income Tax Assessment Act 1997 (Cth) (ITAA 97).
These legislative reforms raise several key questions, such as:
- What eligibility requirements must investors and start-ups satisfy to qualify for the early stage investors tax incentives?
- Practically, how will the tax offset incentive work?
- Practically, how will the CGT exemption work?
- If my business is an ESVCLP or VCLP, how do the amendments to the VCA and ITAA 97 affect my business?
Tax Incentives for Early Stage Investors
The Explanatory Memorandum to the Bill suggests that the proposed incentives are designed to encourage innovation by connecting relevant start-ups with investors that have the funds and business experience to assist entrepreneurs. This investor incentive, which is based on the UK’s successful Seed Enterprise Investment Scheme, has the potential to create an immediate flow of capital to the industries that drive innovation.
The attractive tax offsets afforded to “Angel” investors are intended to operate in the following manner.
The start-up must first satisfy a two-limb test:
Limb 1: “Early Stage Limb” (section 360-40(1)(a)-(d))
- the business must have recently (within the preceding three income years) been incorporated;
- the total expenses of the business are $1 million or less;
- the derived assessable income of the business is $200 000 or less; and
- the business is not listed on the stock exchange.
Limb 2: “Innovation Limb”
Following this, the company must then satisfy the ‘objective test’ in section 360-45 or the ‘principles based test’ in section 360-40(1)(e).
- The Objective Test requires a combined 100 points from any of the following criteria: high level of research and development, in receipt of an Accelerating Commercialisation Grant; participation in the accelerator programs for entrepreneurs or ownership of intellectual property rights granted within the past five years.
- The Principles Based Test requires the company to show: it has the potential for high growth, has scalability, can address a broader than local market and/or has a competitive advantage.
An investor will be eligible for the twenty per cent up-front non-refundable tax offset, provided:
- the investor is a company, individual or trust/partnership member (including foreign investors), but not a widely held company (or a 100 per cent subsidiary thereof) (section 360-15);
- are issued with shares (that are not an Employee Share Scheme (ESS) interest under Division 83A) in a qualifying Early Stage Innovation Company (ESIC) (section 360-15(1)(b),(c),(e));
- they are not affiliated (broadly, neither party could reasonably be expected to act in accordance with the wishes of or in concert with the other (sections 328-130, 360-15(1)(d)); and
- immediately after the acquisition they do not hold more than thirty per cent of the equity interests in the ESIC or an entity connected with the ESIC (section 360-15(1)(f)).
Interestingly for investors, they will not lose this benefit if, at some time after when shares are issued, the relevant ESIC fails to satisfy the above conditions.
Qualifying investors are then permitted the following tax concessions under this automatic regime:
2. Twenty per cent Up-front Non-refundable Tax Offset
- a twenty per cent non-refundable tax offset on investments equal to 20 per cent of the value of the ESIC investment capped at $200 000 per investor per year (section 360-25(1));
- any unused component of the twenty per cent tax offset can be carried forward and used against future tax liabilities (section 360-25(2));
- the twenty per cent tax offset can pass through trusts and partnerships to the underlying members (section 360-15(2)); and
- the twenty per cent tax offset is available to unsophisticated investors generally, where the investment is less than $50 000 in an income year (section 360-20).
3. CGT Exemption
- qualifying investors will be exempt from CGT in respect of gains from the disposal of ESIC shares held for greater than twelve months, but less than ten years (section 360-50(1));
- if ESIC shares are held for longer than ten years, the CGT exemption will be applied to any gain attributable to the period up to the tenth anniversary (section 360-50(4)); and
- capital losses will not be available in respect of a failed ESIC (section 360-50(2);
- investors will receive deemed capital account treatment on their ESIC investment (section 360-50(2));
- investments must held be for three years or more to be eligible for the ten year CGT exemption (refer to the diagram below).
Click here to view image.
As part of the NISA, the Australian Government provided practical guidance on how this part of the amendment was intended to operate:
“Jessica is the founder of a start-up business called PaySmart Pty Ltd that is developing a software application to automate bill payments. She is looking to raise $200 000 in equity finance to continue developing of the software.
Alex is an experienced early stage (angel) investor and believes that PaySmart has excellent growth potential. He invests $200 000 and claims a twenty per cent non-refundable tax offset, reducing his income tax payable by $40 000.
In addition to contributing capital, Alex uses his business skills to help PaySmart grow. He sells his shares for $400 000 four years later. As Alex has held the investment in PaySmart for the minimum three year period and less than ten years, the full capital gain of $200 000 is exempt from capital gains tax.”
Venture Capital Investment
4. Effect of the Amendments to VCLPs and ESVCLPs
In addition, the Bill also amends the ESVCLP and VCLP regimes within the VCA and ITAA 97. Intended to encourage innovation, risk-taking and an entrepreneurial culture in Australia according to the Explanatory Memorandum, the venture capital investment provisions are a welcome addition.
The threshold requirements are as follows:
A VCLP must:
- receive at least $10 million in contributed capital from its partners; and
- VCLP’s total assets must not exceed $250 million.
An ESVCLP must:
- receive a minimum investment of $10 million;
- there is a $200 million cap (previously $100 million) on investment; and
- the entities the ESVCLP invest in must be valued at less than $50 million.
The reforms will provide the following tax concessions:
- a non-refundable carry-forward tax offset for limited partners in ESVCLPs, equal to up to ten per cent of contributions made by the partner to the ESVLCP during an income year;
- a removal of the requirement that an ESVCLP divest an investment in an entity once the value of the entity’s assets exceed $250 million, but restricting tax concessions for such investments; and
- allowing entities in which a VCLP, ESVCLP or an Australian venture capital fund of funds has invested to invest in other entities, provided that after the investment the:
- investee controls the other entity; and
- the other entity broadly satisfies the requirements to be an eligible venture capital investment.