On 1 July 2016, the Australian Government introduced favourable tax concessions for investors who support Early Stage Innovation Companies (ESIC). The changes aim to encourage a culture of entrepreneurship and growth in Australia. If your startup satisfies the definition of an ESIC, and your potential investor is eligible, an investor may view your startup more favourably. Below, we set out the relevant tests both an investor and startup must satisfy.
The Tax Incentive
An eligible investor who makes an eligible investment in your startup will receive the following:
1. A 20% non-refundable, carry-forward tax offset on their investment (capped at $200,000 per investor, per year).
This means that for qualifying investments, the tax offset will reduce the investors yearly income tax bill, and if they don’t use all of their offset in one year, they can carry this forward for future income years. For example, say I am a sophisticated investor, and I invest $500,000 in an ESIC during the current financial year. I am now entitled to a $100,000 tax offset. I have to pay $20,000 in income tax that same year. I can apply $20,000 of my offset and reduce my income tax payable that year to zero. I can then carry forward the remaining $80,00 for future income years.
2. A 10-year capital gains tax (CGT) exemption for any eligible investment held for at least 12 months.
If a CGT event (such as a share sale) happens after the investor has held their shares for 12 months, the ATO will disregard any capital gain if an individual or trust (not a company) sold the shares. Consequently, an investor does not then pay tax on a capital gain. Equally, they cannot write off a capital loss. If this investor held their shares for over ten years, CGT will only be measured on the increase of the value of the shares between year ten and the CGT event.
An Eligible Investor
To qualify for the tax incentives, the investor must have invested into a company which meets the ESIC requirements at the time the startup issued shares. If at a later date, the company no longer meets the ESIC requirements, this will not affect the investor. Any investments before 1 July 2016 will not be eligible.
The investor must also satisfy the following:
- have purchased the newly issued shares directly from the company,
- hold no more than 30% of the equity interest in the company, and
- not be an affiliate of the ESIC (affiliate generally points to a position of control).
Importantly, investors who do not satisfy the ‘sophisticated investor test’ will only be eligible for the tax incentives if their total ESIC investment is less than $50,000. By investing more than $50,000 in ESICs, the investor will forfeit any tax incentive, even for the part of the investment which was under $50,000.
A ‘sophisticated investor’ is someone who either:
- holds a certificate issued by a qualified accountant that confirms they meet the asset and income requirements (namely a gross income of at least $250,000 for the last two years and net assets of at least $2.5 million),
- paid at least $500,000 for the shares in that company,
- controls assets worth at least $10 million,
- holds a financial services licence (i.e. a ‘professional investor’) or
- was offered the shares by a qualifying licensee.
An Eligible Startup
For founders, the most important part of this new legislation is whether or not they are eligible for ESIC status. As mentioned above, timing is crucial, as the company must qualify as an ESIC immediately after it issues new shares to the investor. The legislation has introduced a series of tests to determine whether a startup will be eligible as an ESIC.
A company will need to meet both the early stage test and either the 100-point innovation test or the principles-based innovation test.
Early Stage Test
|1||The company must have been either incorporated in Australia or registered on the Australian Business Register within the last three years.|
|2||The company and any subsidiaries must have had expenses of $1 million or less in the previous year.|
|3||The company and any subsidiaries must have assessable income of $200,000 or less in the previous year.|
|4||The company’s equity interests must not be listed on any stock exchange.|
If the company was incorporated in the last six years, to be eligible, it must show that it has had expenses of $1 million or less across the last three income years.
100-point Innovation Test: A test table is used to determine whether a company satisfies the 100 point innovation test. There are a number of different activities that a startup may be able to check off against the table to gain points, for example:
|50-75||15% or more of the company’s expenses for the previous year are eligible for deduction under a research and development tax incentive.|
|50||The company has completed or undertaken an eligible accelerator program.|
|25||The company has been granted a standard or innovation patent in the last five years.|
Principles-based Innovation Test: There are five requirements a company must meet to satisfy this test.
|1||The company must be genuinely focused on commercialising a new or significantly improved product, process, service or method.|
|2||The business relation to this must have high growth potential.|
|3||The company must demonstrate that it has the potential to scale the business successfully.|
|4||The company must demonstrate that it has the potential to address a broader than local market (including global).|
|5||The company must demonstrate that it has the potential to have a competitive advantage.|
These are more intangible than the 100-point test and will require the company to make a self-assessment and provide evidence. Generally speaking, the 100-point innovation test is a simpler test to satisfy than the principles-based innovation test.
Although the onus is on the investor to confirm that the company qualifies as an ESIC, it is in the company’s interests when securing this investment to be able to offer this up to the investor.
A company can request a ruling from the ATO on whether it qualifies as an ESIC, however, this is not mandatory. Indeed, this step can be costly (both in time and resources), and by the time the ATO makes a decision, the circumstances of your fast moving startup might have changed.
An alternative is to have your accountant or a specialist ESIC adviser make a determination on your status by following the tests that are laid out in the legislation.
There are considerable financial benefits available to an investor who invests in an ESIC, and these benefits will certainly flow through to the startup community. Startups looking to raise capital, and investors looking to buy in should then familiarise themselves with the new legislation. A startup that can pitch to an investor as an eligible ESIC will not only demonstrate its high growth potential and understanding of the sphere, but it will be much more attractive to that investor.