In recent years, the Federal Government has made a move towards encouraging innovation in Australia by a series of tax concessions for innovative companies and their investors. One such tax concession is for investors in early stage innovation companies (‘ESIC’). These incentives include an immediate tax offset in addition to beneficial capital gains tax (‘CGT’) treatments.
The company must satisfy a series of tests before it can be classified as an ESIC.
Obtaining ESIC Status
Before investors in an ESIC can claim the two tax concessions, the company must first qualify as an ESIC. The ESIC status must be reconfirmed each time an investor subscribes for new shares in the company, though many of the tests will be satisfied for a whole income year.
Local Company Test
The first test is that a company must not be a ‘foreign company’ in accordance with Section 9 of the Corporations Act 2000 (Cth). A foreign company in this sense refers to one which has been incorporated outside of Australia, therefore if a company is created, owned and operate domestically, it is likely that they will satisfy this element.
Early Stage Test
Step two involves a variety of questions directed at the structure of the business and its current financial position. In particular, the following requirements must be met:
- The company’s equity interests are not listed for quotation in the official list of any stock exchange domestically or internationally;
- The company has an assessable income of $200,000 or less in the previous income year;
- The company had total expenses of $1 million or less in the previous income year; and
- The company is registered or incorporated within the Australian Business Register:
- Note: if neither incorporated nor registered within the last three income years, the company must have been incorporated in the last six income years plus additional tests on expenses
The 100-Point Innovation Test or the Principles-Based Innovation Test
The final requirement is that a company must satisfy either the 100-Point Innovation Test or the Principles-Based Innovation Test.
The 100-point innovation test is preferable for two reasons:
- It allows for self-assessment; and
- Gives greater certainty on whether it is satisfied (i.e. 100 points are obtained or not).
The company must get 100 points based on the circumstances of the company. The points can come from qualifying for the Research and Development Tax Incentive, holding certain patents or licenses, participation in some accelerator programs and whether the company has raised capital previously. Each requirement is very specific, and companies looking to qualify for ESIC status should carefully assess whether they qualify.
If the 100-point innovation test cannot be satisfied, the principles-based innovation test can be used instead. This test is complex due to the vague drafting of the legislation. Expert advice is necessary to satisfy this test, and often investors insist on ATO verifying the conclusion in a private ruling, as the tax risk sits with the investors.
Regardless of the particular test that you elect to utilise in determining your ESIC eligibility, it is crucial that the elements are satisfied at the ‘test time’, which is the time new shares are issued to the investors.
ESIC Investor Concessions
Investors to an ESIC may be eligible for certain tax concessions, which causes many start-ups to seek ESIC status when raising early capital. However, the tax offsets applicable to investors will vary based on whether they are a ‘sophisticated investor’ or a non-sophisticated investor as defined in the Corporations Act 2000 (Cth).
A sophisticated investor can obtain a maximum tax offset in one income year of $200,000. This is calculated as 20% of the investment made into qualifying ESIC’s. If the investor exceeds the cap of $200,000 for the tax offset, the remaining offset can be carried forward to use in the next income year.
The concessionary treatment of capital gains applies regardless of investment size for sophisticated investors. A capital gain made on ESIC qualifying investments shares are disregarded if they had been held longer than 12 months and less than 10 years. Capital losses on ESIC investments held less than 10 years are also disregarded.
If an ESIC investment is held for more than 10 years, on the 10th anniversary the investment will receive a market value cost base and will have normal CGT treatment for later years. This has the effect of ‘locking-in’ the tax-free value on the 10th anniversary, and capital gains from this date are taxed.
Investors who are not sophisticated investors can receive the same concessions as above, unless they invest more than $50,000 in an income year. If they do invest more than $50,000 in an income year, they are not entitled to both the tax offset and concessional CGT treatment.
The policy reasons for these restrictions are to discourage retail investors from over-exposure to higher risk investments.
It is important to note that, even where an entity indicates that it is ESIC-qualified, it is strongly recommended that each investor seeks their own tax and legal advice on the investment itself and whether they qualify as a sophisticated investor. This is particularly the case if the company relies on the Principles-Based Innovation Test.
If you would like to explore the possibility of your company qualifying as an ESIC, or you wish to invest in ESIC’s, or if you have any other tax-related questions, please do not hesitate to contact our tax law and ESIC specialists.