Tax Incentives for Early Stage Investors
- Financing a Business
The Early Stage Innovation Company (“ESIC”) rules were introduced in July 2016 as a means of incentivizing investment into start-up and innovation focused companies. These concessions provide a great benefit for early investors which can help businesses to attract investment and help investors maximise their ROI. We outline throughout this article some of the key eligibility criteria.
If an investor makes an investment into an ESIC eligible company, the investor receives the following benefits (which are substantial):
- Non-Refundable carry forward tax offset equal to 20% of the investment. This means, the investor gets a credit towards their income tax equal to 20% of the value of the investment they make; and
- Modified capital gains tax treatment under which any capital gain made between 12-months and 10 years is disregarded. This means that the investor will pay no capital gains tax if they sell the investment after owning the shares for greater than 1 year and within 10 years. If the investor holds the investment for greater than 10 years, the market value at the 1o year point will become the next cost base for tax purposes, so that they don’t pay tax on the gains made in the first decade.
The downside is that the investor won’t get to claim a capital loss if the shares are sold at a loss in the 10 year period.
There are annual caps that apply to investors:
- Sophisticated investors can invest up to $200,000 per year into ESIC qualifying investments
- Other investors can invest up to $50,000 per year into ESIC qualifying investments
ESIC ELIGIBILITY CRITERIA
For a company to qualify as an ESIC it should not be a foreign company and must satisfy both requirements:
- Early stage test; and
- 100-point innovation test or principle-based innovation test
The 100-point innovation test is an objective test and the simplest way to determine if a company is qualified while, for principle-based innovation test, the company must be able to demonstrate how will it meet the requirements.
EARLY STAGE TEST
The criteria for the early stage test are as follows:
- The company must have been incorporated or registered on the Australian Business Register within the last three income years (counting current income year in which the requirement is being tested)
- The company (plus any wholly-owned subsidiaries of the company) must have the following:
- total expenses of $1 million or less in the previous income year
- assessable income of $200,000 or less in the previous income year
- The company’s equity interests shall not be included in the list for the quotation of the official list of any stock exchange, in Australia or any country
QUALIFICATIONS FOR THE PRINCIPLE-BASED INNOVATION TEST
The company must center on the development of one or new notable improved innovations for commercialization, in relation to that, the business should possess high growth potential. Potentially speaking, the company must have demonstrated:
- To be able to successfully scale-up that business
- Reach wider market including local and global markets through the said business
- Must be able to have competitive advantages
The company may request a ruling from the ATO, in order to determine if they are qualified for as an ESIC for principle-based innovation test.
100-POINT INNOVATION TEST
To qualify for the 100-point innovation test, the company must attribute set of points and must self-assess if the said company has reached the needed points. If the investor does not meet qualification or obtain needed points the ESIC will be amended.
The corresponding points is dependable on the 100-point innovation test requirements including:
- At least 50% of the company’s total expenses for the previous income year are eligible notional deductions for the research and development tax incentive [50 points are given if the percentage is between 15% and 50%]
- The company has received an Accelerating Commercialisation Grant
- The company has completed or is undertaking an eligible accelerator program that provides time-limited support for entrepreneurs with a start-up business.
- The entity providing the program has to have been providing eligible programs for at least six months, and the programs must have been completed by at least one cohort of entrepreneurs.
- One or more third parties have previously paid a total of at least $50,000 for the issue of new shares in the company. These points are available only if:
- the third party was not an associate of the company immediately before it was issued with the shares and did not purchase those shares primarily to assist another entity to become entitled to early stage investor tax incentives
- the company issued the third party with the shares at least one day before the test time
- The company has enforceable rights on an innovation through an innovation patent and design right granted in Australia in the last five years or granted in another country for an equivalent intellectual property right.
- The company has a written agreement to co-develop and commercialise an innovation with:
- an institution or body listed in Schedule 1 to the Higher Education Funding Act 1988, or
- an entity registered as a Research Service Provider
We find these rules to be a great incentive when we are speaking with potential investors into start-up or scale-up businesses. It offers an investor a means of getting an upfront tax rebate on their investment (to reduce their risk exposure) and the benefit of no capital gains tax means that the future exit will provide a far greater return, than if tax were payable.
The ESIC concessions need to be carefully navigated and reported to the ATO each year.
If you would like assistance with applying the ESIC tax concessions and to see if you are eligible, please contact us.