In brief - Measures will help start-ups overcome capital raising difficulties
As part of the National Innovation and Science Agenda, new measures in the Income Tax Assessment Act 1997
have come into effect on 1 July 2016 to stimulate investment in early stage innovation companies (ESICs) to assist them to overcome difficulties in raising capital in the start-up phase. The measures will be particularly attractive to sophisticated investors as defined in the Corporations Act 2001
Tax offset and modified capital gains tax treatment
The new provisions allow some investors in ESICs to a tax offset and modified capital gains tax treatment for shares acquired on or after 1 July 2016.
The tax offset is 20% of the amount invested and can be carried forward to future income years, but is not refundable. Unlike a tax deduction, a tax offset directly reduces the amount of tax payable by 100 cents in the dollar.
For sophisticated investors the tax offset is limited to $200,000 for each income year. Therefore the tax offset is available for investments of up to $1 million. This threshold includes tax offsets carried forward to that year and the tax offset entitlements of any affiliates. An affiliate is a person or a company that in relation to business affairs, acts or could reasonably be expected to act in accordance with the directions or wishes of, or in concert with, the investor.
Under the modified capital gains tax treatment:
- the shares are exclusively taxed under the capital gains tax provisions
- any capital gain is exempt provided that the shares have been held continuously for at least one year but not more than ten years
- if the shares are held for at least ten years, capital gains are taxable but the cost base is the market value of the shares on the tenth anniversary of acquisition
The quid pro quo for the modified capital gains tax treatment is that investors are not entitled to capital losses in the first ten years of ownership.
The threshold for sophisticated investors for the tax offset does not apply to the modified capital gains tax treatment.
A non-sophisticated investor is not eligible for either incentive if the amount invested is more than $50,000 in one income year. The maximum tax offset for non-sophisticated investors is therefore $10,000. This threshold is intended to prevent non-sophisticated investors being over-exposed to investments in ESICs.
Who is an eligible investor?
Generally, any form of resident or foreign entity is eligible for the incentives, but widely held companies (generally listed companies and companies with more than 50 members) or their wholly owned subsidiaries are not eligible. In addition, affiliates (as defined above) of the ESIC are also not eligible. An investor will also not be eligible in any of the following circumstances:
- the shares are not equity interests for tax purposes (for example, some forms of redeemable preference shares)
- the shares are not newly issued shares
- the investor holds more than 30% of the shares in the ESIC or any entities connected with the ESIC*, immediately after the shares are issued, or
- the shares were acquired under an employee share scheme
* An entity is connected with the ESIC if the entity either controls, or is controlled by the ESIC, or both entities are controlled by the same entity.
Although foreign residents can qualify for the incentives, the tax offset will be of no benefit if the foreign resident does not have an Australian tax liability. Further, the modified capital gains tax treatment will only be of benefit to foreign residents where the ESIC invests in Australian real property (including mining, quarrying and prospecting rights).
Early stage investment companies are those that pass early stage test and innovation test
An ESIC is a company that passes the early stage test and the innovation test immediately after the shares are issued.
To meet the early stage test, the ESIC must meet the following requirements:
1. the ESIC must have been recently incorporated or registered on the Australian Business Register. To satisfy this requirement, one of the following must be satisfied:
(a) the ESIC must have been incorporated in Australia within the last three income years
(b) the ESIC must have been incorporated in Australia within the last six income years, and in the last three of those years it and its wholly owned subsidiaries incurred expenses of $1 million or less, or
(c) the ESIC was registered on the Australian Business Register within the last three income years
2. the ESIC and its wholly owned subsidiaries incurred expenses of $1 million or less in the previous income year
3. the ESIC and its wholly owned subsidiaries had a total assessable income of $200,000 or less in the previous income year
4. the ESIC is not a listed company
Innovation test is based on 100 point test or principles-based test
To meet the innovation test, the ESIC must satisfy either a 100 point test to establish its innovation status or a principles-based test.
The 100 point test is based on the accumulation of points if certain objective criteria are met. The criteria relate to such matters as the level of expenditure on research and development, the receipt of at least $50,000 in funding from a third-party investor and holding enforceable intellectual property rights. Regulations may be made to expand the criteria.
The principles-based test requires the following subjective criteria to be satisfied:
1. the ESIC is genuinely focused on developing one or more new or significantly improved innovations for commercialisation
2. the business relating to that innovation has a high growth potential
3. the ESIC can demonstrate that it has the potential to be able to scale the business
4. the ESIC can demonstrate that it has the potential to be able to address a broader than local market
5. the ESIC can demonstrate that it has the potential to be able to have competitive advantages
Regulations may be made to allow the government to tailor the incentives so that certain innovations or ESICs are excluded, for example where the Australian Taxation Office (ATO) considers that the measures are being abused.
While ESICs can self-assess satisfaction of the innovation test, it is possible to obtain a binding ruling from the ATO. To avoid uncertainty, we expect that many ESICs will elect to obtain a ruling.
Annual reporting requirement is triggered by issuing shares
An issue of shares by ESICs triggers a requirement to submit a form annually to the ATO which contains details of the eligible investors and the shares issued. Although the form is being developed, we understand that it will include a declaration that the ESIC meets the applicable requirements.
Further information available on Australian Taxation Office's website
This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2023.