One of the many side effects of the Covid-19 pandemic has been that some pre-Covid tax incentives have been overlooked; in particular, the tax incentive for equity investments in early stage innovation companies (ESICs).
These incentives, first introduced for the 30 June 2017 year, include both a tax offset for investors and a capital gains tax (CGT) exemption from future gains made in shares in such ESICs.
This article briefly considers the tax incentives for investors in qualifying ESICs.
In addition, this article suggests that such ‘start-ups’ and / or new ‘innovative’ companies confirm their status as an ESIC, so as to assist in targeting equity investments from suitable investors.
1. Tax benefit to investors in ESICs
There are two significant tax incentives for eligible investors who invest in shares in an ESIC. These are:
- a non refundable carried-forward tax offset equal to 20% of the amount paid for the ESIC shares. This is capped at a maximum amount of $200,000 for the investor in any financial year. (In other words, if an eligible investor invested $1 million in buying an ESIC’s shares, their maximum tax offset, which can be offset against other tax payable, for that year would be 20% of their $1 million investment – ie an offset of $200,000); and
- a full CGT exemption on any capital gains made where the ESIC shares are held for at least 12 months and less than 10 years. (Note that, regrettably, capital losses made on such shares held for less than 10 years are also disregarded.) Where the ESIC shares are held for more than 10 years, investors obtain a market value CGT cost base at the 10 year mark.
Potential investors should note that the maximum tax offset cap (of $200,000 per financial year) does not limit the CGT exemption for capital gains made on such ESIC shares. In other words, for sophisticated investors, the CGT exemption on such shares is not subject to an annual cap.
2. The ‘sophisticated investor’ test
Generally speaking, the incentive is aimed at so called ‘high net worth individuals’ who invest in ESICs. In order for an individual to qualify for the maximum annual tax offset of $200,000 per annum, the individual must qualify as a ‘sophisticated investor’ under the Corporations Law.
There are many ways of satisfying the sophisticated investor requirement. The most common is obtaining a certificate from an accountant, confirming that the individual has gross income of at least $250,000 for each of the two previous financial years, or has net assets of at least $2.5 million.
For the purposes of this article, the critical point is that in order to maximise the tax offset in an ESIC, the investor needs to satisfy the ‘sophisticated investor’ test.
3. Limits on investors who don’t meet the ‘sophisticated investor’ test
Where an investor does not meet the ‘sophisticated investor’ test, the investor is limited to an amount of $50,000 per annum that they can invest in qualifying ESIC shares. (In other words, their maximum annual tax offset is limited to $10,000 per financial year.)
Note there is a sting in the tail in these rules for non-sophisticated investors. The rules provide that if such an investor invests more than $50,000 in new shares in a qualifying ESIC in a financial year, then they would not be entitled to receive any ESIC tax incentives for that year. This was a deliberate move on the government’s part to ensure that so called ‘retail investors’ did not invest in too many investments with a degree of risk attached to them.
4. How does the company qualify as an ESIC?
In order for investors to obtain these tax benefits, the company itself must qualify as an ESIC for the purposes of these rules.
In summary, the rules require that the relevant company meets both:
- the early stage test; and
- either the:
- 100 point innovation test; or
- principles-based innovation test.
(a) The early stage test
There are four requirements in order to meet this test:
- the company needs to have been incorporated or registered in the Australian Business Register;
- the company (plus any wholly owned subsidiaries) must have total expenses of $1 million, or less, in the previous financial year;
- the company (plus any wholly owned subsidiaries) must have assessable income of $200,000 or less in the previous income year; and
- the company’s equity interests are not listed in a stock exchange in Australia or in a foreign country.
(b) 100 point innovation test requirements
To qualify under the 100 point innovation test, the company must obtain at least 100 points by meeting certain objective innovation criteria described below. The relevant 100 point test time is immediately after the shares are issued to the investor.
Below are examples of the criteria that allow a company to obtain points for the purposes of the 100 point innovation test:
- where the company has qualified in the previous income year for the research and development tax incentive;
- where the company has received an Accelerating Commercialisation Grant;
- whether the company has completed or is undertaking an eligible Accelerator program;
- where one or more third parties have previously paid a total of at least $50,000 for the issue of new shares in the company (but provided the third party was not an associate of the company, or the share purchase was not part of a scheme to assist another entity to become entitled to the ESIC tax incentives);
- where the company has a patent, plant breeders rights or some other intellectual property rights granted in the last five years; and
- where the company has a written agreement to co-develop and commercialise an innovation with certain institutions or educational type bodies.
(c) The principles-based innovation test
This test requires the following five requirements to be met:
- the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation;
- the business relating to that innovation must have a high growth potential;
- the company must demonstrate that it has a potential to be able to successfully scale up that particular business;
- the company must show that it has the potential to focus on a broader market than just the local market – ie, that there is global potential; and
- the company must demonstrate that it has the potential to have some competitive advantages for that particular business.
5. Company reporting requirements
ESICs are also required to complete a form to the ATO declaring that they meet the requirements above so as to qualify as an ESIC. In particular, the company will be asked to specify whether it has satisfied the 100 point innovation test, or the principles-based innovation test for ESIC-qualification purposes.
The company will also then be required to report on the investors who are likely to be claiming the ESIC investor tax incentives on the basis that the company itself is an ESIC.
In summary, the ESIC rules make equity investments in qualifying ESICs more attractive to potential investors. The rules achieve this as follows:
(a) Where the investor meets the ‘sophisticated investor’ test, they will obtain a 20% tax offset (based on their equity investment in the ESIC), to a maximum offset of $200,000 per financial year. Any excess offset can be carried forward to use in future years.
(b) The relevant investor also obtains a CGT exemption on capital gains made on the shares where the shares are held for more than 12 months and sold within 10 years. Note that where the shares are held for more than 10 years, the investor will obtain a market value uplift to the value of the shares at the 10 year mark.
(c) For ‘retail investors’, the tax offset is reduced. Non-sophisticated investors will obtain a 20% tax offset to a maximum annual investment in ESICs of $50,000 per annum. In other words, their maximum annual tax offset is limited to $10,000 per annum.
(d) As you might expect, most of the work required to qualify under these rules is squarely aimed at the relevant ESIC. It will therefore be necessary to determine that the company meets either the ‘100 point innovation test’ or the ‘principles-based innovation test’.
(e) Finally, it is necessary to inform the ATO that the company considers itself as meeting the ESIC requirements and further, that non-affiliated investors will be seeking to obtain both the relevant ESIC tax offset and CGT exemption applicable to them.
As a general rule of thumb, if a relatively new company qualifies for the research and development tax incentive, there is a good chance that it will also be an ESIC for the purposes of these rules. In our experience, the ESIC’s chances of obtaining new equity are greatly enhanced by offering investors the ESIC incentives of the 20% tax offset and the CGT exemption on future capital gains on the company shares.
If you have any questions about this article, please get in touch with an author or any member of our Tax team(s).
This information and the contents of this publication, current as at the date of publication, is general in nature to offer assistance to Cornwalls’ clients, prospective clients and stakeholders, and is for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.