Since 1 July 2016 an investment in an early stage innovation company (ESIC) may be eligible for tax incentives.
What follows is an outline of the items that potential ESIC investors need to consider.
What Entities Qualify as an ESIC?
To qualify as an ESIC the investment entity must satisfy two requirements.
Requirement 1 – Early Stage Start-Up
The entity must:
- be incorporated as an Australian resident company within the last 3 years (or 6 years if within the last 3 years expenses of less than $1 million have been incurred);
- incur less than $1 million of expenses in the current year;
- have a total assessable income of less than $200,000.00; and
- not have its shares listed on the Australian Stock Exchange.
Requirement 2 – Innovation Limb
This requirement can be satisfied if the entity passes one of the two tests below.
Requirement 2A – Principles Based Test
Entities may choose to self-assess their eligibility against the principles-based test, which focuses on the substance of the entity in determining whether its activities constitute innovation. This test sets down basic guiding principles without being prescriptive and, consequently unintentionally exclusive. However, this lack of prescription also make the test ambiguous and difficult for the companies to opine on with certainty.
To pass the principles-based test, a company must demonstrate:
- The business is focussed on innovative commercial offerings;
- The business has high growth potential;
- The business is scalable;
- The business offerings are capable of being sold to a broad market; and
- The business exhibits a competitive advantage for its offerings.
Requirement 2B – The 100 Points Test
The ESIC rules are drawn widely to include services, processes or marketing or organisational methods as offerings.
A 100 point test outlines various innovation criteria that can be applied to enable an objective answer as to whether the business qualifies as an ESIC. As an example 75 points can be earned either because more than 50% of the businesses’ expenditure would qualify as R & D expenditure or the business has received an accelerating Commercialisation Grant. See Table 1.
The ESIC Incentives
There are two incentives offered to investors under an ESIC entity:
- A tax offset is granted to investors; and
- No capital gains tax is payable on sale of the ESIC shares.
Individuals are entitled to a tax offset if they meet certain conditions, including if the company:
- is an ESIC;
- is not an affiliate of the company;
- shares are not issued as part of an employee share scheme; and
- after the issue of the shares the investors holds less than 30% of the shares in the ESIC entity.
The tax offset granted is 20% of the total amount paid for the shares issued to the investor. The amount of the tax offset the investor can claim (or carry forward) is limited to $200,000.00.
The capital gains tax provisions apply if the issuing of a share gave rise to an entitlement to an offset.
The shares are held to be on capital account, meaning shares can only be taxable under the CGT provisions and not as trading stock or as an income asset.
An investor cannot claim a capital loss that may be made on disposal of the shares.
Any capital gain made on the shares within 10 years of buying them can be disregarded.
If the shares are held longer than 10 years a market value cost base is applied on the 10th anniversary of holding the shares. Any loss or gain made after 10 years is calculated using the market value at that time as a starting point.
Qualifying for the Tax Incentives
To qualify for the tax incentives, investors must have purchased new shares in a company that meets the requirements of an ESIC immediately after the shares are issued. The shares must be issued on or after 1 July 2016.
If the company no longer meets these requirements after the ‘point-in-time’ test is applied, this does not affect the investor’s entitlement to the early stage investor tax incentives.
The ESIC tax incentives are not available to an investor if:
- the investor did not purchase the shares in the ESIC directly from the company as newly issued shares;
- the investor did not meet the sophisticated investor test and the total investment in qualifying ESICs in an income year is more than $50,000;
- the investor and the ESIC are affiliates of each other immediately after the shares are issued. An affiliate is an individual or company that, in relation to their business affairs, acts or could reasonably be expected to act in accordance with the investor’s directions or wishes or in concert with the investor;
- the investor holds more than 30% of the shares in the ESIC together with any entities connected with the ESIC, immediately after the relevant shares are issued. 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 third entity; or
- the investor acquired the shares under an employee share scheme.
The tax incentives are not available to an investor that is a widely held company or a wholly-owned subsidiary of a widely held company. A widely held company is either a company that is listed on an approved stock exchange, or a company with more than 50 shareholders (unless certain requirements are met).
The ESIC tax incentives are available to both Australian resident and non-resident investors.
If the investor is a trust or partnership, special rules apply so that entitlement to the tax offset flows through to the member of the trust or partnership (or the ultimate member if there is a chain of trusts or partnerships).
A self-managed super fund may be eligible for the early stage investor tax incentives, however the usual rules about their investments will apply. This includes the restrictions on investing in a related company and arms-length terms if a limited recourse borrowing arrangement is used to fund the investment.
The Sophisticated Investor Test
Under the Corporations Act 2001, ‘sophisticated investors’ who meet certain requirements do not have to be provided with a disclosure document, such as a prospectus or product disclosure statement, when being offered shares in a company.
Under sophisticated investor rules, an investor may be a sophisticated investor if one of the following applies to the investor for at least one offer of qualifying shares in an ESIC in an income year:
- the investor holds a certificate issued by a qualified accountant within six months of the qualifying shares being offered to the investor, which confirms the investor meets certain asset and income requirements. At the time of publication, this certificate is available only if the investor has a gross income of at least $250,000 per year and net assets of at least $2.5 million;
- the investor has paid at least $500,000 for the qualifying shares (including any amounts the investor previously paid for shares of the same class that the investor holds in the same company);
- the investor is offered the qualifying shares through a financial services licensee who is satisfied that certain requirements are met and the investor signs a written acknowledgement that the licensee has not given the investor a disclosure document in relation to the offer;
- the investor meets the requirements of being a ‘professional investor’ under the Corporations Act 2001 (such as a financial services licensee); or
- the investor has or controls gross assets of at least $10 million (including any assets held by an associate or a trust that the investor manages).
Where the investor meets the sophisticated investor test, there is no restriction on the amount that the investor can invest in an ESIC, except that the investor cannot hold more than 30% of the shares in the ESIC or a connected entity immediately after the shares are issued or have a degree of influence to be an affiliate of the ESIC.
Limits for Investors Who do not Meet the Sophisticated Investor Test
If the investor does not meet the sophisticated investor test and the investors’ total investment in one or more qualifying ESICs in an income year exceeds $50,000, the investor will not be eligible for either:
- the early stage investor tax offset for any of the investor’s investments in that income year, or
- the modified CGT treatment for any of the investor’s investments in that income year.
This applies to all of the shares the investor purchased in that income year, including to the amount of the investor’s investments that are below $50,000.
This limit is intended to ensure that the tax incentives do not encourage retail investors to be over-exposed to the risk that is inherent in investing in qualifying ESICs.
If the investor meets the requirements of the sophisticated investor test for at least one offer of qualifying shares in an ESIC during an income year, this limit does not apply to the investor.
The CGT Treatment
The CGT treatment for ESIC shares is determined solely by whether a tax offset entitlement arose on their acquisition.
If a share in an ESIC is disposed of within 10 years of the date of acquisition then any gain made on the disposal may be disregarded.
Similarly if the disposal of the share gave rise to a capital loss then the capital loss is to be disregarded.
If the share is held longer than 10 years then the market value of the share on the 10th anniversary of its acquisition will be taken to be its cost base for gains or losses made after that date.
As the shares are deemed to be acquired on capital account the only way that a disposal of them can give rise to tax will be under the capital gains tax provisions. Any income from the sale of the shares cannot be taxed in any other way.
Being able to disregard a capital gain will have different consequences depending on which entity owned the asset. Below I will quickly consider the situation of each possible investor:
- An individual has the simplest position. The gain is disregarded, it does not have to be included in the individual’s tax return and is therefore available to them as if they were an after tax return on an investment.
- A partnership is dealt with so that each partner will be treated as if they directly owned an ESIC share and will be treated as if they were an individual, i.e. their share of the gain in the disposal of an ESIC share will not be taxable.
- A discretionary trust is also in a relatively simple position. The discretionary trust will not include the gain in its tax return and treat the receipt as a non-taxable accretion to the capital of the trust.
- A private company will not be able to pass the benefit of the tax free gain to its shareholders. The shareholder will receive any dividend paid by the company sourced from the gain as an unfranked dividend and so the exemption will be lost.
- A unit trust has a similar dilemma to the company. The unit trust cannot distribute the exempt gain to its unitholders without eroding their cost base and potentially giving rise to a taxable capital gain in their hands.
Hence any person considering investing in an ESIC should consider doing so either in their own name or through a discretionary trust.
Ongoing ESIC Reporting Obligations
A company that issues ESIC shares will be required to provide certain information in the approved form to the ATO within 31 days of that financial year end. The approved form has not yet been finalised; however, the ATO has indicated certain information will likely be mandatory, such as:
- ESIC identification information, such as TFNs, names, addresses and ABNs;
- ESIC qualification information, such as:
- a declaration that the company qualifies as an ESIC for all share issues reported on the form;
- a declaration that the company is not an affiliate or any investor reported on the form;
- a description of the innovation’
- which innovation test is satisfied, that is:
- the 100 points test; or
- the principles-based test; and
- ruling(s) received; and
- investor identification information, such as names, addresses and the type of investor, e.g. individual / trust / partnership.
|75 points||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.|
|75 points||The company has received an Accelerating Commercialisation Grant under the program administered by the Commonwealth known as the Entrepreneur’s Programme.|
|50 points||At least 15% but less than 50% of the company’s total expenses for the previous income year are eligible notional deductions for the research and development tax incentive.|
Examples of entities that would be an associate of a company include:
A company that holds a license to intellectual property owned by another party is able to obtain these points.
A company that holds a license to intellectual property owned by another party is able to obtain these points.
These points are only available if the company did not receive 50 points for holding a standard patent, plant breeder’s right or equivalent right overseas under the previous criterion.
The company has a written agreement to co-develop and commercialise an innovation with either:
Corporate Lawyers Sydney at Pavuk Legal can provide you with legal advice in respect of your investment in an Early Stage Innovation Company (ESIC) and how to qualify for any ESIC tax incentives you may be eligible for, as well as structure entities to provide ESIC incentives to the shareholders.
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