What start-ups need to know about the new tax incentives for early stage investors

  • By Gary Shapiro
  • 23 Mar, 2016

A version of this article appears in   StartupSmart

A Bill proposing a series on new tax incentives for innovation was introduced to parliament last week to encourage new investment in Australian early stage innovation companies (ESICs) with high growth potential by providing qualifying investors, who invest in such companies, with a tax offset and a capital gains tax (CGT) exemption for their investments.

Background

The Australian Government currently provides tax concessions to support innovative Australian companies through the Research and Development (R&D) Tax Incentive, Early Stage Venture Capital Limited Partnership (ESVCLP) and Venture Capital Limited Partnership (VCLP) regimes.

The tax incentive for early stage investors (TIFESI) is designed to promote an entrepreneurial and risk taking culture by connecting relevant start-up companies with investors and aim to bridge the funding gap between pre-concept stage financing and support (typically provided through self-funding, friends and family and government offsets such as the refundable R&D tax offset) and financing through the ESVCLP and VCLP regimes for companies further along the development pathway.

The legislation can be quite confusing and time consuming to go through, so to make it easier it is summarised below. For those interested, the Bill and Explanatory memorandum can be found   here .

Summary of the benefit

There are two main benefits of the proposed legislation:

  1. Entities that acquire newly issued shares in an Australian ESIC (as defined later on in this article) may receive a non-refundable carry-forward tax offset of 20 per cent of the value of their investment subject to a maximum offset cap amount of $200,000. A total annual investment limit of $50,000 applies to retail (non-sophisticated) investors.
  2. In addition, investors may disregard capital gains realised on shares in qualifying ESICs that have been held for between one and ten years. Investors must disregard any capital losses realised on these shares held for less than ten years.

If the Bill becomes law it is proposed that these amendments apply in relation to shares issued on or after 1 July 2016 and would not be retrospective.

Which investors qualify for the tax incentives?

  • The tax incentives introduced by these amendments are available to all types of investors, regardless of their preferred method of investment (whether an investment is made directly as a corporation or individual or indirectly through a trust or partnership) other than ‘widely held companies’ and 100 per cent subsidiaries of these companies. A trust or partnership will not directly be entitled to the tax offset, however, specific rules apply to ensure the value of these tax incentives flow through to beneficiaries and partners, where such an investment method is chosen.
  • To ensure the tax offset is broadly available for all prospective investors, there are also no restrictions on an investor entity’s residency. That said, the tax offset may be less attractive to foreign residents that do not have an Australian income tax liability.
  • Non-sophisticated investors are limited to investing amounts of $50,000 and below in an income year.

There are some relationship restrictions on the investors:

  • In order to qualify for the tax offset, the ESIC must not be an affiliate of the investor entity nor can the investor entity be an affiliate of the ESIC at the time the relevant shares are issued.
  • In order to qualify for the tax offset, the investor entity must not hold more than 30 per cent of the equity interests of an ESIC, including any entities ‘connected with’ the ESIC.

What type of investment qualifies?

  • Qualifying shares are newly issued equity interests that are shares in a qualifying ESIC. These rules ensure that the tax incentives are targeted at new investors in a qualifying ESIC rather than shares issued under an employee share arrangement or in relation to interests with a debt character, such as preference shares. Investors that acquire equity interests from the conversion of convertible notes are not precluded from qualifying for the tax offset, where the company issuing those equity interests is a qualifying ESIC at the time of the conversion into shares.

What is a qualifying ESIC?

Generally, an Australian-incorporated company will qualify as an ESIC if it meets the tests of being at an early stage of its development ( the early stage limb) and it is developing new or significantly improved innovations with the purpose of commercialisation to generate an economic return ( the innovation limb).

The early stage limb

A company must pass four tests to satisfy the early stage limb of the qualifying ESIC test. Each of these tests is discussed below:

  1. The company must have been incorporated in Australia within the last three income years.
  2. The company and any of its wholly-owned subsidiaries must have not incurred ‘total expenses’ of more than $1,000,000 in the previous income year.
  3. The company and any of its wholly-owned subsidiaries must have derived assessable income of no more than $200,000 in the previous income year.
  4. The company must not be listed on any stock exchange

The innovation limb

In order for companies to determine if they satisfy the innovation limb of the qualifying ESIC test companies may choose to:

  1. apply their circumstances against the   objective tests ;
  2. self-assess their circumstances against the   principles-based test ; or
  3. seek a ruling from the Commissioner about whether their circumstances satisfy the principles-based test.

 

The principles-based test

To meet the principles-based test, a qualifying ESIC will need to be genuinely focused on developing its   new or significantly improved   innovation   for the purpose of   commercialisation   and show that the business relating to that innovation:

  • has the potential for   high growth ;
  • has   scalability ;
  • can address a   broader than local market ;
  • has   competitive advantages .

To further define these 7 requirements:

  1. Innovation
    • The Oslo Manual, published by the Organisation for Economic Co-operation and Development (OECD) provides a description of different types of innovations and a copy of this manual is available on the OECD website ( www.oecd.org) .
  2. New or significantly improved
    • The innovation that is being developed by a qualifying ESIC must either be new or significantly improved for the applicable addressable market.
  3. Commercialisation
    • The company must be focussed on developing its innovation for a commercial purpose, or in other words, for the purpose of generating economic value and revenue for the ESIC.
  4. High growth potential
    • A qualifying ESIC would need to show that it has the potential for high growth within a broad addressable market.
  5. Scalability
    • A qualifying ESIC must have the potential to successfully scale its business.
  6. Broader than local market
    • A qualifying ESIC would need to demonstrate that it has the potential to address a market that is broader than a local city, area or region.
  7. Competitive advantages
    • A qualifying ESIC will need to demonstrate that it has the potential to have competitive advantages, such as a cost or differential advantage over its competitors which are sustainable for the business.

 

Objective tests

As an alternative to satisfying the principle-based test for a qualifying ESIC, a company may be a qualifying ESIC if it has at least   100 points   for meeting objective innovation criteria as listed below:

Item Points Innovation criteria
1 75 At least 50 per cent of its total expenses for the previous income year constitute expenses which are eligible for the tax offset for R&D activities.
2 75 The company has received an Accelerating Commercialisation Grant.
3 50 At least 15%, but less than 50%, of its total expenses for the previous income year constitute expenses which are eligible for the tax offset for R&D activities.
4 50 It is undertaking or has completed an eligible accelerator programme.
5 50 A third party has previously invested at least $50,000.
6 50 It has one or more enforceable rights on an innovation through a standard patent or plant breeder’s right that has been granted in Australia or an equivalent intellectual property right granted in another country.
7 25 It has one or more enforceable rights on an innovation through an innovation patent or design right or an equivalent intellectual property right granted in another country.
8 25 It has a collaborative agreement with research organisation or university to commercialise an innovation

 

What are the reporting requirements for the ESIC?

ESICs that receive investments from one or more investor entities in a financial year will need to provide information about those entities to the Commissioner 31 days after the end of the financial year. For most companies, this would be 31 July of the following financial year. ESICs will need to provide this information in the ‘approved form’.

When does it come into affect?

If the Bill becomes law it is proposed that these amendments apply in relation to shares issued on or after 1 July 2016.

Venture capital investment

As part of the same Bill, Schedule 2 amends the early stage venture capital limited partnership (ESVCLP) and venture capital limited partnership (VCLP) regimes to improve access to venture capital investment and make the regimes more attractive to investors. The amendments provide an additional tax incentive for limited partners in new ESVCLPs, relax restrictions on ESVCLP investments and fund size and clarify the legal framework for venture capital investment in Australia.

Conclusion

It is very encouraging to see the government introduce these measures in order to foster investment in early stage innovation companies in Australia. Their definition of an ESIC or start-up is interesting and likely something that will generate further discussion.

Let’s hope that this Bill gets passed and passed soon so that start-ups currently raising, or planning on raising in the near future, are not adversely affected by investors waiting to utilise these benefits.

by Gary Shapiro

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