The Early Stage Innovation Company (ESIC) Tax Incentives have been available to certain investors into qualifying investments since July 2016. The incentives reflect the Government’s intention to encourage investment into the Australian tech sector. Ironically though, in our experience the complex, tax-oriented concepts and ambiguity contained in the rules can make it very difficult for a typical tech company and its investors to understand and access the incentive with confidence. Our two articles seek to distil many of our conversations with tech companies regarding this tricky topic.
The Key Points
There are extensive online materials detailing the ESIC Tax Incentives, so a detailed and complete listing of the eligibility requirements is outside the scope of this article. The focus here is providing a easily-digestible overview of this incentive.
At a glance, the key points are broadly:
- A qualifying “sophisticated investor” of an “Early Stage Innovation Company” can receive a tax offset of 20% of their investment, up to $200,000 per year for the investor and their “affiliates”. This tax offset reduces the investor’s tax liability, with any offset not used in a particular year carried forward and used in future years.
- Capital gains made on qualifying shares held for between 1 to 10 years are not taxed. Clearly, this is potentially a very large tax benefit for the investor and future attempts to access it for large capital gains will attract Tax Office scrutiny as to the eligibility of the original investment.
- Investors that do not satisfy the definition of a “sophisticated investor” won’t be eligible for any tax incentive at all if their investment into qualifying ESICs in an income year exceeds $50,000. This is the Government’s measure to protect “mum and dad” investors.
- Most types of investor entities are potentially eligible – individuals, companies, trusts and partnerships.
- Additional investor-level eligibility requirements include:
- The investor is not a “widely held company”;
- The investor holds less than 30% of the company after the relevant investment; and
- The investor and company are not “affiliates” of each other.
- For a company to be an “ESIC”, it needs to satisfy two tests –
- The ATO’s ESIC decision tool is a useful starting point to assess whether a company is an ESIC. Note however that the tool is not binding on the ATO and does not address any of the technical issues examined in Part II of our series which could make or break a company or investor’s eligibility.
- Despite the reference to “early stage”, ESIC eligibility can actually be elusive for newly incorporated startups because:
- Two of the most common ways to accrue the 100 points needed tend to come from the company claiming the R&D tax incentive and having raised at least $50,000 from external investors. However, the R&D claim must relate to the prior income year and the $50,000 capital raise must have been completed previously.
- If the startup seeks to satisfy the principles-based test instead of the 100 points test, the company must be able to demonstrate various merits via very extensive documentation, which truly early stage startups often lack.
- We are often asked “What if an eligible ESIC later ceases to qualify as an ESIC – does this affect the eligibility of investors who accessed the tax concessions?” The answer is “No”. Provided eligibility for a particular investment is established, later changes to the company’s circumstances does not impact on the earlier investment.
- Sometimes, angel investors will band together and invest as one entity into a startup in order to give themselves a seat on the board. The question arises then as to what is the structure that should be used – company, unit trust, or other? Where structured correctly, a partnership consisting of the angel investors’ family trusts could work well by allowing “flow through” treatment of the tax incentives to the relevant entities best positioned to benefit from the incentives. However, the mechanisms for the flow-through treatment can be complex and seeking advice from an experienced tax professional is key.
This is Part I of our discussion, covering ESIC basics and practical issues. You can read “Part II: Common Traps to Avoid” here.