This article continues our discussion about the Early Stage Innovation Company Tax Incentives. You can read Part I: The Basics and Practical Issues here.
Based on our conversations with startups and investors, these are the most common traps when accessing the ESIC tax incentives:
- Be careful with representations – To get a capital raise across the line, startups often self-assess their own ESIC status and advise investors that they are a qualifying ESIC. However, due to the complexity of these measures and to avoid legal exposure, extreme care should be taken in both self-assessing the ESIC status and providing investors with what could be construed as tax advice. By the same token, it is the investor who misses out if they relied on a startup’s assurances of ESIC eligibility which turn out to be incorrect. Accordingly, the investor must do their own ESIC due diligence.
- ATO rulings – when to use and not to use – The principles-based test should generally not be relied upon without a binding ruling from the Tax Office. This is because the concepts are both complex and subjective, and the risk of the Tax Office adopting a different view is real when the amount of tax revenue at stake is significant. Conversely, the Tax Office has indicated that usually it will not be making any rulings under the 100 points test, with the provided reasoning being that often, to provide a ruling on this test would be to implicitly confirm that the startup’s R&D claim is correct. For the Tax Office to do this, a review of the R&D tax incentive claim would be needed, thereby rendering the ruling process impractical and inefficient.
- Timing is crucial – ESIC eligibility is highly correlated with specific points in time. A company may be eligible in one year and ineligible the next, or vice versa. Regardless of whether the ESIC eligibility is self-assessed or confirmed by a tax advisor or a Tax Office ruling, the passage of time requires the eligibility of every capital raise to be assessed.
- Careful with subsequent restructures – An investor’s capital gains tax (CGT) exemption for qualifying ESIC investments may be terminated by certain “CGT rollovers” in the event of a legal entity restructure, which are common in the tech sector. Whenever a restructure is contemplated, the impact on investors must be evaluated prior to finalisation. This is where having a holistic tax advisor will pay dividends.
- Not all accelerators are created equal – Under the 100 points test, 50 points could be available for startups that have completed or are undertaking an accelerator program. However, some accelerators are in fact ineligible due to any of the following:
- The accelerator’s support is not time-limited;
- Entry into the accelerator is not competitive – e.g. they are arguably co-working spaces;
- The accelerator has not been operating for at least 6 months; and
- The startup is part of the accelerator’s very first cohort.
- Another reason to make sure your R&D claim is solid – Under the 100 points test, 50 points could come from the startup having claimed the R&D tax incentive in the prior income year. However, should the startup’s R&D claim later be denied under an audit, the ESIC tax concessions could unravel and become collateral damage. This interconnectedness between ESIC and the R&D tax incentive further emphasises the importance of adopting best practice when claiming the R&D tax incentive.
- Group structures can be problematic – As a prudent asset-protection measure (see tip #2 here), startups often adopt a group structure involving a head company holding a 100% interest in one or more subsidiaries. Ironically, this could cause complications in the ability to qualify as an ESIC. Current Tax Office guidance (as at March 2020) regards the holding company as the single company that must satisfy the 100 points test or the principles-based test – the actions and characteristics of a subsidiary are not automatically taken into account for ESIC eligibility purposes. To address this issue, advance planning and relevant documentation will be critical.
- Watch how your accounting is done – Under the “early stage” test, one of the requirements is that the startup cannot have expenses exceeding $1m in the prior income year. Attempts to capitalise certain expenses (i.e. recognising expenses as an asset on the balance sheet instead of an expense on the Profit and Loss) has attracted Tax Office attention. Clearly, incorrect characterisation is problematic. However, there are of course instances where it is both reasonable and justified to recognise an expense as an asset, and this can make a real difference to a startup’s ESIC eligibility.
- You’re making a declaration to the Tax Office – ESICs must report to the ATO on an annual basis where investors are seeking to access the ESIC tax concessions. This report is a declaration to the ATO that the eligibility requirements are met. The ATO has warned that criminal and civil penalties could arise where companies knowingly lodge incorrect details (e.g. regarding the company’s ESIC eligibility).
- Accountant’s signoff needed before investing – Where the investor is relying on an accountant’s signoff to qualify as a “sophisticated investor”, they are generally required to have this signoff prior to making the investment – it isn’t sufficient to merely obtain the signoff before 30 June.
- Equity vs Debt – The ESIC tax concession only applies to shares that are equity interests under tax law. This means that convertible note investments are not eligible until converted into equity. Further, SAFE notes throw in additional complexity as depending on their terms, they could be either debt or equity for tax purposes.
- New shares only – Investors are not eligible if they acquired existing shares. Only newly issued shares are potentially eligible.
As can be seen from above, there are numerous traps and ambiguities which could invalidate the ESIC tax incentives for investors or render a startup ineligible to be an ESIC. Given the potential financial impact on the investors (and by extension, the company), we advise startups to tread carefully and seek our advice where questions arise.