There’s been much talk around innovation since Prime Minister Malcolm Turnbull launched the government’s innovation statement in December 2015 with many a tax break, concession, and relaxation announced.
This article will focus on the Early Stage Investor Tax Offset that has been effective for new share investments made from 1 July 2016 after the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 received Royal Assent on the 5th of May 2016.
Like all good tax concessions, the devil is in the detail and while this is a great measure that is sure to encourage much needed investment in our local start-ups, both investors and start-ups alike must be sure to apply the tests correctly.
What is the Early Stage Investor Tax Offset?
Broadly, from 1 July 2016, if you invest in a qualifying early stage innovation company (ESIC) via the acquisition of new shares you (the investor) will be eligible for:
- A tax offset equal to 20% of the amount paid for the qualifying investment, up to the prescribed cap; and
- Modified capital gains tax treatment allowing any gains upon disposal of the qualifying share investment to be disregarded provided the shares are continuously held for at least 12 months and less than 10 years.
Maximum cap for the offset:
- For a “sophisticated investor” as defined under the Corporations Act 2001 the maximum tax offset amount is $200,000 (ie. $1M total investment) for the investor & their affiliates combined in each financial year.
- For investors that don’t meet the sophisticated investor requirements, the cap will be reduced to $10,000 ($50,000 total investment).
TRAP! Nasty trap for investors who exceed their cap and are not considered a sophisticated investor:
- If a sophisticated investor exceeds the cap and is not eligible for the tax offset, while they will not be entitled to any amount of tax offset, this will not limit the investor’s ability to access the modified CGT treatment. However, if an investor that does not meet the definition of a sophisticated investor exceeds their cap ($50K investment) the investor will not receive either the tax offset or the modified CGT treatment of any shares acquired in that year.
So what is an ESIC?
For a company to be considered an ESIC, there are two tests that must be passed. Firstly, the company must pass the “early stage test”. Then, in addition, either the “100 point innovation test” or “principles-based innovation test” must be passed.
Early Stage Test – Four requirements must be met:
- The company must have been incorporated or registered in the Australian Business Register within the last 3 income years. If the company is outside of the last 3 years, but within the last 6 years AND the company (plus its wholly-owned subsidiaries) had expenses of $1 million or less across the last three of those years, the company would meet this requirement
- The company (plus any wholly-owned subsidiaries of the company) must have total expenses of $1 million or less in the previous income year
- The company (plus any wholly-owned subsidiaries of the company) must have assessable income of $200,000 or less in the previous income year
- The company’s equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country
100-point innovation test requirements – the company must obtain at least 100 points by meeting certain objective innovation criteria as outlined in the ATO’s “100-point innovation test table”.
Easy? And we pass without having to look at the final test? Hopefully! The principles-based innovation test is arguably far more subjective and therefore naturally a higher risk of getting it wrong. In practice, if a company undertakes activities that meet the 100-point innovation test, this is likely to be the simplest way to determine its eligibility, when compared to the principles-based innovation test.
Principles-based innovation test – Five requirements must 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 the potential to be able to successfully scale up that business
- The company must demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business
- The company must demonstrate that it has the potential to be able to have competitive advantages for that business
How does an investor qualify?
The investor must have purchased new shares after 1 July 2016 in a company that meets the requirements of an ESIC immediately after said shares have been issued.
Exclusions? The early stage investor tax incentives aren’t available to you if:
- The shares weren’t purchased directly from the company as newly issued shares;
- The shares are not “equity interests” in the company;
- The company is a widely held company (ie. either listed on an approved stock exchange or >50 shareholders) or a wholly-owned subsidiary of a widely held company;
- Your investment exceeds the relevant cap;
- You and the company are “affiliates” of each other at the time the shares are issued;
- You hold >30% of the equity interest in the company (including any connected entities) immediately after you are issued with the new shares;
- You acquired the shares under an employee share scheme
Australian resident and non-resident investors are eligible as are investors who may be a trust or partnership.
TRAP! As at time of writing, the ATO’s published information states that they are currently considering how these tax incentives apply to superannuation funds that invest in a qualifying ESIC. Watch this space!
Now that we’re either an eligible ESIC or an investor who’s made an investment in an ESIC, what do we need to do?
By 31 July each year, companies that are an ESIC must report the information for new shares issued in the previous year. The form to report this information is being developed, so all available information pertaining to new shares issues (including investors’ details) should be obtained. If a company is having difficulty assessing whether it qualifies as an ESIC a private ruling could be sought from the ATO.
The investor must determine whether they are eligible for the early stage investor tax incentives, which means that the onus is on the investor to confirm that the company qualifies as an ESIC at the relevant test time. Note, even if an ESIC has obtained a private ruling at an earlier point in time, this is not sufficient to argue the company was an ESIC at a later time. If the investor would like to rely upon a private ruling from the ATO, they would be required to lodge their own application. All tests are applicable immediately after the new shares are issued to the investor. The investor should keep records to support their entitlement to the early stage investor tax incentives.
Although this paper has been kept brief there are many factors to consider with regard to these new measures for investors & start-ups alike, so it is critical to seek professional advice from a qualified expert in the field.
For further discussions or information on this matter please contact Michael Kerwin on 07 3394 2311.