Have you considered investing in an Early Stage Innovation Company (ESIC)? Investing in an ESIC can sound in a reduction in your overall tax bill provided the relevant statutory requirements are met.
The tax breaks arising on investments in ESICs, which were introduced last year, are contained in Division 360-A of ITAA 97. They provide investors in qualifying ESICs with the following tax incentives:
- a tax offset (credit) of 20 per cent of the cost of their investment, which is non-refundable, subject to a $200,000 cap. Any excess credit can be carried forward; [i] and
- modified capital gains tax (CGT) treatment, under which capital gains on shares that are held for one to ten years may be disregarded. Capital losses on shares held less than ten years must be disregarded.
This is a boon for both investors in and founders of innovative start-ups, who may otherwise struggle to raise the capital they need to steer their business out of the high risk period between initial funding and the generating of revenue (referred to in the EM which introduced the Bill, as the ‘valley of death’) when companies often flounder under mounting cash flow pressures. Note that any one ESIC investor cannot end up with more than 30% of the ESIC.
As such, if you have:
- incorporated or registered an (unlisted) company in the Australian Business Register within the last 3 years (or incorporated an (unlisted) company within the last 6 years and the company and any wholly owned subsidiaries have incurred expenses of $1 million or less over the last 3 years); and
- in the previous income year, the company and any wholly owned subsidiaries have incurred expenses of $1 million or less and have derived taxable income of $200,000 or less;
your company will meet the Early Stage Limb, and investors in your company may be eligible for the tax offset and modified CGT treatment if it is also meets the Innovation Limb discussed below.
It is recommended that start-up companies undertake steps to qualify as ESICs as early as possible to ensure ESIC investors can start investing in the company in a timely manner. Satisfying the eligibility criteria can be a time-consuming process and can require considerable planning – and potentially some capital outlay – before a company can promote its ESIC status when pitching to investors.
Are you ESIC ready?
To qualify as an ESIC, the company will need to:
- satisfy the Early Stage Limb; and
- be developing new or significantly improved innovations with the purpose of commercialisation (the Innovation Limb).
The Innovation Limb encompasses two alternate tests, a Points Based Test and a Principles Based Test. The former is an objective test and therefore offers greater certainty than the later test, which is based on subjective criteria.
The Points Based Test will be made out if a company has achieved at least 100 points in accordance with the following criteria:
- For the previous income year, notional deductions were (or can be) made for the research and development tax incentive under s 355-205[ii] which amount to:
o more than half of the company’s total expenses (75 points); or
o between 15 percent and half of the company’s total expenses (50 points).
- It has:
o received funding support under the Australian Government’s “Entrepreneurs’ Programme” (75 points);[iii] or
o completed or is undertaking a qualifying “accelerator program” (50 points).[iv]
- It has issued shares to a non-associated third-party investor(s) of at least $50,000 (50 points).
- It is an owner or licencee of a right that was granted within the last 5 years which is:
o a patent or plant breeder’s right (50 points); or
o an innovation patent or registered design (25 points)
- It has entered into a partnership with a research organisation or university to co-develop and commercialise an innovation (25 points).
The Points Based Test is more readily a self-assessment test.[v]
The Principles Based Test will be satisfied if:
- the company is genuinely seeking to develop and commercialise new, or significantly improved, products, processes, services or marketing or organisational methods;
- the business has high growth potential;
- the business is scalable;
- the company can potentially expand to a broader than local market, including global markets, through its business; and
- the company has potential competitive advantages.
The Points Based Test appears to favour scientific-related innovation (e.g. development of new inventions and designs), due to the extra points attached to patents, plant breeders rights and registered designs, protected by registration. This is in contrast to non-scientific related innovation of products and services that are instead protected without registration, under Australian copyright law (e.g. the development of software), or that are marketing strategies or trade secrets (e.g. novel business plans), which are not recognised under the Points Based Test, and therefore need to use the Principles Based Test. However, companies that need to rely on the Principles Based Test are likely to have incurred less expenditure to get to that stage than those able to rely on the Points Based Test.
It appears from the ESIC database (www.esic.directory/) that many pending ESICs are software and marketing focused rather than strictly scientific.
Due to the subjective nature of the Principles Based Test, prospective innovation companies may need to seek a private ruling from the Commissioner about whether their circumstances meet the test.
Reliance on a private ruling from the ATO may involve a drawn out process (around 2 months according to the co-founder of Epic Delivery, one of the first companies to acquire ESIC status) involving back and forth communication. It is noted, however, that the lag time should decrease over time as more ESIC applications are made and the ATO has had a chance to streamline the process.
Ultimately, the success of getting a private ruling will come down to the ATO’s particular approach to interpreting the financial information and evaluating the business model of the company.
As regards the $50,000 minimum investment by a third party criterion under the Points Based Test, whilst this investor is not entitled to the tax offset and CGT exemption (because at that stage the company is not an ESIC), as a “mezzanine” investor, it would usually be the case that they are buying in at a lower price than those investing later and who are entitled to the tax concessions.
Companies can only claim ESIC status for a finite period (between three to six years). Accordingly, start-ups must plan for and establish their ESIC eligibility early so that they can offer investors the tax offset and CGT exemption as soon as possible and maintain their ESIC status for a reasonable length of time.
It is worthwhile noting there is no restriction on how investor funds are used by ESICs – they can be used for innovation purposes or otherwise. However, if the company is relying on the R&D deductions criterion in the points-based test, it must remain conscious of the fact that a significant amount of the expenses of the company must be for R&D purposes.
Companies which satisfy the eligibility criteria may benefit immensely from the tax incentives by making it easier for them to obtain seed funding. The tax incentives also provide an excellent opportunity for investors to contribute to growth and innovation in the Australian economy whilst also easing their overall tax burden.
If you wish to discuss whether your company may be an ESIC or if you are considering investing in an ESIC and would like further information, please contact Anthony Pointon, Robert Gordon or Jonathan Slade on (03) 9614 7707.
___________________________________________________________________________________________________________________
[i] Note, non-sophisticated or “retail” investors (the definition of a sophisticated investor is contained in s 708 of the Corporations Act 2001) are only entitled to the tax offset of up to $50,000 if they invest no more than $50,000 in ESICs in an income year. A sophisticated investor is not limited to the amount of their investment although their offset is capped at $200,000.
[ii] For more information on the R&D tax incentive, see the following link: https://www.ato.gov.au/Business/Research-and-development-tax-incentive/.
[iii]For more information on the Entrepreneurs’ Programme, see the following link: https://www.business.gov.au/assistance/entrepreneurs-programme-summary.
[iv] There is no clear guidance on what constitutes an accelerator programme, although generally speaking it is a programme which provides access to expert guidance and grants to help businesses commercialise their novel products, processes and services. A list of providers of such programmes can be found e.g. at: https://blog.thefetch.com/startup-incubators-and-accelerators-in-australia/. It is important to note, however, that the accelerator programme must meet the criteria contained in section 360-45 to qualify.
[v] Note that additional criteria may be added by the regulations in the future.
Authors
