Tax Incen­tives for Investors in Ear­ly Stage Invest­ment Companies

“Aus­tralians are renowned for their smart ideas, but we often fail to back them and turn them into com­mer­cial real­i­ties.
Only 9% of Aus­tralian small to medi­um sized busi­ness­es brought a new idea to mar­ket in 2012 – 13, com­pared to 19% in the top five OECD coun­tries.

We will pro­vide new tax breaks to remove the bias against busi­ness­es that take risks and inno­vate…”[1]

True to its com­mit­ment under the Nation­al Inno­va­tion and Sci­ence Agen­da, the Gov­ern­ment has now released a Bill to amend the Income Tax Assess­ment Act 1997 to encour­age new invest­ment in ear­ly stage inno­va­tion com­pa­nies with high growth poten­tial.

What is the incentive?

Pro­vid­ed that the investee com­pa­ny sat­is­fies a num­ber of qual­i­fy­ing cri­te­ria (described below), investors will ben­e­fit as follows:

• Receive a non refund­able car­ry for­ward tax off­set of 20% of the val­ue of their invest­ment sub­ject to a cap of $200,000 per year. In the case of non-sophis­ti­cat­ed or retail investors, the tax off­set is capped at $50,000 per year.
• If the invest­ment is held for between one and 10 years, CGT is not trig­gered on any dis­pos­al of the investment.
• Any unused por­tion of the off­set may be car­ried for­ward to future income years.

When will changes take effect?

The changes will take effect on or after 1 July 2016 (depend­ing on when the Bill receives Roy­al Assent).

What investors are eli­gi­ble for the tax concessions?

Investors may include:

• indi­vid­u­als;
• pro­pri­etary com­pa­nies (with not more than 50 shareholders);
• part­ner­ships (the tax off­set flows through and may be utilised by the mem­bers of the partnership);
• trusts (the tax off­set flows through and may be utilised by the ben­e­fi­cia­ries of the trust); and
• super­an­nu­a­tion funds.

Qual­i­fi­ca­tions

The dev­il of course lies in the detail. The require­ments that need to be met before these incen­tives may be enjoyed by those who take the risk of invest­ing in ear­ly stage inno­va­tion com­pa­nies (referred to as ESICs) should be care­ful­ly con­sid­ered.

Investor Qual­i­fi­ca­tions

• An investor may only invest in new shares of an ESIC.

• An investor must not hold more than 30% of the equi­ty inter­ests in the ESIC, includ­ing enti­ties ​“con­nect­ed” with the ESIC.

• The investor and the ESIC must not be ​“affil­i­ates” of each other.

Com­pa­ny Qualifications

The investee com­pa­ny must be a qual­i­fy­ing ESIC. In gen­er­al terms, this means that the com­pa­ny is at an ear­ly stage of its devel­op­ment and it is devel­op­ing new or sig­nif­i­cant­ly improved inno­va­tions with the pur­pose of com­mer­cial­i­sa­tion to gen­er­ate an eco­nom­ic return.

Specif­i­cal­ly, the investee com­pa­ny must sat­is­fy two fun­da­men­tal tests:

• the ear­ly stage limb test; and
• the inno­va­tion limb test.

Ear­ly Stage Limb 

There are four objec­tive tests that need to be sat­is­fied under this limb. In short, these are:

(i) the com­pa­ny must:

 — have been incor­po­rat­ed in Aus­tralia with­in the last 3 years; or
 — have been reg­is­tered in the Aus­tralian Busi­ness Reg­is­ter with­in the last 3 years; or

if not reg­is­tered in the ABR, then:?

 — it must have been incor­po­rat­ed in Aus­tralia with­in last 6 income years; and
? — it must have incurred expens­es of no more than $1million in total across the last 3 income years; and

(ii) total expens­es of the com­pa­ny must not exceed $1 mil­lion; and
(iii) the com­pa­ny’s assess­able income must not exceed $200,000; and

(iv) the com­pa­ny must not be list­ed on any stock exchange.

Inno­va­tion Limb

The inno­va­tion limb may be sat­is­fied through sat­is­fy­ing a prin­ci­ples-based test, a points based test or by seek­ing a rul­ing from the ATO.

• Prin­ci­ples-based test

This requires prospec­tive ESICs to self-assess their cir­cum­stances against the fol­low­ing prin­ci­ples, which are as follows:

• its inno­va­tion must either be new or sig­nif­i­cant­ly improved for the applic­a­ble address­able market;
• the com­pa­ny must be focused on devel­op­ing its inno­va­tion for com­mer­cial pur­pose. In oth­er words, for the pur­pose of gen­er­at­ing eco­nom­ic val­ue and revenue;
• it must have the poten­tial for high growth;
• it must have the poten­tial to suc­cess­ful­ly scale its business;
• it must be able to address a mar­ket that is broad­er than a local city, area or region;
• the com­pa­ny must demon­strate that it has the poten­tial to have com­pet­i­tive advan­tages such as a cost or dif­fer­en­tial advan­tage over its competitors.

• Points based test

As an alter­na­tive to sat­is­fy­ing the prin­ci­ples-based test, a com­pa­ny may be a qual­i­fy­ing ESIC if it has at least 100 points for meet­ing cer­tain ​“objec­tive” inno­va­tion cri­te­ria.

Click here to see the num­ber of points (rang­ing from 25 to 75) and the inno­va­tion cri­te­ria that must be sat­is­fied for these points to be award­ed to the prospec­tive ESIC.

One of the main con­cerns with the prin­ci­ples-based test is that it is craft­ed with high­ly sub­jec­tive lan­guage. For exam­ple, the prospec­tive ESIC must be sat­is­fied that it has the ​“poten­tial for high growth”, the ​“poten­tial for suc­cess­ful­ly scal­ing its busi­ness” etc. The extent to which a prospec­tive ESIC and/​or a poten­tial investor will be assured that the ESIC sat­is­fies these cri­te­ria is ques­tion­able. What should the prospec­tive ESIC be required to do in order to demon­strate that it gen­uine­ly believes that it sat­is­fies these cri­te­ria? More impor­tant­ly, will this be suf­fi­cient to attract prospec­tive investors who, but for the tax con­ces­sions, would not invest in the com­pa­ny?

Although the so-called points-test is intend­ed as an alter­na­tive to the sub­jec­tive prin­ci­ples-based test, some of the inno­va­tion cri­te­ria that must be sat­is­fied in order for points to be award­ed to the com­pa­ny are poten­tial­ly vague and com­plex or not yet rel­e­vant to the start up com­pa­ny and would in many instances require the com­pa­ny to seek expert advice.

For exam­ple, the 50 points award­ed to a com­pa­ny that has com­plet­ed or is under­tak­ing an accel­er­a­tor pro­gram that meets cer­tain cri­te­ria, is not some­thing a start­up will be able to gauge with­out seek­ing advice.

Absent con­fi­dent­ly apply­ing the prin­ci­ples-based test or the points-based test, the start-up com­pa­ny would need to apply for and obtain a rul­ing from the ATO to deter­mine its eli­gi­bil­i­ty. This would be both a time con­sum­ing and expen­sive exercise.

One would hope that the Gov­ern­ment takes on board the issues described above. The last thing Aus­tralia and the start-up com­mu­ni­ty need is anoth­er road that is paved with good inten­tions but which is prac­ti­cal­ly impassable.