Since 1 July 2016, investors in qualifying early stage innovation companies may have access to a range of tax incentives which were introduced by the Federal Government to encourage innovation, entrepreneurship and risk-taking. This article takes a look at these incentives and who may be eligible.
What are the incentives:
Eligible investors in Early Stage Innovation Companies (“ESIC”) will be eligible for:
- a 20% non-refundable carry-forward tax offset, up to $200,000 per investor, per year; and
- a capital gains tax exemption for shares which are held for more than 12 months but less than 10 years. For shares held for more than 10 years, the cost base of those shares will be their market value as determined on the 10 year anniversary date. Capital losses (whether the shares are held for more or less than 12 months) must be disregarded.
Who will qualify as an “eligible investor”?
Whilst the incentives will generally be available to all types of investors, there are some exemptions and limitations imposed by the egislation:
- widely held companies (as defined in Section 995(1) of the Income Tax Assessment Act 1997) or their wholly-owned subsidiaries, are not be eligible for the incentives;
- retail investors (i.e. investors who do not meet the definition of a “sophisticated investor” in Section 708 of the Corporation Act 2001) are limited to investing amounts of $50,000 in an income year. It is important to note that if a retail investor exceeds this limit, they will not be entitled to any of the incentives, even on a proportional basis;
- affiliates of the ESIC are not eligible for the incentives (e.g. a director-owner, or their affiliated entities, will be precluded from the incentives); and
- investors who hold more than a 30% equity interest in the ESIC (or any entity connected with the ESIC) immediately after the investment is made, are not eligible for the incentives.
Whilst trusts and partnerships are not directly eligible to the 20% tax offset, there are specific rules contained in the proposed legislation which will enable the offset to be flowed through to beneficiaries and partners.
In addition, the legislation contains a number of integrity measures to ensure that the incentives are not abused (e.g. affiliate-grouping rules to ensure that entities under common control do not enter into arrangements to access multiple tax offsets).
What is a qualifying Early Stage Innovation Company (“ESIC”)?
In order to qualify as an ESIC, the entity must be an Australian-incorporated company and satisfy both of the following:
- the entity must be at an early stage of its development (the “early stage limb”); and
- the entity must be developing new or significantly improved innovations with the purpose of commercialisation to generate an economic return (the “innovation limb”).
In order to satisfy the early stage limb, a company must pass four tests:
- the company must have been incorporated or registered in the Australian Business Register (“ABR”) within the last 3 years, or if it has not, within the last six years so long as it has not incurred expenses exceeding $1 million in total across the last three years;
- the company must not have incurred expenses of more than $1 million in the previous income year;
- the company must have assessable income of no more than $200,000 in the previous income year; and
- the company must not be listed on any stock exchange.
In order to satisfy the innovation limb, a company must either:
- obtain at least 100 points for meeting certain objective innovation criteria. This is likely to be the simplest and fastest way for companies to determine if they satisfy the innovation limb of the qualifying ESIC test.
There are a number of criteria which will provide points including previous eligibility to the R&D tax offset, being a recipient of an Accelerating Commercialisation Grant, completion of a eligible accelerator programme, having previously received $50,000 from a third-party investor and the holding of one or more enforceable rights (e.g. a patent), among other tests. As an example, a company will be awarded 75 points if it has at least 50% of its total expenses for the previous income year which are eligible for the R&D tax offset;
- self-assess their circumstances against principles-based tests. Unlike the first avenue for satisfying the innovation limb, these principles-based tests are subjective and have been designed to provide flexibility to accommodate both existing and future forms of innovation. The overall principles however require a company to show that they are genuinely focused on developing a new or significantly improved innovation for the purpose of commercialisation and show that the business relating to that innovation has high potential for growth, has scalability, can address a broader than local market, and has competitive advantages; or
- seek a ruling from the Commission of Taxation about whether their circumstances satisfy the principles-based tests.
What is an eligible investment in an ESIC?
In order to qualify for the incentives, the investor entity must be issued with new equity interests that are shares in a qualifying ESIC. Amounts paid for equity interests which are acquired from existing shareholders will not be eligible for the incentives.
The basic tests for what constitutes an equity interest are set out Sections 974-70 and 974-75 of the Income Tax Assessment Act 1997. Put simply, these tests restrict eligible investments to equity interests that have features of ordinary shares. Equity interests with a debt component (e.g. certain preference shares) will not be eligible for the incentives.
In addition, shares issued under an employee share scheme will not be eligible for the incentives.
Important to note is that the time for testing (the “test time”) whether an entity is a qualifying ESIC is the time immediately after the equity interests are issued. Accordingly, investors that acquire equity interests after 1 July 2016 from the conversion of convertible notes may be eligible for the incentives.
Reporting Requirements
ESIC’s that receive investments from one or more investor entities in a financial year will be required to provide details about those investor entities to the ATO by 31 July of the following financial year.
Conclusion
This package of tax incentives no doubt provides some generous concessions for investors in early stage innovation companies however the complexity of the rules does raise some issues for ESIC’s and their investors.
Given that the risks predominately reside with the investors rather than the issuing company, in most cases potential ESIC’s will seek advice on whether they satisfy the relevant criteria which can then be relied upon by eligible investors.
If your company is seeking capital under these rules, please feel free to contact a member of the Navarra Kovac team for further information.
Navarra Kovac Chartered Accountants 