The federal government has recently made changes to our tax system to incentivise investors to support innovative, high-growth potential startups. Based on the UK’s successful Seed Enterprise Investment Scheme, the incentives are designed to encourage innovation by connecting start-ups with investors that have the funds and business expertise to assist entrepreneurs.

Eligible investors who purchase new shares in a qualifying Early Stage Innovation Company (ESIC) will benefit from:

A 20% non-refundable carry forward tax offset on investments, capped at $200,000 for the investor and their affiliates per year, and

A 10 year capital gains tax (CGT) exemption for qualifying investments held for at least twelve months.

20% tax offset –

Tax offsets directly reduce the amount of tax payable on your taxable income. While offsets can reduce your tax payable to zero, on their own they cannot result in a refund. This means that if an investor does not have a tax liability in the year that they make the investment they will not receive any benefit. However, the incentive does allow for the offset to be carried forward and claimed in the next year when the investor does have a tax liability.

The 20% investment tax offset is capped at $200,000 therefore investments over $1M will not attract any further benefit. The offset cap does not limit the shares that qualify for the modified CGT treatment.

CGT Exemption –

Qualifying investors will be exempt from CGT on gains arising from their investment provided they have held the investment for at least 12 months and for no longer than 10 years. If the investment is held for longer than 10 years, the CGT exemption will be applied to any gain attributable to the period up to the tenth anniversary of the investment. Note that investors do not receive CGT exemptions for any short term gains made within 12 months and capital losses will not be available in respect of a failed ESIC.

An example

Angus is the founder of a startup business called DogsLife Pty Ltd that is developing a concierge service app to outsource household chores. He needs to raise $200,000 in equity finance (25% of the company) to finish developing the app and take it to market.

Ruby is an experienced early stage investor and believes that DogsLife has excellent growth potential. She invests $200,000 into the company and claims a 20% tax offset which reduces her tax payable by $40,000.

Three years later DogsLife has realised outstanding growth and Ruby is able to sell her shares for $500,000. As Ruby’s investment is a qualifying investment and has been held for between 12 months and 10 years, the full capital gain of $300,000 is exempt from CGT.

Qualifying as an Investor for the tax incentives

The full incentive is claimable by investors who are considered ‘sophisticated investors’ under section 708 of the Corporations Act.
Investors that don’t meet the ‘sophisticated investor’ test will not be eligible for the incentives if their investment in the qualifying ESIC is more than $50,000 in an income year.
The offset is also available to investors who are beneficiaries of trusts to the extent that the relevant trust would have been entitled to the offset if it was an individual. Therefore, the trust would need to satisfy the ‘sophisticated investor’ criteria if it is seeking to invest more than $50,000.

Qualifying as an Early Stage Innovation Company (ESIC)

Essentially a company qualifies as an ESIC if it can show that it is Early Stage and Innovative.

A company is considered early stage when:

It was incorporated in Australia within the last three years.
It was incorporated in Australia within the last six years and its total expenses over the last three years did not exceed $1,000,000.
It has assessable income of $200,000 or less in the previous income year.
It is not listed on any stock exchange.

A company is considered innovative if it can:

Earn at least 100 points on the objective test; or
Self-assess it’s circumstances against the principles based test; or
Seek a ruling from the Commissioner about whether it satisfies the principles based test.

Potential investors should remember that as it is the individual who is getting the tax advantage, they should obtain as much proof as possible that the company is eligible. Hence, we would advise investors to ask for the ruling at minimum.

The principles based test

A company is required to show that it is:

Genuinely focused on developing for commercialisation one or more new, or significantly improved products, processes, services, marketing or organisational methods; and
The business relating to those products, processes, services or methods has a high growth potential; and
The company can demonstrate that it has the potential to be able to successfully scale that business; and
The company can demonstrate that it has the potential to be able to address a broader than local market through that business; and
The company can demonstrate that it has the potential to have competitive advantages for that business.

The 100 points innovation test

To qualify under the 100-point innovation test the company must obtain at least 100 points by meeting objective innovation criteria. This is tested immediately after the relevant shares are issued to the investor (the test time).

Further help:

If you would like to discuss your innovation and investment options, please contact our Marsh & Partners advisors. You can reach us on 07 3023 4800 or at mail@marshpartners.com.au.

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