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18 May 2016 Tax Incentives for Investors in Early Stage Investment Companies

By Michael Phillips, Partner


"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.
  • Specifically excluded are preference shares (or other investments with a debt character).
  • Convertible notes are permissible provided that at the time the equity is issued (on conversion), the investee company is a qualifying ESIC.
  • An investor must not hold more than 30% of the equity interests in the ESIC, including entities "connected" with the ESIC.

 An ESIC is connected with another entity if the ESIC controls the other entity (or vice versa) or  both are controlled by the same third party entity.
 
  • The investor and the ESIC must not be "affiliates" of each other.
  • This means that the ESIC must not act in accordance with the investor's directions or wishes or act in concert with the investors.
  • As such a director-owner of an ESIC would be precluded from qualifying for the tax offset.

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.
 
[1] Extracted from the Federal Government's National Innovation and Science Agenda released in December 2015.

Michael Phillips, Partner  |  Phone: +61 2 9233 5544  |  Email: mpp@swaab.com.au

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This article is not legal advice and the views and comments are of a general nature only. This article is not to be relied upon in substitution for detailed legal advice.

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