Tax Incentives For Early Stage Investors

The Early Stage Innovation Company legislation, which commenced operations from 1st July 2016, has introduced significant taxation benefits for investors.

There is a 20% tax offset based on the amount of the investment and a capital gains tax exemption. The tax offset maximum amount is $200,000 for sophisticated investors.

A sophisticated investor is someone who has net assets of $2.5M or who has earned, at least, $250,000 in each of the last two years and an accountant has signed a statement relative to the value of assets held or earnings in the last two years.

A retail investor is entitled to a maximum tax offset of $10,000, but the maximum investment that a retail investor can make into an ESIC is $50,000.

The capital gains tax exemption applies if the shares are held for longer than twelve months and less than ten years, then a complete capital gains tax exemption applies on that investment.

From an investor's point of view, the taxation benefits appear to be substantial.

For a company to qualify as an Early Stage Innovation Company, it has to pass two out of three tests. The first test (Test Time Determination) relates to:

  • whether the company has been incorporated in the last three, or in some cases, six years;
  • whether the company has had assessable income of less than $200,000 last year, whether the company's expenditure was less than $1M and
  • there is a complete ban on the company being listed on a stock exchange anywhere in the world.

If the company satisfies those tests and keeps the supporting evidence, the company has passed the first test.

The second test is the Gateway Test.  There are seven separate items that are considered under the Gateway Test and the company can earn points for achieving satisfactory results under those subjects.  To qualify under the Gateway Test, the company must earn 100 points.

These subjects include:

  1. “research and development expenditure” as a percentage of the company's total expenditure – over 15% of total expenditure
  2. whether the company has participated in the “Accelerating Commercialisation” Grant Program
  3. whether the company has completed, or is undertaking an “Accelerator Program”
  4. whether the company has already “raised $50,000 or more share capital from arms-length investors”
  5. whether the company has already registered a “patent” ot “plant patent”
  6. whether the company has registered an “innovation patent or registered design”
  7. where the company has a written agreement with an entity registered under the “Higher Education Funding Act” or the “Industry Research and Development Act” for joint participation in a project

If the company has earned 100 points or more from those subject questions, then the company has self-assessed to be an ESIC, but very importantly, the company must have prepared full supporting evidence.  It's just not a matter of ticking the box; they have to have supporting evidence that they can submit to you as an investor or, more importantly, as part of the investment process, they have the supporting evidence ready to go to the Australian Taxation Office and AusIndustry because ultimately, the ATO is the final arbitrator as to whether a company has passed the ESIC tests.

Now, if a company cannot pass the Gateway Test, it then moves into the Principle Based Test.  The Principle Based Test is looking for five questions to be answered in the affirmative, but with a supporting commentary to be prepared for each of those questions.

The questions basically relate to:

  1. Has the company got the intention of commercialising a new product, process, service, organisational or management system?
  2. The business relating to those products has a high growth potential.
  3. The company has the ability to be scaled.
  4. The product can be promoted and marketed beyond the local market in which it's been developed.
  5. The company can demonstrate that it has the potential to have competitive advantages.

That is the Principles Based Test.

If the company is able to answer the appropriate questions and file the supporting evidence, the company is able to self-assess as an ESIC.  Unfortunately, these taxation advantages are not available to all investors. 

The benefits of the tax offset and the capital gains tax exemption are only available on the original shares issued.  If the shares are owned by an investor who is a widely held company, such as a public company or a subsidiary of a public company, then that entity is not able to receive these benefits and nor is an investor who owns more than 30% equity in the Early Stage Innovation Company.

That is the background to the incentives.  In my opinion, these are significantly better than what an investor obtains from investing in a company that has been incorporated under Section 708 of the Corporations Code; but that is up to your individual judgement and obviously only companies that are active in the innovation space are going to be an Early Stage Innovation Company.  If that is the type of company that you're looking for, that's the background to the assessment process.

If you would like us to assist you in your due diligence review on a company, please do not hesitate to contact us.

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