New tax incentives for early stage investors (sometimes referred to as ‘angel investors’) have come into effect from 1 July 2016. The measures are contained in Division 360 of the Income Tax Assessment Act 1997 (ITAA) and provide a tax offset that operates as a credit against other tax payable by the investor and some CGT concessions.
To qualify for the incentives, investors must subscribe for new shares in a company that meets the requirements of an ‘Early Stage Investor Company’ (ESIC) immediately after the shares are issued. The shares must be issued on or after 1 July 2016.
The new concessions link to the Government’s policy of encouraging innovation and assisting with the acceleration of start-ups.
What are the tax incentives?
Broadly, the Act provides investors with:
- a 20% non-refundable carry-forward tax offset for qualifying investments, capped at $200,000 for each investor and their affiliates (combined) per year
- a deemed capital account treatment and an exemption from capital gains tax (CGT) for qualifying investments held between one and ten years (capital losses on investments held for less than ten years must be disregarded) (tax incentives). Investors who hold the shares for at least 10 years receive a market value cost base on the 10th anniversary of their acquisition
Tax offsets directly reduce the amount of tax payable by investors. As the early stage investor tax offset is a non-refundable tax offset, it can reduce the amount of tax payable to zero, but it cannot result in a tax refund on its own.
What investments will qualify?
To qualify as an ESIC, the investee company must satisfy:
- the ‘early stage test’; and either
- the ‘100-point innovation’ test, or the ‘principles-based’ innovation test.
The ‘early stage’ test comprises a number of tests that require:
- The investee company to have been incorporated in Australia or registered on the Australian Business Register within the last three income years. Alternatively, the investee company must have been incorporated in Australia within the last six income years and had expenses of $1 million or less over the last three income years.
- The company (plus any wholly-owned subsidiaries of the company) must have:
- total expenses of $1 million or less in the previous income year
- assessable income of $200,000 or less in the previous income year.
- The company’s equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.
The ‘principles-based’ innovation test requires a company to satisfy all of the following elements:
- The company must be focused on developing new or significantly improved innovations for commercialisation. A revolutionary product or process that can be commercialised will meet this test; less likely will be the mere evolutionary development of an existing product.
- The business relating to that innovation must have a high growth potential in a broader market, such as an new app that is developed locally but which aims to tap into the demand of a national or international market.
- The company must demonstrate that it has the potential to be able to successfully scale up that business. Scalability requires an ability to leverage market share to increase profitability (because per unit costs can be markedly reduced), rather than merely being able to make more sales.
- The company must demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business.
- The company must demonstrate that it has the potential to be able to have competitive advantages for that business.
The 100-point innovation test sets out a range of factors with various ‘points’ attributed to them. If a company can satisfy 100 points they will be considered to be an ESIC. It operates in the same way that ‘100 points’ of identification criteria are required to be met in order to set up a bank account.
The types of factors that carry significant weight in applying the 100-point innovation test include:
- at least 50% of the company’s total expenses for the previous income year were eligible notional deductions for the research and development tax incentive – 75 points (50 points are available if the percentage is between 15% and 50%)
- the company has received an Accelerating Commercialisation Grant – 75 points, or
- the company has enforceable rights on an innovation through either a standard patent, a plant breeder’s right or an equivalent intellectual property right granted in the last 5 years -50 points.
If, after the company has satisfied these requirements, it ceases to be an ESIC, this won’t affect an investor’s entitlement to the early stage investor tax incentives for the shares.
The principles based innovation test requires a lot of work to be put into business plans and growth strategies and, because it is so heavily reliant on a subjective assessment of the criteria, we expect that investors and their investee companies will more likely rely on the 100-point innovation test.
Who can access the tax incentives?
The incentives are predominantly focussed on sophisticated investors, although ‘mum and dad’ investors can avail themselves of the incentives in some cases. The incentives are not available to widely held companies and trusts, such as listed companies.
A sophisticated investor can access the tax incentives when they invest in an ESIC. Under the Corporations Act 2001 (Cth) (Corporations Act), an investor may be considered a sophisticated investor if:
- they hold a certificate issued by a qualified accountant confirming certain asset and income requirements (gross income of at least $250,000 for the last two years and net assets of $2.5 million)
- they pay $500,000 or more for the shares
- they access the shares through a financial services licensee who is satisfied that the investor has sufficient previous experience and the investor signs an acknowledgement
- they are a ‘professional investor’ under the Corporations Act, or
- they control gross assets of $10 million or more.
Investors who do not meet the requirements of the sophisticated investor test under the Corporations Act can only access the tax incentives if their total investments in innovative start-up companies do not exceed $50,000 in an income year.
This limit is designed to ensure that retail investors are not encouraged to become over-exposed to the risk that investing in start-up companies entails.
What will happen where the investor is a trust or partnership?
Under Section 360-15 of the ITAA, where the investor is a trust or partnership, special rules apply so that the entitlement to the tax offset flows through to the members of the trust or partnership.
Under the rules, a member of a trust (or partnership) will be entitled to an offset if the trust (or partnership) would otherwise be entitled to the offset under the general provisions. This means that while the trust or partnership will not directly be entitled to the tax offset, the value of the incentives can flow through to beneficiaries and partners.
Other conditions for the incentives
The objective of the rules is to stimulate new investment in small Australian innovation companies with high-growth potential. To deliver this, specific types of investment are excluded from the incentive scheme.
- To qualify for the incentives, an investor can only invest in new shares. Preference shares or other debt-like investments are specifically excluded. Convertible notes will attract the incentive provided that the company is an ESIC on conversion.
- The incentive does not apply to employees or contractors who receive equity in the start-up under the employee share scheme rules.
- An investor must not hold more than 30% of the equity interests in the ESIC, and must not be connected with entity. This will apply where the ESIC controls, or is controlled by, the investing entity, or both are controlled by a third party.
- The ESIC and the investor also must not be affiliates of each other. An individual or company is an affiliate of another entity where, in relation to their business affairs, the individual or company acts or could reasonably be expected to act in accordance with that entity’s directions or wishes or in concert with the entity. A director-owner of an ESIC would therefore be precluded from accessing the tax offset.
- The ongoing availability of the CGT exemption may be impacted by certain types of CGT roll-over which could cause the exemption to be lost.
While the measures demonstrate the Government’s commitment to innovation, there exist some key concerns. For example, there is significant room for uncertainty as to whether an entity satisfies the criteria to be an ESIC. Similarly, a concern with the principles-based innovation test is that it includes highly subjective terms. While the 100-points test is intended as a more objective alternative, some of the criteria necessary to satisfy the 100-points test can still be vague and subjective, referring to undefined concepts such as ‘innovation’ and ‘mentoring’.
In most instances, both investors and ESICs will require advice to determine whether they satisfy the criteria. If a confident conclusion cannot be drawn on the criteria, the ESIC would have to apply for a ruling from the ATO to determine eligibility and satisfy concerns of investors.
To manage the goal of start-up growth and to account for potential problems, the legislation provides for regulations to be introduced to specify the exclusion of certain products or companies or to mandate additional criteria. It will be interesting to see whether this power is sufficient to deal with the uncertainties described above.
If you have any questions regarding this tax incentive scheme, contact the Hall & Wilcox tax team for further information.
This article was written with the assistance of Ella Simmons, Law Graduate.