Tax Incentives for early stage investors
In May 2016 the Government passed legislation that gives effect to tax incentives for early stage investors effective 1 July 2016.
This is a welcome measure that will encourage investors to invest in new start up businesses. What is important to understand is that the definition of an early stage innovation company (ESIC) is not only targeted towards your typical ‘start-up’ tech company, it can apply to a range of entities that fall within the definition.
So what’s in it for the investor?
There are effectively two classes of investors, sophisticated investors and non-sophisticated investors.
Type of Investor
Sophisticated investors – these investors meet the requirements of section 708 of the Corporations Act. Generally they have gross income of $250,000 or net assets of $2.5m.
Sophisticated investors have no restriction on the amount they can invest (however they are subject to the $200,000 cap on the value of the tax offset – see below).
Non-sophisticated investors – are those investors that are unable to pass the sophisticated investor test above. These investors are limited to investing amounts of $50,000 and below in an income year.
The non refundable carry-forward tax offset for qualifying investors is 20 per cent of the amount paid for qualifying shares. Typically qualifying shares will be new shares issued in an ESIC. Effectively the rules target new investors.
There are special rules for members of trusts, partnerships and trustees accessing the 20 per cent offset.
For sophisticated investors this allows a maximum offset of $200,000, less the sum of any previously claimed offsets carried forward into the income year. The cap is based on an affiliate inclusive basis.
Restrictions on the relationships of the investor and ESIC
The investor and the ESIC must not be affiliates of each other as defined in s328-130 of the ITAA.
In addition the investor entity must not hold more than 30 per cent of the equity interest of an ESIC.
What is a qualifying ESIC?
Generally an Australian incorporated company will qualify as an ESIC if it is at an early stage (early stage limb) of its development and it is developing new or significantly improved innovations with the purpose of commercialisation to generate an economic return (the innovation limb).
The early stage limb
- It has been recently incorporated or registered in the Australian Business Register
- Must have been incorporated in Australia within the last three income years (the latest being the current income year at the test time), or
- If not incorporated in the last three income years, it must have been registered in the ABR with the last three income years (the latest being the current income year at the test time), or
- If it has not been registered in the ABR within the last three income years – then
- It must have been incorporated in Australia with the last six income years, and
- It and any wholly owned subsidiaries must have incurred expenses of no more than $1,000,000 in total across all of the last three income years (the latest being the current income year at the test time)
Total expenses are reported at item 6 on the income tax return, therefore this is used for the purpose of this test.
- It has total expenses of $1 million or less
- It has assessable income of $200,000 or less
- It is not listed on a stock exchange
The innovation limb
The principle-based definition of innovation is designed to provide enough legislative flexibility to accommodate both existing and future forms of innovations while specifically targeting high growth potential companies based on the innovation company’s focus and potential business capabilities.
However, recognising that not all companies will want to self-assess, or seek a ruling from the ATO about whether they satisfy such a test, these amendments also provide some objective activity-based criteria that companies can apply against their own circumstances. In practice, this may be the simplest and fastest way for companies to determine if they satisfy the innovation limb of the qualifying ESIC test.
What CGT treatment applies to shares in qualifying ESICs?
The benefit of investing in a ESIC is not only the non—refundable tax offset, but also the preferential capital gain tax treatment. An investor that acquires shares in a qualifying ESIC will be taken to hold these shares on capital account.
In determining what shares qualify for the modified treatment, it does not matter whether the investor has actually received the tax offset in relation to the shares. In addition it does not matter if the company subsequently ceases to be a qualifying ESIC.
- Shares held for less than 12 months
An investor that has continuously held a qualifying share for less than 12 months may not disregard any capital gains arising to that share but must disregard any capital losses.
- Shares held for more than 12 months and less than ten years
An investor that has continuously held a qualifying share for between 12 months and less than ten years can disregard a capital gain arising from the share. Be warned, capital losses are disregarded.
- Shares held for ten years or more
An investor that has continuously held a qualifying share for at least ten years will receive market value, as determined on the ten year anniversary date, as the first element of the cost base and reduced cost base of the share. In effect, you get a step up in cost base so you will only pay tax on the gain over and above the reset cost of the share.
There are many advantages in investing in ESIC. If you are an ESIC or an investor in a ESIC and required guidance and/or tax assistance please contact Sean Urquhart of Nexia Australia – Sydney Office on 02 8264-0755.
All information provided in this publication is of a general nature only and is not taxation, legal, personal financial or investment advice. It does not take into account your particular objectives and circumstances. No person should act on the basis of this information without first obtaining and following the advice of a suitably qualified professional advisor. To the fullest extent permitted by law, no person involved in producing, distributing or providing the information in this publication will be liable in any way for any loss or damage suffered by any person through the use of or access to this information.