Early Stage Investor Tax Initiatives – What you need to know
As mentioned in my prior newsletters, TCF Services will be reporting on all of the initiatives dropping from PM Turnbull’s Innovation agenda as they become legislated, today’s newsletter covers the new “Early stage investor tax incentives” which commence 1st July 2016. I would like to thank Bill Shew, chartered accountant and principal of Whitehawk Advisors for assisting us co-write this newsletter.
Bill and I are available to discuss this topic and assist both early stage investors and innovation companies access the benefit. Bill’s contact details are also included at the bottom of this newsletter.
Tax incentives will be available from 1 July 2016 for investors who purchase qualifying shares in early stage innovation companies (ESICs). The tax incentives will be in the form of a non-refundable carry-forward tax offset equal to 20% of the amount paid for the shares and a favourable capital gains tax (CGT) treatment where the shares are held continuously for more than one year. However, capital losses on qualifying shares held for less than ten years are foregone. There are a number qualifying requirements that companies, shares and investors must meet. Investors may be individuals, incorporated companies, trusts and partnerships. In the case of trusts and partnership, the tax offset passes to the members.
Tax Incentive Benefit Details
The non-refundable tax offset is capped at a maximum amount of $200,000 in each income year for “sophisticated investors” and their affiliates. The tax offset is non-refundable – therefore it is of no immediate benefit to an investment entity without a tax liability in that income year. However, the tax offset may be carried forward to future income years, but the carry forward amount is capped at $200,000.
Other investors (“non-sophisticated” investors) are limited to investing amounts of $50,000 in any one income year corresponding to a non-refundable offset of $10,000.
The CGT concessions for investors who have continuously held a qualifying share in an ESIC is as follows:
- For shares held between 12 months and ten years – the investor may disregard the capital gain arising from the share.
- Capital losses are also disregarded for shares held for the first ten year’s period. The cost base of the shares will be adjusted to the market value on the ten-year anniversary date. As such only the incremental gains (or losses) in value after 10 years will be taxable
This modified CGT applies to all “qualifying” shares purchased by a “sophisticated investor” that potentially gives rise to the 20% offset entitlement, regardless of the value of the shares purchased by the investor in an income year. In other words, the maximum tax offset cap of $200,000 per income year does not limit the shares that qualify for the modified CGT treatment. However, if an investor does not meet the “sophisticated investor” test, they will not receive either the early stage investor tax offset or the modified CGT treatment if the total value of “qualifying shares” purchased in an income year exceeds the limit for “other investors” which is an investment amount of $50,000. Example 1 illustrates how a “sophisticated investor” may be able to benefit from these tax treatments:
Alex qualifies as a “sophisticated investor” and his tax liability in 2016/17 will be $300,000. Alex invests $3M in qualifying shares in the 2016/17 period and therefore would receive a $200,000 tax offset reducing his tax liability to $100,000 for the 2016/17 income year. Alex is able to carry forward an additional $200,000 tax offset to the 2017/18 income year and is able to use this against his tax liability for the 2017/18 income year. Therefore, he is able to receive a 20% offset in relation to $2M of the shares purchased. However, the modified CGT treatment applies to all the shares that Alex purchased, i.e. there is no capital gains tax payable on all the shares that were purchased for $3M if the shares are continuously held for the 1 to 10 year period.
However, where the shares are held for less than 12 months, an investor will be taxed on any capital gain as normal but must disregard any capital losses. Capital losses on shares held for between one and ten years must also be disregarded. Example 2 below illustrates this:
Lucy is an individual who invests $50,000 in a qualifying ESIC and receives a tax offset of 20 per cent ($10,000) that she can use to offset against her income tax liability. In the event that the ESIC is not successful and the value of its shares decreases and become worthless, Lucy will not be able to utilise any capital loss resulting from those shares.
Qualifying Companies (ESICs)
A company will qualify as an ESIC if it satisfies an early stage test AND either a 100-point innovation test or a principles-based innovation test.
Early Stage Test
The early stage test requirements that the company (including affiliates):
- was incorporated in Australia or registered in the Australian Business Register (ABR) in the last 3 income years or
- if incorporated between 3 and 6 years, did not incur expenses of more than $1mil in total in the last 3 income years, and
- has total expenses of $1 mil or less and has assessable income of $200,000 or less in the previous income year, and
- is not listed on any stock exchange or has more than 50 shareholders.
Note: The current income year counts as a year. Thus a company incorporated in the 2014/15 income year will satisfy test 1 in the 2016/17 year but not in the 2017/18 year.
100-point Innovation Test
To satisfy this test, companies seeking to qualify as ESICs may accumulate points as follows:
- 75 points if it has at least 50% of its total expenses for the previous income year was eligible R&D Tax Incentive expenditure or 50 points if at least 15% and less than 50% of total expenses was eligible R&D Tax Incentive expenditure. Please note that companies that are not eligible to claim the R&D Tax Incentive benefit (for example, the company is a partnership) are most unlikely to be entitled to any points under this provision.
- 75 points if, at any time, it received an Accelerating Commercialisation Grant
- 50 points if it is undertaking or has completed an eligible accelerator programme
- 50 points if a third party has previously invested at least $50,000
- 50 points if it has enforceable rights on an innovation through a standard patent or plant breeder’s right that has been granted in Australia or an equivalent intellectual property right granted in another country or 25 points if it has enforceable rights on an innovation through an innovation patent or design right or an equivalent intellectual property right granted in another country. The right must have been granted and certified within the last 5 years.
- 25 points for a collaborative agreement with a research organisation or a university to commercialise an innovation
- additional criteria for points may be specified by regulation in the future.The alternative to satisfying the 100-point Innovation Test is for the company to satisfy the Principles-Based Test. This test requires the company to be genuinely focused on developing a new or significantly improved innovation for the purpose of commercialisation and to show that the business relating to the innovation.
The Principles-Based Test
- has the potential for high growth, i.e. the company is able to show that the business has the potential for high growth within a broad addressable market,
- has scalability, i.e. the company has the potential to successfully scale the business. The EM interprets this as operating leverage, where existing revenues can be multiplied through incurring a reduced or minimal increase in operating costs.
- addresses markets including global markets that are broader than just the local market
- has competitive advantages that the company is able to demonstrate.
ESIC Reporting Requirements
- A self assessment process applies to whether a company qualifies as an ESIC, but the option is available to apply to the ATO for a ruling. ESICs are required to report information to the ATO if they issue new shares to one or more investors during a financial year that could lead to an investor being entitled to access the early stage investor tax incentives.
- If the qualification is based on meeting this test, then the company should be able to demonstrate how it satisfies the different elements of this test through the use of its existing documentation such as business plans, commercialisation strategies, competition analysis or other company documents. In addition, the company must show that tangible steps have been or will be undertaken in relation to that focus or capability.
- Declaring that the company meets the requirements to be an ESIC for all of the reported investments and specifying whether the 100-point innovation test or principles-based innovation test has been applied, and whether there is an ATO ruling on eligibility.
- Identifying the investors who were issued “qualifying shares”.
- Reporting to the Tax Commissioner 31 days after the end of the financial year. Qualifying shares are newly issued equity interests that are shares in a qualifying ESIC, where the issue of the shares does not constitute an acquisition of ESS interests under an employee share scheme. The time for testing whether an entity is a qualifying ESIC is the time immediately after the relevant equity interests are issued. This means that an investor who acquires shares in a company that is a qualifying ESIC at the time of issue, will not be disqualified from accessing the tax offset in relation to those shares if the company subsequently ceases to be a qualifying ESIC.
- The shares must be directly purchased by the investor from the ESIC.An investor may either invest as a “sophisticated” or as an “other “investor (non-sophisticated investor) and the investor entity may be either an individual or a corporation. This includes incorporated companies and extends to trusts and partnerships that are not directly entitled to the tax offset. There are specific rules that must be complied with to ensure that the value of the tax incentives flows through to beneficiaries and partners of trusts and partnerships. “Sophisticated investors” do not have to be provided with a disclosure document, such as a prospectus or product disclosure statement, when being offered shares in a company.
- There are also specific rules that apply to preserving the modified tax treatment of qualifying shares that are the subject of a CGT roll-over and shares held by partnerships.
- Qualifying Shares
- Holds a certificate issued by a qualified accountant. This certificate is available only if the investor has gross income of at least $250,000 per year and net assets of at least $2.5 million.
- Paid at least $500,000 for the qualifying shares (including any amounts the investor previously paid for shares of the same class that the investor holds in the same company).
- The investor is offered the qualifying shares through a financial services licensee who is satisfied that certain requirements are met and the investor signs a written acknowledgement that the licensee has not given the investor a disclosure document in relation to the offer.
- Meets the requirements of being a ‘professional investor’ under the Corporations Act 2001 (such as a financial services licensee).
- Gross Assets
- Has or controls gross assets of at least $10 million (including any assets held by an associate or a trust that the investor manages).
If an investor does not satisfy the sophisticated investor test and the total investment in one or more qualifying ESICs in an income year exceeds $50,000, the investor is not eligible for either the non-refundable tax offset or the beneficial CGT treatment.
There are other restrictions:
- An investor cannot hold more than 30% of the shares in the ESIC or a connected entity immediately after the shares are issued, or
- have a degree of influence to be an affiliate of the ESIC. Thus, for example, a director-owner of an ESIC would be precluded from qualifying for a tax offset, as the ESIC would be an affiliate of the director-owner.The Tax Commissioner will seek to apply the anti-avoidance provisions of the tax law if investors enter into an artificial scheme to qualify for the tax offset or the modified CGT treatment for shares in a qualifying ESIC, or contrived an arrangement to qualify for both the tax offset and any subsequent CGT outcome. The following is an example of the ATO applying anti-avoidance provisions:
Example 2 (continued)
To circumvent being unable to utilise the capital tax losses, Lucy contrives an artificial scheme utilising interposed entities, enabling her to indirectly obtain the benefit of the tax offset and directly obtain the tax benefit of the capital losses (which could arise from Lucy’s interest in the interposed entity) resulting from the investment in the shares in the ESIC. If the scheme had not been entered into, then Lucy would not have been able to utilise those capital losses.
As a result, Part IVA will apply to this scheme and the Commissioner may determine that the whole part of the capital loss (relating to the ESIC shares) was not incurred. Further, the Commissioner may impose additional administrative penalties for the intentional disregard of the law which would equate to 75 per cent of the tax shortfall resulting from the Commissioner’s amended assessment.
The Government observes that there is a high risk period between initial funding to the time a start-up company begins generating revenue. There is also substantial risk in that the start up may either not become profitable or survive in the long term or that the shares increase in value above the issue price. Therefore, the investor needs to weight up, before purchasing qualifying shares, the risk factors involved. For example, whether not being able to utilise any future capital losses outweighs the benefits of the 20% offset and being able to disregard potential capital gains.
Investors also need to proceed with caution in investing in ESICs since, in determining what shares qualify for any modified capital loss treatment, it does not matter whether the investor has actually received the tax offset in relation to the shares. On this matter, the legislation states that the investment entity MUST disregard, i.e. forego, any capital loss it makes from a CGT event. Therefore, an investor who purchases “qualifying shares” from an ESIC and then decides not to claim the 20% offset when the shares fall in value to a fraction of their issue price would, most likely, be unable to utilise the capital loss even if the shares are continuously held for more than 12 months.
– Early Stage Investor Tax Initiatives –
Director – Whitehawk Advisors
Managing Director – TCF Services
- Scope your potential to claim various grant programs
- Assist with the preparation and lodgement of grant applications
- Review or provide a health check on your internally prepared grant applications
- Establish record-keeping practices as required under various grant programs
- Provide prepayment loans against future cash refunds under the R&D Tax Incentive
- Keeping industry informed on all new Government policy and grant initiatives
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