Tax incentives for early stage investors

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As part of the National Innovation and Science Agenda (NISA), the Australian Government seeks to encourage innovation by aligning our tax system and business laws with a culture of entrepreneurship and risk-taking.

The NISA contains complementary measures to ensure innovative companies are supported at different stages of development, and includes tax incentives for early stage investors which will provide concessional tax treatment for investments made in qualifying early stage innovation companies (ESICs), such as startups, with high growth potential.

The new tax incentives will provide eligible investors with:

  • a 20 per cent non‑refundable carry-forward tax offset on amounts invested in qualifying ESICs, with the offset capped at $200,000 per investor per year (on an affiliate-inclusive basis); and
  • a 10 year exemption on capital gains tax for investments held as shares in an ESIC for at least 12 months, provided that the shares held do not constitute more than a 30 per cent interest in the ESIC.

The tax incentives are designed to promote this culture by connecting relevant startup companies with investors that have both the requisite funds and business experience to assist entrepreneurs in developing successful innovative companies, particularly at the pre-commercialisation phase where a concept is in development, but the company requires additional investment to assist with commercialisation. To target the incentives to innovative activities, the startup receiving the funding must satisfy two limbs:

  • The first limb determines that the company is early stage, against criteria related to expenditure, assessable income, stock exchange listing and incorporation.
  • The second limb determines that the company is involved in innovation, by allowing the company to self‑assess against either a principles-based or gateway test, or by receiving a determination from the Australian Tax Office.

Allowing companies to self-assess against one of two tests provides startups with choice, accommodates the unique circumstances of different innovative start-ups, and reduces the uncertainty and costs involved in determining whether a startup is involved in innovation. Further, these tests have been designed with stakeholder feedback in mind, to ensure they reflect industry concepts and remain flexible to new innovation.

Often it is the high risk period between initial funding to the time a start-up company begins generating revenue that makes it difficult to attract investors or obtain finance to develop a concept past initial funding. In fact, this stage is sometimes described as a ‘valley of death’ where most start-up companies fail simply because they find themselves vulnerable to cash flow requirements. Accordingly, the incentives focus on providing an attractive tax offset at the outset for investors who invest in ESICs, with an exemption for any subsequent capital gains realised on the investment, but without access to any losses realised on the investment.

These amendments bridge the funding gap between pre‑concept stage financing and support (typically provided through self‑funding, friends and family and government offsets such as the refundable R&D tax offset) and financing through the venture capital investment regimes for companies further along the development pathway.

Key definitions

An investor will qualify for the incentives if it:

  • invests in a qualifying ESIC (see below);
  • is not a widely-held company; and
  • is either:
    • a legal person controlled by an individual considered a sophisticated investor pursuant to subsection 708(8) of the Corporations Act 2001; or
    • a non-sophisticated investor that has invested $50,000 or less in the income year.

A company will be a qualifying ESIC at the time of investment if it:

  • had expenditure of  $1,000,000 or less in the prior income year;
  • had assessable income of $200,000 or less in the prior income year;
  • is not listed on any stock exchange;
  • was incorporated in Australia:
    • in the last 3 years; or
    • prior to that but received an Australian Business Number in the last 3 years; or
    • in the last 6 years and total expenditure in the previous three tax returns does not exceed $1 million; and
  • is involved in innovation, by either
    • satisfying the principles-based test through self-assessment; or
    • satisfying the gateway test through self-assessment; or
    • receiving a determination from the Australian Taxation Office.

Principles-based test:

The principles-based test provides guidance to help determine if a company will be an ESIC, through self‑assessment of whether:

  • it is genuinely focused on developing for commercialisation one or more new, or significantly improved, products, processes, services or marketing or organisational methods;
  • the business relating to those products, processes, services or methods has a high growth potential;
  • it can demonstrate that it has the potential to be able to successfully scale that business;
  • It can demonstrate that it has the potential to address a broader than local market, including into global markets, through that business; and
  • it can demonstrate that it has the potential to be able to have competitive advantages for that business.

Gateway test – must achieve at least 100 points:

The gateway test contains a more objective set of tests to provide additional assistance to identify an early stage innovation company. If a total of 100 points is achieved, the company will be considered an eligible innovation company for the purposes of this measure.

Points will be given for a range of activities including: a company’s level of expenditure on research and development; whether the company has received an Accelerating Commercialisation grant; whether the company is undertaking/completed a genuine accelerator program that supports entrepreneurs; received at least $50,000 from a third-party financial investor; is an applicant on one or more enforceable intellectual property rights on an innovation through a standard or innovation patent; or has a written agreement with a listed/registered entity under the Higher Education Funding Act 1988 or the Industry Research and Development Act 1986.

Frequently Asked Questions

Why are the tax incentives limited to investments in certain companies? 

The targeting is designed to focus on innovative startup companies with high growth potential, as distinct from low-risk, low-growth companies.

Innovative startup companies with high growth potential tend to involve a high degree of risk early in their lifecycle, which can deter investors and lead to less investment in developing innovative new ideas.

Why are the tax incentives not available to investors and ESICs that are affiliates of each other?

The tax offset is designed to encourage new investment in ESICs rather than merely subsidise the existing investment. If an investor exerts a degree of influence over an ESIC or vice versa, as per an affiliate relationship, it might be expected that the offset is not attracting this type of new investment. Further, the measure intends to partner ESICs with new investors who are able to provide business experience and expertise to assist entrepreneurs in developing successful innovative companies.

Can a member of a trust or partnership be eligible for the tax incentives?

The tax incentives are available to all types of investors, regardless of their preferred method of investment (whether an investment is made directly as a corporation or individual or
indirectly through a trust or partnership) other than ‘widely held companies’ and 100 per cent subsidiaries of these companies. A trust or partnership will not directly be entitled to the tax offset, however, specific rules apply to ensure the value of these tax incentives flow through to beneficiaries and partners, where such an investment method is chosen.

Where can I find the draft legislation and explanatory memorandum for the incentives?

The Bill and associated explanatory materials are available on the Parliament of Australia website.

When are the tax incentives expected to apply from?

The enabling legislation, the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, received Royal Assent on 5 May 2016. This means that the tax incentives will be available from the 2016-17 income year.