a 20% tax offset; and
a capital gains tax exemption for ESIC shares held for between one and ten years.
The tax offset is effectively a tax payer funded 20% discount on the subscription price of investing in eligible startups. For sophisticated investors, the tax offset applies to investment amounts of up to $1 million per year. Retail (non-sophisticated) investors are limited to investment amounts of $50,000 per year. Unlike the approach for sophisticated investors, if retail investors invest any amount above this cap they will not be entitled to the offset at all. In either case investors are able to carry forward the offset, although for sophisticated investors the total offset (ie carried-forward and for investments made in that year) will at all times be capped at $200,000.
In relation to the capital gains tax exemption, the downside is that capital losses on ESIC shares are not deductible. If the investor has not dealt with the shares by the 10th anniversary of the investment date, the cost base of the ESIC shares will be their market value at that time, rather than their original subscription price.
The bill also contains changes which benefit ESVCLPs and VCLPs; that is vehicles designed to attract investment into venture capital funds through attractive tax treatment. The key change is a tax offset for investors (limited partners) in ESVCLPs equal to 10% of contributions made by the partner to the ESVCLP per year.
These incentives are planned to come into effect on 1 July 2016. We are aware of reports of investors delaying early stage investments until then. Unless investors plan to take their money elsewhere if the bill does not become law, startups should consider offering convertible notes now which automatically convert to shares on 1 July 2016 (or a later date), as these tax incentives (if they become law) will apply to those shares.
WHAT IS AN ESIC?
For a startup to qualify as an ESIC it must be early stage and innovative.
Early stage means that a startup must have been:
incorporated in Australia or issued with an ABN within the last three years; or
incorporated in Australia within the last six years, provided that it has not incurred expenses of more than $1 million in total over the last three years.
In addition, a startup must have total expenses of no more than $1 million and taxable profits of no more than $200,000 in the previous year, and must not be listed on the ASX or another stock exchange.
A startup can satisfy the innovative limb by self-assessing under a ‘principle-based' test, or by accruing sufficient points under an ‘objective’ test.
‘Principle-based’ innovation means that:
the startup must be focused on developing one or more new or significantly improved products, processes, services or marketing or organisational methods;
the startup’s business:
has high growth potential;
has a broader than local market; and
the startup can demonstrate that that business potentially has competitive advantages.
The explanatory memorandum to the bill (which can be found at this link) contains some useful hypothetical examples which apply these concepts.
Alternatively, a startup will be innovative if it can attain 100 points across the following areas:
It does not matter that a company that qualifies as an ESIC at the time of issuing shares ceases to qualify thereafter.
ARE PREFERENCE SHARES EXCLUDED?
The tax incentives apply to equity interests that are shares issued by an ESIC. The explanatory memorandum includes a rather loose reference to preference shares to illustrate that the tax incentives will not apply to debt interests. In our view, preference shares will not as a matter of principle be excluded, and it will be a straightforward matter to issue preference shares with rights that create “equity” interests for the purposes of the “debt/equity” tax rules. Redeemable preference shares which are redeemable at the option of the investor will however be debt interests and will not qualify for the tax incentives.
WHICH INVESTORS AND INVESTMENTS ARE EXCLUDED?
The tax incentives are available to most types of investors, regardless of their preferred method of investment, including overseas investors, trusts and partnerships*. However, the incentives are not available to:
a ‘widely held company’, which is a publicly listed company or, with certain exceptions, a company with more than 50 members, or in either case their 100% subsidiaries;
a person acquiring shares under an employee share scheme;
an affiliate of the ESIC, being a person exerting a degree of control or influence over the ESIC; or
an investor holding an equity stake of more than 30% in an ESIC immediately after the relevant ESIC shares are issued. Equity stakes in companies that are ‘connected with’ an ESIC (eg subsidiaries) are aggregated for this purpose, as an anti-avoidance measure.
*Both trusts and partnerships have more complex rules regarding ESIC investments that can be found in paragraphs 1.48-1.60 in the Explanatory Memorandum for the Bill.