On 16 March 2016, the Turnbull Government introduced the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (“Bill”) into the Federal House of Representatives.
The Bill aims to encourage new investment in Early Stage Innovation Companies (“ESICs”) by providing investors with tax incentives for qualifying investments.
In essence, the Bill provides two tax incentives:
- a 20% non-refundable carry forward tax offset, capped at $200,000 (the equivalent of a $1M investment) per investor per year; and
- a capital gains tax (“CGT”) exemption on gains (not losses) realised on ESIC shares held for between one and ten years, with market value cost base uplift thereafter.
The incentives were intended to go live from the earlier of 1 July 2016 or date of assent. However, given the recent prorogation of Federal Parliament and the current political state of play, there remains uncertainty over whether or when the Bill will be passed.
A broad range of investors are intended to qualify for relief, including individuals, trusts, partnerships and companies (other than widely held companies/their subsidiaries). However, non-sophisticated (retail) investors are restricted to a maximum investment of $50,000 per year. There are no restrictions on the investor’s tax residency status.
There are restrictions, however, on the mode of investment. For instance, the investment must take the form of a monetary investment in exchange for newly issued shares in an ESIC that cannot exceed 30% of total shares on issue. Investor/investee relationships are also restricted, whereby the investor and the ESIC cannot be “affiliates” of each other. Nor can ESIC shares be issued pursuant to an employee share scheme.
Early Stage Innovation Companies
Broadly, an unlisted Australian company may qualify as an ESIC if it is in an early stage of development and it is developing new or significantly improved innovations with the intention of commercialising them to generate profit. This essentially requires satisfaction of both an “early stage” limb and an “innovation” limb.
The early stage limb requires that the company was incorporated or registered on the Australian Business Register within the last three income years. A company incorporated within the last six years may also qualify provided it and any wholly-owned subsidiaries incurred expenses of less than $1M across the last three income years. In either case, less than $1M of expenses and $200,000 of assessable income must have been generated in the last income year.
The innovation limb can be satisfied through either a statutory points-based test (which assigns a certain number of points to particular objective innovation criteria) or a subjective principles‑based test. Whilst the content of these tests is extensive, the prevalent focus is on the company’s research, development and innovation activity as well as the ability to realise high growth potential through scalability and attaining competitive advantage in Australia and abroad.
Critically, if a company later ceases to qualify as an “ESIC” this will not deny investors the above tax incentives.
Implications for Investors
Overall, the Bill appears to provide attractive tax incentives for investors wishing to tap into Australia’s growing startup and innovation scene. However, there are some practical observations to be made about the proposed measures.
Before considering the proposed tax offset, investors should bear in mind that it is non‑refundable. For this reason, investors (or their investment vehicle) will need to have a taxable income against which the offset can be applied for it to provide any income tax benefit.
Whilst the CGT exemption may be attractive, importantly capital losses are also disregarded for the first ten years of an investment. This is undesirable, particularly in the event the ESIC fails or does not take off as anticipated. When capital losses become available after 10 years, this may not provide any significant comfort either as the cost base of ESIC shares are reset to market value at this time in any event.
The early stage limb may effectively limit the types of startup companies that qualify as an ESIC. To the extent the company has commercialised and scaled an innovative idea, the ability to satisfy the turnover and expense thresholds may prove difficult here. The incentives, therefore, appear to target companies in the true genesis of their development.
In the Bill’s present form, the investor/investee relationship restrictions could also create practical and other commercial hurdles for investors seeking to apply the incentives. The incentives appear limited to arm’s-length investments only and the 30% cap will inhibit any investor wishing to obtain a majority stake or control over the ESIC.
Only time will tell if the Bill will survive the current political environment. If passed, the legislation will provide significant incentives to investment in innovative startups and this will be a real positive. However, the complexity of the Bill and the strict and detailed compliance requirements mean that startup companies and investors should obtain legal and tax advice before applying the new rules, particularly as a large degree of judgement is required to determine if a target company qualifies as an ESIC.
Cowell Clarke has significant expertise and experience in advising startup companies and investors as well as all aspects of taxation law. If you require assistance in any of these areas or wish to discuss the proposed legislative changes further, please contact us.