The Australian Taxation Office (ATO) has recently issued draft guidelines detailing what expenses are considered in determining whether a company meets the requirements to be an ESIC. In general, taxpayers who invest in an ESIC are entitled to a tax offset, if the specific legal requirements are satisfied. To qualify as an ESIC, the company must satisfy the following:
- The early stage test; and
- The 100-point innovation test; or
- The principles-based innovation test.
The Tax Offset
The tax incentives for early stage investors were announced by the government in its National Innovation and Science Agenda on 7 December 2015. Generally, early stage investors in innovation companies are entitled to the following tax offsets:
- A tax offset at the outset for investors who invest in an ESIC. Investors who acquire newly issued shares in an Australian ESIC may receive a non-refundable carry-forward tax offset of 20% of the value of their investments subject to a maximum offset cap amount of $200,000. In addition, a total annual investment limit of $50,000 applies to retail investors; and
- An exemption for any subsequent capital gains realised on the investment, but without access to any losses realised on the investment. Investors may disregard capital gains realised on shares in qualifying ESIC’s that have been held for between 1 and 10 years. Investors must disregard any capital losses realised on these shares held for less than 10 years.
The Early Stage Test
The early stage test contains a condition that the company and its wholly owned subsidiaries (if any) incurred total expenses of $1 million or less in the previous income year (the expense test).
The ATO’s interpretation of words ‘expenses’ and ‘incurred’ in relation to the early stage test are outlined in the guidelines.
According to the ATO, ‘expenses’ are amounts recognised as expenses under general accounting concepts. However, an expense that has been properly capitalised and results in the recognition of an asset under general accounting concepts is not an expense for the ESIC expense test. That is, an expense for accounting purposes is not necessarily incurred for the purposes of the expense test.
In the ATO’s view, the early stage test is only concerned with expenses which have been ‘incurred’ at the test time. ‘Incurred’ has the same meaning as given by the Courts’ in many decisions regarding the tax deductibility of expenses. In determining whether an expense has been incurred, the Courts have held that an expense is incurred when a presently existing liability exists.
The ‘test time’ means the time immediately after the company has issued shares to the investors. If the company no longer meets the ESIC requirements after the test time, this fact will not affect the investor’s entitlement to the early stage investor offsets.
The 100-Point Innovation Test
To qualify under the 100-point innovation test, the company must obtain at least 100 points by satisfying certain objective innovation criteria. This is tested immediately after the relevant shares are issued to the investor (the test time).
The Principles-Based Innovation Test
To qualify under the principles-based innovation test, the company must satisfy the following five requirements.
- The company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation;
- The business relating to that innovation must have a high growth potential;
- Evidence must exist that the company has the potential to be able to successfully scale up that business;
- Evidence must exist that the company has the potential to be able to address a broader than local market, including global markets, through that business; and
- The company must demonstrate the potential to be able to have competitive advantages for that business.
The principles-based innovation test is tested immediately after the new shares are issued to the investor.
For assistance with preparing your ESIC application please speak to your Nexia Adviser.