Investing In Innovation – An Investors Guide
In the October 2017 edition of EQUITY we discussed the key features of the new investment framework for investors looking to diversify their portfolio and obtain significant tax incentives by investing in early stage innovation companies (ESIC®). From 1 July 2016 proven sophisticated and non-sophisticated investors (Corporations Act 2001) owning newly issued equity in an early stage innovation company obtain:
1. Access to a new alternative asset class to diversify their portfolio and include a range of early stage, unlisted businesses in fast-growing industries
2. Tax free capital gains and a 20% tax rebate on their investment with Federal Government support This article provides a user guide for early stage investors in this exciting new asset class.
Planning an early stage investment
Investors wanting to benefit from these early venture tax incentives are obliged, under Australia’s tax laws, to determine whether the business they wish to purchase new equity from qualifies as an early stage innovation company on the day of investment.
There are five options an investor can choose from when verifying an early stage innovation company:
1. Do it yourself
You will need to understand the tax laws – legislation, case law interpretations, tax rulings, media releases and ATO interpretations – and apply them to the company’s financial situation in the context of the Early Stage Test and either the 100 point Innovation Test or Principles-Based Test (outlined below). Verifying an ESIC® investment requires time, knowledge and experience to read and understand financial statements, income tax returns and the various components thereof. You will also have to research the full business activities of the company and its competitors, identify its innovations and understand its key points of difference including its commercialisation strategies. Getting it wrong means not only losing out on early stage investor tax incentives but also potentially being penalised by the ATO.
2. Rely upon the representations made to you by the early stage company
The company is keen to obtain your capital to help grow the venture. In the pursuit of securing your capital a compelling story is created. The onus is on investors to look through the hype and measure the company against the eligibility criteria in the law. Relying upon what is told to you by management during the courting period will not provide the shield of defence required to validate whether your investment qualifies for the early stage investor tax benefits.
3. Rely upon a private ruling from the Tax Office
The company can apply to the Tax Office for a private ruling relating to being an early stage innovation company. The ruling is based on the facts stated in the application and all correspondence to the Tax Office. If the circumstances are materially different from these facts, the ruling has no effect and cannot be relied upon. The application will need to be prepared in a manner that involves a full disclosure of all facts, knowledge and reference to the relevant aspects of the tax law. The Tax Office will then decide if the company meets the eligibility criteria under its interpretation.
If the Tax Office issues a positive ruling, you will not be protected if:
• the facts of circumstances set out in the ruling change
• the law on which the ruling is based changes
• another ruling issues a revision or changes this ruling before you begin the arrangement described in the ruling
An application is not guaranteed to succeed. We are aware of applications being rejected or disallowed by the Tax Office.
If you disagree with a ruling and choose not to follow the decision and later on your position is deemed incorrect then, you will have to repay any tax shortfall plus interest on the underpaid amount. You may also have to pay penalties unless you can show you have exercised reasonable care in deciding to not act in accordance with the ruling.
Extract from official Tax Office private ruling: “The ruling is only about how the tax law applies to the company based upon the facts and information that the company has provided to the Commissioner. Your eligibility for the early stage investor tax incentives will depend on your circumstances as well as whether the company meets the ESIC requirements at the time immediately after it issued you with new shares. Consequently, you should make enquiries to confirm that there has been no change in the company’s activities subsequent to the date the private ruling issued that could lead to a different outcome under the tests. Potential investors must form their own view about the commercial and financial viability of the company. The Commissioner recommends an adviser be consulted for such information.”
4. Be ignorant of the law and seek retrospective ESIC® eligibility for your investment
Just like retrospective planning, seeking ESIC® eligibility post investment is an option, however, it is fraught with risk. Do you have the time and resources to perform such investigations to verify the company’s activities against the eligibility criteria? If relying upon a private tax ruling is it still current and the company’s business activities still eligible and, are you willing to risk the financial implications if not?
5. Find the right adviser
Unable to appropriately cover the volume of material when advising clients, the tax profession is increasingly being divided into specialist areas to best serve the community. With the introduction of early stage investor legislation in July 2016 there are now authorised ESIC® specialists who understand your needs and provide access to validated ESIC® opportunities directly and/or through a managed structure. ESIC® advisers are also certified to provide the appropriate financial information and guidance for those seeking to invest in new business opportunities.
So how is an early stage company actually determined? A qualifying early stage innovation company must fulfil strict requirements under the following Income Tax Assessment Act:
Does it satisfy the early stage test?
The following criteria need to be met:
1. The company must have been either:
• Incorporated in Australia within the last 3 income years;
• Registered on the ABR within the last 3 income years; or
• Incorporated in Australia within the last 6 income years and the total expenses of the company and its 100% owned subsidiaries do not exceed $1million over the last 3 income years.
2. The company and its 100% subsidiaries must have total expenses not exceeding $1million and assessable income not exceeding $200,000 in the previous income year.
3. The company is not listed on any stock exchange in Australia or overseas.
Does it satisfy the 100-point innovation test OR the principles-based test?
The 100-point innovation test involves an innovation scorecard against which the company’s activities are to be measured and analysed on the day of your investment. The legislation’s scorecard identifies 8 items with a points rating ranging from 75 points to 25 points. For example, if the company has a notional R&D tax deduction available for at least 50% of the company’s total expenses, 75 points will be allocated with another 25 points to be contributed from other eligible sources identified on the scorecard and as amended by regulations made under the tax law before the company is eligible.
The principles-based test involves the company meeting all the following criteria on the day of your investment:
1. It is genuinely focussed on developing for commercialisation one or more new, or significantly improved, products, processes, services or marketing or organisational methods; and
2. The business relating to those products, processes, services or methods has a high growth potential; and
3. The company can demonstrate that is that the potential to be able to successfully scale that business; and
4. The company can demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business; and 5. The company can demonstrate that it has the potential to be able to have competitive advantages for that business; and
6. The company has not engaged in any of the prohibited activities listed under the tax regulations at any time prior to your investment.
The next step for an educated Investor
Identify an ESIC® specialist who can actively assess early stage ventures and make decisions on their ESIC® eligibility using a rigorous process of investigation, due diligence and assessment. ESIC® specialists can also provide you with suitable investment opportunities into companies that fit the early stage innovation criteria.
You and Us working together
ESIC® Hub is Australia’s first and only online platform dedicated to serving the needs of the early-stage community. We offer you an effective pathway to efficiently allocate resources by utilising our deep technical knowledge and expertise to ensure client-centric outcomes are achieved.
We look forward to working with you.
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