Start-up funding is at an all-time high. It has been reported that 8 out of 10 entrepreneurs who start businesses crash within their first 18 months. However, it appears there’s a new wave of support available to help these young start-ups flourish.
The government has introduced the Early Stage Innovation Company (ESIC) regime to encourage investments into start-ups or early-stage business entities in Australia. The ESIC aims to incentivize angel investors and venture capital funds to invest in qualifying start-up companies.
What Is ESIC?
The ESIC is an alternative way of structuring investments for early-stage businesses. The program offers tax relief and relief from capital gains tax for investors who contribute to qualifying start-ups or early-stage entities.
How Does It Work?
A start-up becomes eligible under the ESIC if it satisfies objective criteria from the Australian Tax Office. Once a start-up has been accepted, it can obtain an ESIC Investment Certificate only from a government-approved service provider of ESIC.
When a company or investor holds this certificate, it is entitled to tax concessions on any investments into qualifying start-ups. A capital gains tax exemption is available regarding any future capital gains made by the investor upon the disposal of its ESIC investment.
Qualifications For Receiving ESIC
A company must be based in Australia and meet the Early-Stage Test. There are also two revenue tests (the 100-point innovation test and the principles-based innovation test) to determine whether or not the business entity will be classified as a start-up.
Start-up entities must pass both tests to be eligible for the ESIC. The first test is that an entity’s revenue cannot exceed USD$1 million if it operates for less than two years. If the company or business entity has been operating for more than two years, its annual revenue cannot exceed USD$5 million.
The second test is that the company must prove to have a competitive edge to succeed. A company applies to this using its business plan, strategy for commercialization, and competition analysis.
Benefits On Investments With ESIC
There are several critical benefits for early-stage investors and start-ups that will take advantage of this new regime:
1. Capital Gain Tax Exemption
Capital gains tax exemption for investments is held in an ESIC. The exemption runs for 12 months to 10 years from the issuance of the company’s ESIC Investment Certificate.
To illustrate this benefit, consider the following example:
An individual purchases a share in a qualifying start-up for USD$1,000 and held on to it for two years. In the third year, he sells these shares for USD$2,500. They won’t be subject to capital gains tax on this profit of USD$1,500 because it’s considered an ESIC investment.
2. Tax Deductions On ESIC Investments
There’s an exemption from taxation on any income derived from ESIC shares for investors who hold the shares as a long-term investment. The exemption runs from the date that an ESIC Investment Certificate is issued. So, if you receive USD$1,000 in dividends from an ESIC investment that you hold as a long-term investment, then your taxable income will be reduced by the same amount.
3. Investment Income Tax Relief
This is an exemption from taxation on any interest derived from an ESIC portfolio investment for investors who hold the portfolio investment for at least three years.
For example, an individual purchases share in a qualifying start-up for USD$1,000 and held them for two years. They are then paid dividends of USD$100 on their investment. This USD$100 will reduce their taxable income because it’s considered an ESIC portfolio investment.
Fundamental Rules To Know About ESIC
- Losses can’t be carried forward to offset future profits.
- The capital gain or low-income tax benefits do not apply to the disposal of shares in a start-up company that has failed.
- The capital gain tax exemption only applies if the company was granted an ESIC Investment Certificate within 30 days of share purchase.
- The investor won’t be entitled to an ESIC tax benefit for shares he holds in a company that fails to add up to the requirements of the applicable Commonwealth, state, or territory law to be a qualifying start-up.
What Are Some Disadvantages Of ESIC?
Although the ESIC regime provides many benefits, there are also some disadvantages for investors to consider before entering into any contractual arrangements. These are as follows:
- The capital gains tax exemption won’t apply if the individual disposes of their shares in an ESIC within 12 months of receiving them.
- The income tax exemptions only apply when the shareholder holds the investment for at least five years.
- The investor doesn’t benefit from the tax exemptions if the company fails to meet the applicable Commonwealth, state, or territory law to be a qualifying start-up.
- There’s a fine in certain circumstances where false information has been provided under this measure.
Are There Any Automatic Reminders?
To keep track of when you need to lodge your capital gains tax return for discounted ESIC shares, make sure you keep a record of the:
- company name
- date you purchased the shares
- percentage of ownership interest in the company
Make sure you hold on to this information until you lodge your capital gains tax return.
You’ll also need to hold on to other documents, including:
- the contract which you entered into with the ESIC
- any additional agreements between you and the ESIC
You can choose to hold on to these documents for up to 10 years, but you must keep them in case of an audit.
Other Information You Should Know
If you’re investing in ESIC, make sure you read other articles on the ATO website so you’ll be aware of any potential tax traps. You can also visit the ATO’s Business Portal for business tips, news, and information on all things related to taxation.
The ESIC was established to encourage investments in innovative start-up companies. The information here is current as of publication date only and may be subject to change without notice. This article’s ESIC information is not a substitute for obtaining legal or other professional advice, so seek independent financial advice where necessary. Please visit the ATO website for more information on any of the taxation topics covered by this article.