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.
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.
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.
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.
There are several critical benefits for early-stage investors and start-ups that will take advantage of this new regime:
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.
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.
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.
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:
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:
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:
You can choose to hold on to these documents for up to 10 years, but you must keep them in case of an audit.
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.
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