What is an ESIC and How Can They Benefit My Business?

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Table of Contents

• Tax Benefits
• Qualifying ESIC
• Timing 
• Eligible Investors
• Key Takeaways
• Frequently Asked Questions

The ESIC tax incentives aim to encourage investors to invest in early-stage Australian companies with high growth potential. The tax incentives are available for eligible investors who invest in Early Stage Innovation Companies (ESIC). If your company can demonstrate that it qualifies as an ESIC, this can be a good way to encourage investors into your early-stage company. We explore how they can benefit your business.

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Tax Benefits

There are two tax benefits available for eligible investors who acquire new shares in an ESIC:

• tax offset; and
• modified capital gains treatment.

Tax Offset

A non-refundable tax offset equal to 20% of the amount paid by the investor for their investment into the ESIC. This will be subject to the caps described below. 

The 20% amount is “offset” against the investor’s taxable income for the income year in which they made the investment. If the investor does not have taxable income in that income year (i.e. they are in losses), the offset may be carried forward to the tax years in which they do have taxable income.  

Notably, the available offset is subject to maximum caps. The applicable cap depends on the type of investor:

1. If the investor is a “Sophisticated Investor” (as defined in the Corporations Act), the available tax offset is capped at $200,000 each income year (i.e. a total ESIC investment of $1,000,000 each income year). 
2. If the investor is not a Sophisticated Investor, the maximum investment amount for that investor in qualifying ESICs is $50,000 each income year (i.e. a total tax offset of $10,000 each income year). 

The purpose of these restrictions is to ensure that investors are not over-exposed to high-risk investments. 

Modified Capital Gains Treatment

The second benefit is that capital gains are disregarded on ESIC shares held continuously by the investor for between 12 months and 10 years. 

If an investor holds your company shares for longer than 10 years, the cost base to dispose of those shares will be the market value of the shares at the 10-year mark. This means that the investor should only be subject to tax on any gain in the value of the shares after 10 years.  

If the investor holds your shares for less than 12 months, they will be subject to capital gains tax on the gain in value of those shares (but must disregard any capital loss). 

Qualifying ESIC

If you are an early-stage company, your main concern will be whether your company qualifies as an ESIC. To do so, your company must satisfy the “Early Stage Test”, and either (a) the “100 points test” or (b) the “Principles Based Test” immediately after issuing shares to the investors. 

Early Stage Test

To satisfy the early stage test, your company must meet the following 4 requirements:

1. The company must have been either incorporated in Australia or registered on the Australian Business Register within the last three income years OR have been incorporated within the last six income years and the company and any wholly owned subsidiaries collectively had expenses or $1m or less in each of the three previous income years. 
2. The company and any subsidiaries must have had expenses of $1m or less in the previous income year.
3. The company and any subsidiaries must have assessable income of $200,000 or less in the previous income year. 
4. The company’s equity interests must not be listed on any stock exchange.  

100 Points Test

To qualify under the 100 Points Test, the company must obtain at least 100 points by meeting certain innovation criteria (e.g. taking part in an accelerator program).  The ATO has a table of the criteria and the corresponding number of points.

We recommend determining whether the company will meet the 100 Points Test before considering the Principles Based Test. This is because the 100 Points criteria are objective/bright-line tests. As such, there is little ambiguity about whether the company does or does not meet those criteria. 

Principles Based Test

There are five requirements a company must meet to satisfy the Principles Based Test:

1. Your company must be genuinely focused on commercialising a new or significantly improved product, process, service or method.
2. The business relating to that innovation must have high growth potential.
3. Your company must demonstrate that it has the potential to scale the business successfully.
4. The company must demonstrate that it has the potential to address a broader than local market (including global).
5. The company must demonstrate its potential to have a competitive advantage.

The Principles Based Test is subjective and can be difficult to apply. If you would like to rely on the Principles Based Test, we recommend seeking a private tax ruling from the ATO as there is a real risk of the ATO adopting a different conclusion to you. As the determination may take up to 6 months, we recommend applying as soon as you are aware of an upcoming raise. LegalVision can assist with preparing this ruling application.  

Timing 

To qualify for the tax incentives, eligible investors must have purchased new shares in a company that meets the ESIC requirements immediately after the shares are issued. This means that:

• if a company issues convertible notes or rights to purchase shares, the tax benefits will not apply unless the company meets the ESIC requirements immediately after those securities convert to shares; and 
• the tax incentives will not apply in respect of shares transferred to an investor by an existing shareholder – the shares must be newly issued. 

If the company loses ESIC eligibility at a later point in time, this does not impact the previous ESIC status of the company. For example, this might occur because expenses increase beyond the $1m threshold.

Additionally, you must provide the ATO with a report each income year in which your investors seek to rely on the ESIC concessions. You can file the report through ATO online services. It is important that you file the report by 31 July of the relevant income year. 

Eligible Investors

The following investors cannot benefit from the ESIC concessions:

• widely held companies and 100% subsidiaries of widely held companies;
• early-stage venture capital limited partnerships; 
• affiliates of the ESIC; or
• investors holding interests in the ESIC (and entities connected with the ESIC) that entitle them to more than 30% of the dividend, capital or voting rights assessed immediately after the relevant shares are issued. 

Trusts and partnerships may be eligible investors. However, they are subject to different rules. Your investors will need to seek their own tax advice regarding whether they qualify for the ESIC tax incentives.  

Key Takeaways

The ESIC tax benefits are a great way to encourage investors to invest in your early-stage business. However, applying criteria to be considered an ESIC can be difficult. To ensure that you meet the criteria, we recommend engaging an advisor to confirm that your company will qualify as an ESIC before communicating that status to prospective investors. If you seek to rely on the Principles Based Test, you should also consider whether you should obtain a private binding ruling from the ATO. 

For more information, our experienced corporate lawyers can assist you as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page. 

Frequently Asked Questions