R&D Tax Incentive And Esic Benefits For New Businesses: Key Information

In Short

• R&D Tax Incentive: Companies with turnover under AU$20 million can claim an 18.5% R&D tax credit and a 25% tax deduction on eligible R&D costs.

• ESIC Concessions: Investors in early-stage innovative companies can receive a 20% non-refundable tax offset and modified CGT treatment.

• Eligibility Requirements: R&D claims require at least AU$20,000 of eligible expenditure, and ESIC benefits apply to companies meeting early-stage innovation criteria.

Tips for Businesses

Take advantage of the R&D Tax Incentive and ESIC concessions to reduce tax costs and attract investors. Ensure your business meets eligibility criteria, maintains detailed records of R&D expenditure, and understands the specific requirements for investors to qualify for these benefits.

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Table of Contents

• Research and development (R&D) tax incentive 
• What is R&D? 
• Early stage innovative company (ESIC) concessions
• What Do I Need to Think About When Trying to Access It?
• Key Takeaways 
• Frequently Asked Questions

Starting a new business can be an exciting process, mainly when the activities of that business will be something novel and innovative. If so, it is crucial to be aware of the tax incentives available to your company, as these can:

• provide extra cash to continue investing in the innovative product; and
• incentivise investors to invest in the business.

This article will discuss the research and development (R&D) tax incentive and early stage innovative company (ESIC) concessions and how they provide such benefits to a company.

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Research and development (R&D) tax incentive 

What is R&D? 

The R&D tax offset is a benefit that assists companies in offsetting some of the costs of eligible research and development activities, known as R&D core activities. If the company’s income tax liability in the relevant financial year is less than the R&D tax offset, the incentive will generally provide a cash refund to the company. The refund amount is equal to the company’s income tax rate.

It is important to note that only companies can be R&D entities. Therefore, sole traders, partnerships, and trusts are ineligible.

What do I need to think about when trying to access it? 

Eligible R&D Activities

To be eligible for the R&D tax incentive, the company must complete “eligible R&D activities”. Broadly, these are activities:

• where the outcome could not be known in advance based on current knowledge or experience;
• where a systematic progression of work takes place, from an initial hypothesis to experiment, observation and evaluation and leads to logical conclusions; and
• this work generates new knowledge through new products, materials, processes, services, methodologies, etc.

R&D Expenditure

A minimum of $20,000 eligible R&D expenditure per annum is required to make an R&D claim. The expenses needed to receive an R&D tax credit include a location-based test, meaning that only eligible R&D activities conducted and costs incurred in Australia can be considered “R&D expenditure”.

The types of costs you can include as eligible R&D in the company’s income tax return are those incurred by the company on items such as salary time spent on:

• R&D activities;
• consultants/contractors based in Australia;
• direct costs such as testing;
• conferences;
• domestic travel;
• training; and
• the portion of office overheads or administration staff related to the R&D activities. This does not relate to sales/marketing unless it is technical feedback for a product or service.

Business Structure 

Only an R&D entity can qualify for the R&D tax incentives. Broadly, an R&D entity is a company that carries out the R&D work and effectively owns the R&D work. 

If structuring is not considered, the R&D tax incentive may not be available if the owner of the R&D work (for example, the holding company) is different from the entity doing the R&D work (for example, the operating company). Such an outcome can be circumvented if:

• the group consolidates for income tax purposes, which means that (amongst other things) the R&D tax incentive is assessed at the group, and not an individual company, level; or 
• suppose the group is not going to consolidate. In that case, an intercompany services agreement is put in place whereby the holding company engages the operating company to develop the R&D on the holding company’s behalf. If this structure is implemented, the service fee for this work must be paid before the end of the relevant financial year. 

Early stage innovative company (ESIC) concessions

What are ESIC Concessions?

The ESIC concession is a tax incentive for investors of an early-stage innovative company. 

Where an investor invests in an ESIC, they will be eligible for the following:

• the non-refundable tax offset is 20% of the amount paid for eligible investments, capped at $200,000 per year for the investor and affiliates; and
• Modified Capital Gains Tax (CGT) Treatment: Any CGT on the disposal of the eligible shares will be disregarded where the investor holds the shares for more than 12 months and less than 10 years.

What Do I Need to Think About When Trying to Access It?

The ESIC concession requirements must be satisfied immediately before the ESIC issues the shares to investors. This means that an ESIC assessment must occur each time the company considers an investment. To qualify for the concessions, the investors must be:

• issued new shares; and
• not be transferred shares from an existing shareholder.

“Early Stage” Company Requirements

There are four requirements for a company to be considered “early stage” for ESIC purposes:

1. Incorporation requirement: The company must have been incorporated in Australia or registered its Australian Business Number within the last three financial years. If this is not satisfied, the company:
   1. must have been incorporated in Australia within the last six financial years; and
   2. its wholly-owned subsidiaries must have had expenses of $1 million or less across the previous three income years. 
2. Expenses requirement: The company and its wholly owned subsidiaries must have had total expenses of $1 million or less in the previous financial year.
3. Income requirement: The company and its wholly owned subsidiaries must have had an assessable income of $200,000 or less in the previous financial year.
4. Stock exchange requirement: The company’s equity interests must not be listed on any stock exchange. 

“Innovative Company” Requirement 

To be an “innovative company” for ESIC purposes, the company must pass either:

• the “100 points test”; or
• the “principles based test” immediately before the shares are issued to an investor. 

The 100 points test is a self-assessment regime whereby the company compares its activities against criteria outlined in the legislation. This test determines whether, on balance, its activities accumulate to 100 points. For example:

• if at least 50% of the company’s total expenses for the previous income year are eligible notional deductions for the R&D tax incentive, this is worth 75 points; 
• If the company has completed or is completing an eligible accelerator program, this is worth 50 points; and
• if the company has been granted a standard patent within the last 5 years, it is worth 50 points.

If the company satisfies the 100 points test, there is no need to confirm this with the ATO. A company may choose to do so if it is concerned about eligibility for its R&D expenditure. 

Principle-based Test

To satisfy the principles-based test, the company must demonstrate that the company satisfies five requirements:

1. the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation;
2. the business relating to that innovation must have a high growth potential;
3. the company must demonstrate that it has the potential to be able to scale up that business successfully;
4. the company must 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 must demonstrate that it has the potential to have competitive advantages for that business.

Requirements For Investors 

Additionally, the investor must meet certain conditions immediately before issuing shares. Relevantly, the ESIC concession will not be available to an investor where:

• the investor acquires the shares from another shareholder rather than directly from the company;
• the shares are not equity interests in the company (i.e. they are a debt interest); 
• the investor is a widely-held company or a wholly-owned subsidiary of a widely held company; 
• the investor has invested more than $50,000 into ESICs in a financial year and is not a “sophisticated investor”; 
• the investor and the company are affiliates of each other at the time the shares are issued; 
• the investor holds equity interests in the company (and any entities connected with the company) that carry the rights to 30% or more of:
  • the distribution of income or capital in the company (or entities connected with the ESIC); or
  • the voting power in the company (or entities connected with the company); and/or
• the investor acquired the shares under an employee share scheme.

Business Structure

Similar to the R&D tax incentive, the business structure must be considered if the ESIC concession is applied.  Where the business operates from a single company structure, ESIC is simple to determine. However, issues can arise when a dual company structure (holding company and a subsidiary) is implemented. Unlike the R&D tax incentive, forming an income tax consolidated group has no bearing on the ESIC concession. 

Key Takeaways 

Starting a new business is exciting, especially when doing something no other company has done. To this end, the government has implemented the R&D and ESIC tax incentives, which provide tax benefits to eligible innovative companies and their investors. There are specific requirements to access these concessions. Therefore, consideration should be given to each criterion to ensure eligibility is satisfied. 

If you have any questions regarding tax incentives and concessions, our experienced taxation lawyers can assist 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

Who can access the R&D tax incentive? 

Only companies can access the R&D tax incentive. Sole traders, partnerships, and trusts are not eligible.

What are the requirements for a company to qualify for the ESIC concession? 

The company must meet the “early stage” and “innovative company” requirements, including having less than $1 million in expenses and being involved in innovative activities.