With a few months to go until 30 June when investors can claim the new start-up tax concessions and 31 July when start-ups need to report information to the ATO, it’s good timing to revisit the state of play and some of the key conditions.
It was around this time last year that there was a lot of buzz around new tax incentives for investments in innovative start-up companies. New tax laws were passed and equity issued by start-ups had the green light from 1 July 2016.
While a start-up can help investors by providing information that they qualify under the new rules, the tax law puts the onus on investors to do their homework and make sure all the boxes are ticked. Like all things tax-related, there are quite a few boxes to tick – for both investors and start-ups!
So what’s on offer?
> 20% non-refundable carry-forward tax offset – let’s call this the Start-up Offset.
In simplified terms, this means you can reduce each dollar of tax payable by each dollar of the Start-up Offset available. It can only reduce your tax bill to zero and therefore, can’t result in a tax refund but you can save what’s left over for next year. The amount of Start-up Offset is capped at $200k, so this one applies to the first $1m that you invest in a start-up/s.
> No capital gains tax (CGT) for investments held between one and ten years – let’s call this the Tax-free Exit.
Unlike the Start-up Offset, the Tax-free Exit is not capped. So even if you cap out on the Start-up Offset, the Tax-free Exit will still be available for other investments that qualify under the new rules.
How do investors qualify?
Depending on the investor type, limits can apply. These are discussed below, but before we get there some red flags include:
- If the start-up didn’t qualify under the new rules immediately after they issued you shares (see ‘How do start-ups qualify?’ below);
- The shares issued to you are not ‘equity interests’ under the tax law (eg certain equity in the legal form of preference shares would not be tax equity);
- You and the start-up are ‘affiliates’ under the tax law. This could be the case if it is expected that the start-up would operate in the way that you want or direct;
- After you get your shares you own more than 30% of the start-up; or
- Your shares were issued under a share plan.
Assuming there are no red flags, the limits that can apply to different investors include:
- No limit: The rules are aimed at investors that meet the ‘sophisticated investor’ criteria under the corporations law, which is why they are often called the ‘Angel investor tax incentives’. If you’re in this category you get the full benefit of the Start-up Offset and CGT-free Exit.
- Some limits: For the little fish that are not a ‘sophisticated investor’, you can still benefit but the maximum investment you can make each year in eligible start-ups is $50k. So your maximum Start-up Offset is $10k and those investments are CGT-free for the next 10 years.
- Not available: If you’re a whale (broadly, listed companies or their wholly-owned subs, or companies with more than 50 shareholders), these rules don’t apply to you.
It’s important to remember that it doesn’t matter if you’re an Australian resident or foreign investor, or if you invest via a partnership or trust, the Start-up Offset and CGT-free Exit can still be available.
How do start-ups qualify?
The start-up needs to satisfy the requirements to be an ‘early stage innovation company’ (the acronym being ‘ESIC’). Relevantly, it is not an on-going test so it doesn’t matter if it no longer meets the ESIC requirements after the shares are issued, but the critical testing point is the time the shares get issued to you.
The relevant tests the start-up must pass are:
- the early stage test; and
- either the:
- 100 point innovation test; or
- principles based innovation test.
To satisfy the early stage test, the start-up (including any of its subsidiaries):
- Must have assessable income of $200k or less in the previous income year (certain commercialization grants are ignored and this requirement is met if the start-up had no income); and
- Must have total expenses of $1m or less in the previous income year; and
- Can’t be listed on any Australian or foreign stock exchange; and
- Must either be:
- Incorporated in Australia or registered in the Australian Business Register within the last three income years (tested from the income year which your shares are issued); or
- Incorporated in Australia in the last six income years (same testing time as above) and the company and its wholly-owned subs had expenses of $1m or less across the last three of those income years.
Like all 100 point tests, you need to follow a table and add up the points which apply. Things that give points to start-ups include expenditure on R&D, receiving certain grants, completing or undertaking an eligible accelerator programme, or third parties having invested at least $50k in the start-up.
The principles based test, as it suggests is subjective and generally if this is being relied on, best practice would be to seek a ruling from the Australian Taxation Office (ATO) for certainty.
Start-ups that think they have issued equity that is eligible under the new rules are required to report certain information to the ATO, with the first report due by 31 July 2017.
The exact format for reporting is yet to be confirmed, but start-ups should be aware of the information they need to report and investors should know that this is required to be reported to the ATO.
For investors, you claim the Start-up Offset and CGT-free Exit in your tax return and it is evidenced in the way that you prepare your return.
Take away points
- The start-up tax concessions are not as simple as they may first appear and the conditions must be satisfied at the time you are issued shares.
- Start-ups should be clear on whether they qualify or not and investors should perform their diligence before investing and not assume that the concessions are available to them.
- As with all matters related to the law, it is recommended that both start-ups and investors seek professional advice on the application of these new rules in the tax law.
This article was contributed by Nima Sedaghat, a Tax Partner in the Sydney Commercial practice group of HWL Ebsworth Lawyers. He has extensive experience assisting small business owners understand their obligations under the tax law and provides tax advisory and structuring solutions on all aspects of their business operations. Given the complexities of the tax law, Nima is passionate about keeping tax simple for his clients so they can concentrate on what they do best – running their business! In addition to being a Lawyer, Nima is also a qualified Chartered Accountant.