The ATO has recently issued a taxpayer alert regarding cases where early-stage investor tax offsets have been claimed in respect of shares received via financing arrangements that “appear designed to artificially meet the conditions for claiming the maximum tax offset”.

This article provides a refresher on the potential benefits of falling into the ESIC regime and highlights some of the pitfalls.

ESIC Refresher – Benefits

There’s an understandable desire to be an early-stage innovation company, as it opens the door for two potential tax benefits for the investor that significantly increase the attractiveness of an investment.

The first is a non-refundable carry-forward tax offset equal to 20% of the amount invested in the ESIC, capped at a maximum annual investment of $1,000,000. This provides investors with an immediate ROI of up to 20% on ESIC shares.

The second is modified CGT treatment being applied to the ESIC’s shares issued to you, such that capital gains tax is effectively eliminated for sales of ESIC shares held for 12 months and sold before the tenth anniversary of ownership. This significantly increases the upside potential for investors who receive ESIC shares, as the modified CGT treatment extends to all ESIC shares issued to an investor, even if their upfront tax offset is limited to the first $1,000,000 invested.

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ESIC Refresher – Company Eligibility

A company must be an ESIC at the time of a share issue for an investor to receive the above benefits. The investor must also pass some investor specific tests to receive the benefits.

There are two broad tests a company needs to pass to be considered an ESIC at a point in time: the early-stage test and the innovation test.

For the early-stage test, the company must meet requirements at the test time relating to:

  • Incorporation date OR ABR registration: within the last 3 income years*
  • Prior year expenses: under $1 million in previous income year
  • Prior year assessable income: under $200,000 in previous income year
  • Equity interests: none listed on an official stock exchange

*For incorporation date only, window is extended to 6 income years if the company & its 100% subsidiaries incurred expenses of less than $1 million over the previous 3 income years combined.

For the innovation test, the company must either:

  • Have 100 ‘points’ at the test time based on objective points-based criteria specified in s360-45 ITAA 1997 (earned via having sufficient prior year R&D expenditure, patents, outside investment, business accelerator programs, etc.)
  • Be able to demonstrate satisfaction of the five innovation principles specified in s360-40(1)(e) ITAA 1997 at the test time, being
    • Genuine focus on developing an innovation
    • High growth potential
    • Business scalability
    • Broad potential market
    • Competitive advantage

While the 100-point test consists of bright-line criteria, there is some degree of subjectivity with respect to the five-principles test. This subjectivity is often resolved via an application to the ATO for a private ruling.

5 checklist blocks being turned over

ESIC Refresher – Investor Eligibility

Investors looking to receive ESIC benefits must meet requirements at the test time relating to:

  • Affiliate relationships: cannot be an affiliate of the ESIC, or vice versa
  • Employment relationships: the shares cannot be issued under an employee share scheme
  • Shareholding percentage: cannot hold more than 30% of shares in company immediately after the issue
  • Sophisticated investor status: cannot invest more than $50,000 in ESIC’s annually if not a sophisticated investor

Pitfalls – Corporate Structures

In ZWBX v Commissioner of Taxation [2024] AATA 2065 (“ZWBX”), a holding company whose investors believed it was an ESIC by way of the five-principles test was held not to be an ESIC, on the basis the activities giving rise to satisfaction of the “genuine focus” principle were conducted by a wholly-owned subsidiary company, and the holding activities did not sufficiently satisfy this principle for the holding company.

The applicant put forth many arguments that emphasized the commercially sound substance of their corporate structure (i.e. that the companies all formed part of a single business with one unified purpose, and there were commercial advantages to having multiple companies, including isolation of risk classes, tax effectiveness, structural flexibility), and submitted that a ‘substance over form’ approach should be applied to the five-principles test.

The Tribunal, however, did not accept these submissions, noting the clear references made by the Explanatory Memorandum’s examples to a particular company, rather than a company and its subsidiaries collectively, and that in this case the holding company was the entity that needed to satisfy the five principles.

There’s no obvious alternative that solves this problem. Many "solutions" for tax purposes often result in outcomes that are at odds with a business' commercial objectives.

graphic of a red room, with a man at the base of a ladder to a door

Pitfalls – Contrived Eligibility

Released in December 2024, “Taxpayer Alert 2024/1: Early-stage investor tax offset claimed using circular financing arrangements” highlights the ATO’s renewed attention towards schemes seeking to obtain ESIC benefits via the implementation of artificial structures that in substance do not constitute a genuine investment in an early-stage innovation company.

The taxpayer alert specifically targets arrangements being promoted by advisers where:

  • A financier funds an individual’s share subscription in an ESIC
  • Interest expense deductions & the ESIC tax offset are both claimed in the individual’s tax return, and a tax refund is received
  • Subscription funds are returned to the individual via selective share buy-backs
  • The financing is repaid by the individual via a combination of the tax refund and the returned subscription funds.

This is a highly specific type of arrangement that is designed to obtain a tax offset without a genuine investment in an innovation being present.

The alert states the ATO is looking to produce a taxation determination on whether Part IVA ITAA 1936 can apply to these arrangements. It is worth noting a ‘innovation tax offset’ is a specific kind of tax benefit that Part IVA can apply to deny.

While the ATO’s taxpayer alert is targeted at a blatant scheme that looks to obtain a free tax offset without a genuine investment, the principles should be considered when evaluating any potential investment in an ESIC.

Conclusions

So, what does this all mean?

The ESIC provisions are intended to encourage innovation. The early stages of an innovation’s lifecycle are the most optimal time to implement structures that attract investors whilst keeping founders protected. However, the implementation of such structures requires careful consideration of the principles raised in ZWBX and TA 2024/1 so their benefits are not unwound by the ATO in the case of a review or audit.

Fortunately, Hall Chadwick is well-versed in the ESIC language and can offer solutions that retain ESIC benefits for investors without significantly compromising the ability of a company or corporate group to operate in a commercially sound manner. 

If you wish to understand more about the benefits and pitfalls of investing in an ESIC, or if you have any questions about ESIC eligibility, please do not hesitate to contact us.