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 that may result in investors losing out on said benefits.

ESIC Refresher – Benefits

There’s an understandable desire to be an early-stage innovation company, as it opens the door for two potentially massive 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 effectively provides investors with an immediate 20% ROI 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.

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 $1 million 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.

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.

Cowell Clarke also noted while the corporate group in this case was not tax consolidated at the test time, being tax consolidated would not have assisted the holding company in satisfying the five principles, as the single-entity rule only operates in respect of specific core purposes, being to work out the income tax liability or loss of the head company or an entity in the group. As the ESIC provisions affect the income tax liability of an investor in the head company, the core purposes of the single-entity rule would not affect the Tribunal’s conclusion in ZWBX.

So, what options would they be left with if a do-over was possible? The general conclusion is the options are limited and often undesirable in comparison to simply foregoing the ESIC benefits entirely. Obviously, you could do away with the corporate structure and operate entirely through a single company, but that would sacrifice the commercial benefits offered by a multi-company structure. You could house the innovation activities within the holding company, but this also cuts through some of the multi-company benefits as the assets are then exposed to the risks of the innovation activities.

You could explore eligibility for the holding company via the 100-points test, but this would have likely already been considered by the taxpayer’s advisers, and many of the ways of attaining points either relate to past income years (i.e. you either have enough prior year R&D expenditure or you don’t, and it cannot be retrospectively adjusted), or consist of criteria where there is little flexibility (i.e. you either have or do not have a patent, and the time & resources required to secure a patent often prohibit companies from acquiring them solely to obtain points for the 100-points test).

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 what appears to be a blatant scheme that looks to obtain a free tax offset without a genuine investment, the practical implications for the less aggressive taxpayers is this: the line between a blatant scheme and a commercially sound pre-transaction restructuring is murky at best. This, combined with the limitations on structuring ability and the lengthy timeframes for Part IVA investigations, audits and cases, contributes to a mountain of uncertainty around ESIC investments which could actively discourage investment in cases where the 20% tax offset & the elimination of CGT could materially impact an investment decision.

Conclusions

So, what does this all mean? It appears the ESIC provisions are intended to encourage innovation, but not commercially sound corporate structuring surrounding the innovations.

The fundamental question arising is this: why would investors commit significant funds to innovation plays that are inherently incredibly risky without being able to mitigate some of the risk via the implementation of a corporate structure prior to the investment that extends beyond a single early-stage company.

Yes, the tax benefits offered by the ESIC regime are significant, and the tax offset provides some upfront incentive, but the modified capital gains tax treatment only provides a benefit if the investment is fruitful and does nothing to mitigate the risks associated with the inherent unknown nature of innovation plays, and the potential Part IVA timebombs only add more unknowns onto the pile.

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.