The push for innovation materialises

The federal government’s drive to encourage innovation and innovative companies has opened up a new investment opportunity for SMSFs. Steven Crowe defines what an early-stage innovation company is and some of the benefits individuals can enjoy from an allocation to one of these companies.

In this article we discuss the key features of the new investment framework for investors looking to diversify their portfolio and obtain significant tax incentives by investing in early-stage innovation companies (ESIC).

From 1 July 2016, proven sophisticated and non-sophisticated investors, as defined by the Corporations Act 2001, owning newly issued equity in an ESIC obtain:

Access to a new alternative asset class to diversify their portfolio and include a range of early-stage, unlisted businesses in fast-growing industries.

Tax-free capital gains and a 20 per cent tax rebate on their investment with federal government support.

This article provides a user guide for early-stage investors in this exciting new asset class.

What is an early-stage investment?

An early-stage investment involves individuals subscribing for new equity in Australian unlisted companies that meet prescribed eligibility criteria as designed by the government with bipartisan support. Commencing on 1 July 2016, this new investment framework is now directing investor attention to the benefits, risks and opportunities available for wealth creation within a balanced portfolio.

An early-stage investment is suitable for consideration by those with their eyes wide open to the possibilities created by investing in early-stage businesses seeking to exploit a market opportunity by building innovation, technology or other high-growth potential into a new market with global potential.

These investments are more likely to generate capital gains than franked dividends delivered more so by mature businesses residing within portfolios, however, some of these early-stage ventures may indeed have their sights on disturbing the underlying businesses producing those franked dividends and investors should be aware of the possibilities in framing future investment decisions.

Commensurate with the risks involved, investors gain access at valuations reflective of the early stage of the venture. By nature, not all these investments will succeed and become the next investment unicorn. But those investors fortunate to have exposure to the unicorns will reap the diversity and capital gains offered to their portfolio.

To incentivise investors for this high-risk category, significant tax incentives are offered on eligible investments. Not every early-stage investment will qualify, so it is important your planning and exposure to this asset class are performed properly and with an eye on the prize.

Planning an early-stage investment

Investors wanting to benefit from these early-venture tax incentives are obliged, under Australia’s tax laws, to determine whether the business they wish to purchase new equity from qualifies as an ESIC on the day of investment.

There are five options an investor can choose from when verifying an ESIC:

1.  Do it yourself

You will need to understand the tax laws – legislation, case law interpretations, tax rulings, media releases and ATO interpretations – and apply them to the company’s financial situation in the context of the early-stage test and either the 100-point innovation test or principles-based test (outlined below).

Verifying an ESIC investment requires time, knowledge and experience to read and understand financial statements, income tax returns and the various components thereof. You will also have to research the full business activities of the company and its competitors, identify its innovations and understand its key points of difference, including its commercialisation strategies.

Getting it wrong means not only losing out on early-stage investor tax incentives, but also potentially being penalised by the ATO.

2.  Rely upon the representations made to you by the early-stage company

The company is keen to obtain your capital to help grow the venture. In the pursuit of securing your capital, a compelling story is created. The onus is on investors to look through the hype and measure the company against the eligibility criteria in the law. Relying upon what is told to you by management during the courting period will not provide the shield of defence required to validate whether your investment qualifies for the early-stage investor tax benefits.

3.  Rely upon a private ruling from the ATO

The company can apply to the ATO for a private ruling relating to being an ESIC. The ruling is based on the facts stated in the application and all correspondence to the ATO. If the circumstances are materially different from these facts, the ruling has no effect and cannot be relied upon.

The application will need to be prepared in a manner that involves full disclosure of all facts, and knowledge of and reference to the relevant aspects of the tax law. The ATO will then decide if the company meets the eligibility criteria under its interpretation.

If the ATO issues a positive ruling, you will not be protected if:

• the facts of circumstances set out in the ruling change,
• the law on which the ruling is based changes, or
• another ruling issues a revision or changes this ruling before you begin the arrangement described in the ruling.

An application is not guaranteed to succeed. We are aware of applications being rejected or disallowed by the ATO.

If you disagree with a ruling and choose not to follow the decision and later on your position is deemed incorrect, then you will have to repay any tax shortfall plus interest on the underpaid amount. You may also have to pay penalties unless you can show you have exercised reasonable care in deciding to not act in accordance with the ruling.

Extract from the official ATO private ruling:

“The ruling is only about how the tax law applies to the company based upon the facts and information that the company has provided to the Commissioner.

“Your eligibility for the early-stage investor tax incentives will depend on your circumstances as well as whether the company meets the ESIC requirements at the time immediately after it issued you with new shares.

“Consequently, you should make enquiries to confirm that there has been no change in the company’s activities subsequent to the date the private ruling issued that could lead to a different outcome under the tests.

“Potential investors must form their own view about the commercial and financial viability of the company. The Commissioner recommends an adviser be consulted for such information.”

4.  Be ignorant of the law and seek retrospective ESIC eligibility for your investment

Just like retrospective planning, seeking ESIC eligibility post-investment is an option, however, it is fraught with risk. Do you have the time and resources to perform such investigations to verify the company’s activities against the eligibility criteria? If relying upon a private tax ruling, is it still current and the company’s business activities still eligible and are you willing to risk the financial implications if not?

5.  Find the right adviser

Unable to appropriately cover the volume of material when advising clients, the tax profession is increasingly being divided into specialist areas to best serve the community.

With the introduction of early-stage investor legislation in July 2016, there are now authorised ESIC specialists who understand your needs and provide access to validated ESIC opportunities directly and/or through a managed structure.

ESIC advisers are also certified to provide the appropriate financial information and guidance for those seeking to invest in new business opportunities.

So how is an early-stage company actually determined?

A qualifying ESIC must fulfil strict requirements under the following Income Tax Assessment Act criteria:

Does it satisfy the early-stage test?

1. The following criteria need to be met:
   • The company must have been either:
     • incorporated in Australia within the last three income years;
     • registered on the Australian Business Register within the last three income years; or
   • incorporated in Australia within the last six income years and the total expenses of the company and its 100 per cent-owned subsidiaries do not exceed $1 million over the last three income years.
2. The company and its 100 per cent subsidiaries must have total expenses not exceeding $1 million and assessable income not exceeding $200,000 in the previous income year.
3. The company is not listed on any stock exchange in Australia or overseas.

Does it satisfy the 100-point innovation test or the principles-based test?

The 100-point innovation test involves an innovation scorecard against which the company’s activities are to be measured and analysed on the day of your investment. The legislation’s scorecard identifies eight items with a points rating ranging from 75 points to 25 points. For example, if the company has a notional research and development tax deduction available for at least 50 per cent of the company’s total expenses, 75 points will be allocated, with another 25 points to be contributed from other eligible sources identified on the scorecard and as amended by regulations made under the tax law before the company is eligible.

The principles-based test involves the company meeting all the following criteria on the day of your investment:

1. It is genuinely focused on developing for commercialisation one or more new, or significantly improved, products, processes, services or marketing or organisational methods; and
2. The business relating to those products, processes, services or methods has a high growth potential; and
3. The company can demonstrate the potential to be able to successfully scale that business; and
4. The company can 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 can demonstrate that it has the potential to be able to have competitive advantages for that business; and
6. The company has not engaged in any of the prohibited activities listed under the tax regulations at any time prior to your investment.

The next step for an educated investor

Identify an ESIC specialist who can actively assess early-stage ventures and make decisions on their ESIC eligibility using a rigorous process of investigation, due diligence and assessment. ESIC specialists can also provide you with suitable investment opportunities in companies that fit the early-stage innovation criteria.