The Income Tax Assessment Act 1997 (Cth) (ITAA) to provide tax incentives for investors in eligible Early Stage Innovation Companies (ESICs).  An ESIC is an Australian tax incentive program designed to encourage investment in high-growth, innovative startups. 

What is an ESIC?

An ESIC is a company that satisfies specific “early stage” and “innovation” requirements under the ITAA.  Section 360-40 of the ITAA prescribes the defining characteristics of an ESIC as follows:

• incorporated as a company in Australia within the last three (3) years;
• the company and all subsidiaries incurred total expenses of ≤$1 million in the previous year;
• the company and all subsidiaries had a total assessable income of ≤$200,000 in the previous year;
• none of the company’s equity interests are listed for quotation in any stock exchange; and
• the company is developing new or significantly improved products, processes, services, marketing methods, or business models with high growth potential, as established by either:
• the 100-point innovation test (section 360-45); or
• the principles-based innovation test (section 360-40(1)(e)).

These requirements are assessed at the “test time” being the time that new shares are issued to investors.

Merely being a newly incorporated business or a technology-focused company does not automatically qualify a company as an ESIC.  The company must demonstrate that it is genuinely innovative and capable of scaling commercially.

What are the benefits of this tax-offset for an ESIC?

The ESIC regime is primarily designed to incentivise investment into qualifying start-ups by offering tax concessions to eligible investors.

The principal investor benefits under section 360-25 of the ITAA, include:

• Non refundable tax-offset: a twenty percent (20%) up-front non-refundable carry-forward tax offset on amounts invested in qualifying ESICs, with the offset capped at $200,000 per investor per year;
• CGT exemption: an exemption on capital gains tax (CGT) for investments held as shares in an ESIC for at least twelve (12) months but under ten (10) years, provided that the shares held do not constitute more than a thirty percent (30%) interest in the ESIC.

Pursuant to section 360-15 of the ITAA, members of a partnership or trust can also be entitled to this twenty percent (20%) tax offset. 

Commercially, this has the effect that ESIC eligibility makes a start-up more attractive to angel investors, venture capital participants, and early-stage funding networks.

Sophisticated investors will assess whether a company qualifies as an ESIC before investing, as the tax concessions can materially reduce investment risk.

While investors may receive these benefits on successful investments, the trade-off under section 360-50 of the ITAA is that if the company later fails or becomes worthless, the investor cannot use the resulting capital loss to reduce their CGT.

Who can be an eligible investor?

The tax incentives are available to all types of investors, regardless of whether the investment is made directly as an entity (within the meaning of section 960-100 of the ITAA) or indirectly through a trust or partnership.  There are no restrictions on an investor’s residency status.

However, under the section 360-15 of the ITAA, an investor is not an eligible investor if:

• the investor is a widely held company as defined in section 995-1 of the ITAA;
• the investor is a one hundred percent (100%) subsidiary of a widely held company; or
• the investor is an affiliate of the ESIC (as defined in section 328-130 of the ITAA), or the ESIC is an affiliate of the investor.

Although non-sophisticated investors[1] are eligible investors, they are limited to investing amounts of $50,000 and below in an income year.

Is your start-up a qualifying ESIC?

Determining whether a company qualifies as an ESIC requires careful analysis of both the legislative criteria and the company’s actual commercial activities.

Early stage requirements

A company will generally satisfy the “early stage” limb where it:

• has been recently incorporated or registered;
• has relatively low expenses and assessable income in prior income years; and
• is not listed on a stock exchange.

Innovation requirements

The company must also demonstrate that it is genuinely innovative.

This may be established through either:

• satisfying the objective 100-point innovation test; or
• satisfying the more subjective principles-based test.

The principles-based test requires the company to demonstrate matters such as:

• genuine innovation;
• high growth potential;
• scalability;
• broader than local market potential; and
• competitive advantages.

This assessment is highly fact-specific and often depends on:

• the company’s intellectual property;
• business model;
• technical development;
• commercialisation strategy;
• market differentiation; and
• scalability potential.

Common issues

Many start-ups incorrectly assume that:

• having a mobile app or software product automatically qualifies them as innovative;
• incorporation alone is sufficient;
• research and development expenditure guarantees ESIC status; or
• investor interest itself proves innovation.

In practice, the Australian Taxation Office closely examines whether the business genuinely satisfies the statutory criteria.

Seeking professional advice

Because ESIC eligibility can materially affect capital raising strategy and investor confidence, founders should consider obtaining legal and accounting advice before representing that a company qualifies as an ESIC.

This is particularly important where:

• investor documents reference ESIC status;
• significant capital raises are contemplated; or
• the company intends to rely on the principles-based innovation test.

Key takeaways

The ESIC regime can provide substantial advantages to early-stage Australian start-ups and their investors. However, the legislative requirements are technical and highly dependent on the company’s specific circumstances.

Careful assessment of both the early-stage and innovation criteria is essential before claiming ESIC eligibility or marketing the company to investors on that basis.

Start-ups considering raising capital should ensure that their corporate structure, commercial strategy, and supporting documentation align with the ESIC requirements under the ITAA.

Links and further references

Legislation

Income Tax Assessment Act 1997 (Cth)

Other links

ESIC Directory

---

Further information about ESICs

If you need advice on whether your startup meets the eligibility requirements for an ESIC tax-offset, please contact us for a confidential and obligation free and discussion.

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances

[1] See section 708 of the Corporations Act 2001 (Cth).

Related insights about corporate law