Tax breaks for angels, a bridge for founders

The lesser known Early Stage Innovation Company incentives may give start-ups an advantage in attracting angel investments and breaking out of the ‘Valley of Death’.  But there is a catch, or two.  

The incentives

Introduced by the Federal Government in 2016 as part of the National Innovation and Science Agenda, the Early Stage Innovation Company (ESIC) scheme appears to have received little attention from both the start-up and angel investors communities.

Specifically aimed at assisting start-ups to manage through the ‘Valley of Death’, i.e., the chasm between initial funding to the time a start-up begins generating revenue, where additional financing is scarce and the company is vulnerable to cash flow requirements, the scheme offers investors attractive tax offsets,[1] including:

  1. an upfront 20 per cent non-refundable, carry-forward tax offset (capped at $200,000 per investor per year for ‘sophisticated investors’ and $50,000 for other investors); and
  2. a 10-year capital gains tax exemption for investments held at least 12 months

… on two conditions: the start-up they invest in qualifies as an ‘early stage innovation company’ and the investors themselves must not invest through widely held companies or trusts.

Condition 1: Company – ESIC qualified

A company will qualify as an ESIC if it satisfies both:

  • the early stage test; and
  • either the
    • 100-point innovation test, or
    • principles-based innovation test.

The early stage test is relatively straightforward.  It requires that the company:

  1. had expenditure of $1 million or less in the previous income year,
  2. had assessable income of $200,000 or less in the previous income year,
  3. is not listed on any stock exchange, and
  4. was incorporated in Australia, or registered in the Australian Business Register, within the last 3 years – or if it was incorporated in Australia within the last 6 years, it must have a total expenditure in the previous 3 years not exceeding $1 million.

For the 100 -point innovation test, this is an objective, self-assessed test in which a start-up accumulates points by comparing the activities it has undertaken to a benchmark set out in Division 360 of the Income Tax Assessment Act 1997 (Cth).[2]

As examples:

  • a company which has received the Accelerating Commercialisation Grant, at any time, can claim 75 points towards ESIC status,
  • having a standard patent granted in the previous 5 years will give the company 50

The principles-based innovation test is, on the other hand, a subjective test carried out by the ATO, at a request for a private ruling from either the relevant start-up or investor.  To meet this test, the start-up must demonstrate in its application that:

  1. the company is genuinely focused on developing a new or significantly improved innovation for commercialisation,
  1. the business relating to that innovation has a high growth potential,
  2. it has the potential to be able to successfully scale up that business,
  3. it has the potential to address a broader than local market, including global markets, through that business, and
  4. it has the potential to be able to have competitive advantage for the relevant business.

Reporting requirements

A qualified ESIC must prepare and lodge an ESIC report with the ATO at the latest by 31 July to account for any new shares it issues during the preceding financial year that could lead to an investor being entitled to access the early stage investor tax incentives.

Condition 2: Investors – big, but not too big

To claim the ESIC tax offset on an investment, investors are also subject to certain conditions, including:

  1. their total investment in one or more ESIC is $50,000 or less in the income year – unless they are sophisticated investors by the definition of the Corporations Act 2001 (Cth), in which case the threshold extends to $200,000,
  2. they must hold less than 30% interest in the ESIC,
  3. they must not acquire the relevant equity interest through an employee share scheme, and
  4. they are not, or do not invest through, a widely-held company or a wholly-owned subsidiary of a widely-held company.  A widely held company is either a listed company or a large proprietary company (which has more than 50 members).

 Avoid the complexity

By design, the ESIC scheme was intended to be a simple, self-assessed process in which the 100-point test should be the gateway test.[3]  However, some reports have suggested that start-ups opt for the principles-based innovation test, partly because of pressure from their investors for independent determination.[4]  One difficulty with this process is it usually takes several months to obtain a private ruling from the ATO, making it likely unsuitable for the fast-paced nature of funding transactions.

If you need assistance in assessing your company’s ESIC eligibility or structuring your company (or investment) to comply with ESIC requirements, please contact Tony Petani.

[1] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paras 1.5-1.9.

[2] A more accessible version of the benchmark can be viewed on the ATO’s official website here:

[3] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, para 1.72.

[4] Australian Financial Review, “ATO makes applicants work hard for Early Stage Innovation Company status”, published 11 November 2016; Australian Financial Review, “Early Stage Innovation Company investor tax breaks misunderstood”, published on 5 May 2017.

Alfonso Grillo

Tony Petani