All about innovation

The ATO has issued TD 2023/6 outlining the Commissioners’ views on what is considered an 'expense' for the purposes of the Early-Stage Test, more specifically, what is included in the 1 million dollar per annum (or 1m over 3 year count back).

The determination raises quite lofty points and maybe difficult to interpret for some, however a key, and simple message is reenforced in the compliance approach mentioned, when the commissioner confirms 

'There is low compliance risk in a company and its investors relying on the amount reported as 'total expenses' in the company tax return' 

In essence, Item 6 of the return is a helpful guide, which is reinforced by the Explanatory Memorandum that accompanied the Bill in 2016.

Importantly, the ruling goes on to discuss what is an expense and what is 'incurred', confirming that assets are not counted and that 'incurred' holds its usual interpretation in regards to section 8-1. Whilst these principals have been applied in many a private rulings it is comforting to see this expressed in the TD format.

Given the logical application of 'incurred' the commissioner goes on to confirm that provisions, such as the provision for bad debts, will not be included within the construct of expense and neither will 'depreciation expense' within the statutory context of Division 360.

Let’s hope any prior startups did not fall foul of the expense threshold due to ignorance.

The ESIC tax concessions appear to only apply to issues of 'equity interests', i.e. ordinary shares. However further ATO guidance indicates that is not entirely true of all equity instruments.

Generically, this means that convertible note or SAFE note investments will not eligible until converted into equity, which is clearly a timing issue, however that does not attend to the question of the issue of those notes themselves could qualify.

For example, does an 'equity-like' converting preference share qualify as an equity interest when it is issued?

If you follow, the rules classifying interests as 'equity' or 'debt' are defined very broadly. i.e. firstly the instrument must not be classified as a debt interest, and thereafter pass the equity test in s974-70(1).

Items 1 through 4 therein outline the logical aspects of equity, i.e.; a right to a return based on economic performance (past, current or future), a return subject to the discretion of the company, an interest in, or an interest that may convert to an interest in the company, etc 

whereas debt is loosely classified as 'a 'financing arrangement' where the parties have a non-contingent obligation to provide a financial benefit'.

Further digging shows that "an obligation" is considered non-contingent if it is not contingent on a condition, other than the entities willingness to meet an obligation s374-135(3).

So what does that mean?

Well, It's clear you'll need a tax lawyer to tell how it applies for sure, but from my side, you don't have 'equity' if you preference shares were/are redeemable.

Given the ESIC concessions have a natural cut-off date, it's surely a question worth digging into!

To paraphrase s360-25(1)

The taxpayer is entitled to receive the sum of 'any money received, or entitled to be received, by the company, for the issue of shares' and 'the market value of any non cash benefit received, or entitled to be received, but the company for the issue of shares'.

Looking at this, it would appear that the requirement is that the ESIC is 'absolutely and unconditionally' entitled to the amounts, i.e. the only condition is the timing of payments.

This is particularly useful to know in regards to last minute investments around 30 June, which may or may not be banked, though they must be committed, unconditionally.

It's been seven years since the Turnbull government enacted the ESIC regime with quite some change to the venture industry in Australia.

ESIC investors have contributed over $190 million in early-stage investment clearing $25m and growing year on year.  Over 1,615 companies have raised capital with the help of these measures.

We are aware of several companies that are now listed on the ASX thanks in part to the early stage backing, and strong interest in the markets, until recently.

Speaking to founders, ESIC was most helpful with

- closing a round, and

- building interest in the business, and

- increasing shareholder loyalty

What's hidden is the dual benefit that the ESIC assessment process has, focusing founders and investors on key growth metrics and milestones that help build a foundation for later rounds.

Many founders use the same core docs they used for ESIC through subsequent raises and negotiations.

Investors are clearly attracted to the tax incentives, though frequently use Self Managed Superannuation Funds that may well be in pension phase at the time of exit anyway.

So its unclear if its simply the tax advantage or a wider pool of benefits driving the decision making.

Many startups and investors point out that mirror legislation in the UK, US and Singapore is more attractive and note the current downturn presents an opportunity to expand the regime to include more deep and Bio tech businesses.

In any case, keep the yearend in mind and remember to lodge your ESIC statements before your June BAS.

Cheers,


Matthew

Some learnings based on a question put to the ATO forum; which reads  

I invested in a company on 27/6 that qualified for ESIC in the 18/19 financial year. They lodge the application for ESIC for both the 18/19 and the 19/20 financial year on 31/7/20. To meet the ESIC requirements, they did the 100 point test and obtained 50 points from my investment (as a third party investor) would i still quality to claim for the ESIC tax incentive?

From the ATO website on ESIC, i know i can carry the tax offset forward. As i have already lodge the 2018/19 tax return, can i just start the tax offset for the 2019/20 tax year?

Also am i able break up the investment amount to a max 50k over a few years so i do not hv to meet the sophisticated investor requirement?

Our reply:

An investor will not qualify for the first independent 50k investment made because of the investment made*, however this does not rule out qualification, it just means we need to look to the principals based assessment for the company. It is not uncommon for companies to gain points qualification after a seed or pre-seed raise. More info about the principals method is here.

Generally speaking, if the company qualified at the time of the investment* (without the points attributed to your investment), and you also qualified at that time, you will able to claim the carry forward offset in a latter year (assuming you have tax to pay).

Keep in mind that if you invest 1 cent over 50k per annum (across all your investments) you will not be eligible for ESIC incentives unless you are an exempt 708 investor at the time. It is permissible for retail investors to make a series of investments in ESIC's or the same ESIC, provided the 50k cap is not exceeded in any given tax year. 

You should contact the company and find out if they lodged ESIC notification each year with the ATO or if they acquired a Private Binding Ruling (PBR). Ultimately it is your responsibility to maintain proof your ESIC claim so I recommend you read up in detail and try to find a guide for record keeping.

Notes:

* this is a clear anti avoidance mechanism, outlined in the EM 
* Investment on 27/6 could be a timing issue, if this was the last year, I'd recommend you consider the date of the investment (per the company register) and not the date you paid.

* Assumes ordinary shares (not convertible notes etc)