As startup founders in Australia, we have a lot on our plates. On top of developing our business plans, hiring our first employees and other administrative responsibilities, raising capital and finding investors can be overwhelming.
One of the most important things for any AU-based startup to understand is ESIC eligibility. The Early Stage Innovation Company tax incentives were created by the Australian government specifically to support emerging tech companies. Qualifying for ESIC status can provide huge tax benefits and allow startups to reinvest more of capital into growth.
In this article, we'll break down exactly what ESIC is, how to qualify, and how to apply. The process is simpler than you might expect, and the rewards are well worth the effort. Let's dive in!
What is an Early Stage Innovation Company (ESIC)
An Early Stage Innovation Company, as the term implies, refers to innovative and promising early-stage startups who are eligible to access the ESIC tax offset.
These new tax incentives are aimed at early stage investors, and provide startups with a powerful tool that can be used to attract investor attention. The core function of the ESIC tax incentive is to provide investors with a tax offset and concessional Capital Gains Tax treatment in order to encourage investors to support innovative Australian enterprises.
It’s important to note that the investor is the recipient of the tax offset and CGT exemption — not the startup itself. However, this could be considered to be just as beneficial for you, if you think you’re ready to raise capital.
How does ESIC work
The tax incentive functions as a 20 percent non-refundable carry-forward tax offset on their investment, which is capped at $200,000 per investor annually. Investors that make investments in eligible ESIC businesses are provided with a tax offset that reduces their yearly tax income bill. If an investor doesn’t use all of their offset in a single financial year, they are able to carry the offset forward to future years.
The second element of the ESIC incentive is a 10-year capital gains tax exemption (CGT) on any eligible investment, provided it is held for at least 12 months.
This provides investors with the opportunity to reduce the total Capital Gains Tax they pay on capital gains generated through the sale of shares purchased as an investment in an eligible ESIC startup. It’s important to note, however, that investors can therefore not write off capital losses.
Why does ESIC matter
Registering as an Early Stage Innovation Company and promoting the tax incentives to investors is a great way for startups to attract funding. Investors are more likely to take a chance on an early-stage company if they know they can get a decent portion of their investment back in tax offsets.
- More funding means we can accelerate our growth, hire key staff, build our product, and scale faster.
- The ESIC certification also adds credibility and validation for our startup.
The ESIC tax offset is a valuable program for startups and investors alike. As founders, we should take the time to understand the requirements and benefits so we can leverage this initiative to fuel our startup’s success.
The tax incentives for early stage investors are presented in detail via the Australian Taxation Office website.
ESIC eligibility for startups
A startup needs to meet the requirements outlined in two important tests:
- the early stage test and
- either the 100-point innovation test or the principles-based innovation test.
Early stage test
The early stage test determines that the company is indeed early-stage, and demands that a startup meets the following four requirements:
- The startup must have either been incorporated within Australia, or registered on the Australian Business Register within the last 3 years;
- The equity interest of the company must not be listed on any stock exchange;
- The startup — and any subsidiaries — have had expenses of $1 million or below in the most recent year; and
- The startup — and any subsidiaries — must have an assessable income of $200,000 or below in the last year.
The innovation test determines that the company is involved in innovation, measured against criteria known as either a principles-based or objective test.
The 100-point innovation test uses a point system. Startups can use a variety of different activities in order to gain points, and we would always recommending getting professional advice to determine eligibility for the points. Some of the activities include:
- The startup has completed or participated in an eligible accelerator program; or
- The startup has been granted an innovation patent or a standard patent within the last 5 years
*A full test table is available at the ATO Website
The principles-based innovation test can be used as an alternative to the 100-point innovation test and has five requirements. The startup must:
- focus on commercializing an innovative, new, or improved product, method, service, or process;
- demonstrate high growth potential;
- provide evidence that it is able to successfully scale the business;
- provide evidence that it has the potential to scale into a broader market, such as a global market; and
- demonstrate a competitive advantage.
In most cases, the 100-point innovation test is a more straightforward method of satisfying the requirements for ESIC eligibility, however this will depend on your company.
Eligibility for investors
In order to qualify for the ESIC tax incentive, investors must meet the following requirements:
- The investor must purchase newly-issued shares directly from the startup;
- The investor must hold less than 30 percent of the equity interest in the startup; and
- The investor must not be an affiliate of the ESIC startup.
It’s important to note that investors that do not satisfy the requirements outlined in the sophisticated investor test are only able to take advantage of ESIC tax incentives if their total investment does not exceed $50,000.
How to apply for ESIC status
Here's a quick-fire guide to apply for ESIC status
1. Meet the eligibility criteria
First, make sure your startup meets the basic criteria to qualify as an ESIC. This includes:
- Being registered in Australia
- Having been incorporated for less than three years
- Having expenses of at least $1 million over three years
- Satisfying the "innovation" test by developing new tech, processes or services
2. Apply through the ESIC register
Once eligibility is determined, apply through the ESIC Register on business.gov.au. You need to provide details about your company, shareholders, expenses, and innovation activities. The application process typically takes 4 to 6 weeks.
3. Get certified
If application was approved, you receive ESIC certification for a period of 5 years. This certification makes you eligible for valuable tax incentives, like:
- Non-refundable carry forward tax losses —you could deduct losses from your taxable income
- Capital gains tax exemptions — no need to pay CGT on assets used for innovation
- Tax offsets — receive a tax offset of up to $200,000 per year
Fullstack Advisory have proven processes to take you through the above step-by-step, and will save you the headache in messing things up the first time!
Maintaining your ESIC eligibility
To keep your ESIC status, you need to continue to meet the eligibility criteria and innovation test. You have to report annual expenses, revenue, staffing, and innovation activities. If you remain compliant, you can then re-apply for certification after 5 years.
The ESIC program has been hugely beneficial for startup founders. By taking advantage of the tax incentives, we're able to invest more into growing our business.
Here are a few key things we need to keep in mind:
- Report income accurately. Report all taxable income, including revenue from sales, services, investments, and other sources. Under-reporting income to maximize ESIC benefits is illegal and if caught, you risk losing eligibility, facing penalties, and even legal prosecution.
- Keep good records. Detailed records of all income and expenses will make it easier to report accurately and help substantiate claims if audited. Make sure to save invoices, receipts, bank statements, and other documents that provide evidence for the figures reported.
- Meet the $200,000 threshold. To remain eligible for ESIC, your annual turnover must stay below $200,000. If revenue exceeds this amount, you lose access to ESIC tax benefits for that financial year. However, you can re-test for eligibility in the following year.
- Maintain an innovative startup. ESIC supports innovative startups, so you must continue active development of your product or service. If you shift into a purely passive investment mode, you can also risk losing eligibility. Ability to demonstrate ongoing product improvements can help.
- Seek professional advice. The ESIC program has many technical requirements; it's best to consult with an accountant or tax advisor. They can help ensure we meet all eligibility criteria, maximize available benefits, and avoid issues that could jeopardize our access or lead to legal penalties. Their guidance is well worth the investment.
Following these best practices will help you maintain compliance, continue accessing valuable ESIC benefits, and build a successful, innovative startup. The rewards of this program make the effort worthwhile.
So there you have it, startup founders. We've covered the basics of ESIC eligibility and how the tax incentives can benefit your new business. While the requirements and application process can seem complicated, taking advantage of the ESIC scheme is well worth the effort for the potential tax savings and cash flow benefits.
The AU government wants to support local innovation and risk-taking, and the ESIC is designed specifically with startups like yours in mind.
If you have more questions or want to discuss your unique situation, we have legal partners who can help you process through the requirements. They can help determine if you qualify and guide you through the application process. This way, you can focus on building your business, follow your vision, and think about how those future tax incentives might help fuel your growth. The future is yours to shape.
This article is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.