A 20% tax offset and the potential to sell your shares without paying capital gains tax are why many investors look at early stage companies. They can make a substantial difference to your return if the business succeeds.
These concessions are available to eligible investors in an Early Stage Innovation Company, or ESIC. The company’s eligibility is only part of the equation, though. The way you invest, your relationship with the business and the timing of the share issue all matter.
Before you factor the tax benefits into an investment decision, here is what you need to understand.
What is an ESIC?
An ESIC is a company that meets specific tax law requirements designed to encourage investment in young, innovative Australian businesses with high growth potential. It has to pass an early stage test, covering its age, expenditure, income and listing status, and one of two innovation tests. Our guide to the ESIC tax offset sets out both tests in full.
Being a startup, developing an app or claiming the R&D Tax Incentive does not automatically make a company an ESIC. The business needs to meet the requirements immediately after it issues your shares, so an assessment from a previous funding round may need to be revisited.
What the 20% offset is worth to you
Eligible investors receive a non-refundable tax offset of 20% of their qualifying investment, capped at $200,000 a year for the investor and their affiliates combined. An eligible investment of $100,000 could generate a $20,000 offset.
An offset reduces the tax you owe dollar for dollar, so unlike a deduction its value does not depend on your marginal tax rate. Non-refundable means it cannot produce a cash refund on its own, but any unused amount can generally be carried forward to later income years. You still fund the full investment upfront, and the benefit comes through your tax return. Our ESIC page has a full worked example, from investment through to sale.
What happens when you sell?
Qualifying shares held continuously for at least 12 months and less than ten years can be sold without capital gains tax. Suppose you invest $100,000 and sell five years later for $400,000. Assuming all the requirements are met, the $300,000 gain could be exempt.
Hold them for ten years or more, and their cost base resets to market value on the tenth anniversary, so only growth after that point is taxable. A supportable valuation at that anniversary becomes important.
The catch: capital losses are disregarded too
Investors need to understand what happens if the business fails. Capital losses on qualifying ESIC shares held for less than ten years must be disregarded. You cannot use them to reduce capital gains on other investments.
That changes the downside calculation. The upfront offset may provide some benefit, but you could lose your investment without the capital loss you would expect from an ordinary share investment. The tax concessions do not remove the commercial risks of backing an early stage business.
The $50,000 limit deserves attention
Investors who do not meet the sophisticated investor test face a strict annual investment limit. If you do not meet that test for the relevant offerings, investing more than $50,000 across qualifying ESICs in an income year can make you ineligible for all the ESIC tax incentives for that year. The consequences extend beyond the amount above the threshold.
For example, someone who does not meet the test and invests $30,000 in one ESIC and $25,000 in another could lose eligibility for both investments.
The limit applies across the year, so each investment needs to be considered alongside any others you have made. Sophisticated investor status has to be established under the relevant rules, and investment experience alone does not establish it.
Buying shares is only the beginning of the eligibility check
The concessions generally require you to subscribe for newly issued shares. Buying an existing shareholder’s shares does not qualify.
Other restrictions can apply where:
- The shares are acquired under an employee share scheme.
- You and the company are affiliates of each other.
- Immediately after the share issue, you hold rights exceeding the relevant 30% limits for income, capital distributions or voting power in the company or connected entities.
These rules deserve particular attention if you are a founder, already have an ownership interest or are closely involved in running the business.
What should you ask for before investing?
An “ESIC eligible” statement in a pitch deck should prompt further questions.
Ask the company for its eligibility assessment and the evidence supporting it. If there is an ATO private ruling, check that it covers the relevant circumstances and period. Companies can self-assess, so the absence of a ruling does not automatically mean they fail to qualify.
Have your adviser review your own eligibility and proposed investment structure before the shares are issued. Keep the supporting assessment with your subscription agreement, payment records and share issue documents. You may need that evidence years later when the shares are sold.
The tax concessions do not tell you whether the investment itself is sound, and that is a question for a licensed financial adviser.
Investing in an ESIC, frequently asked questions
Can I claim the ESIC tax offset if I buy shares from another shareholder?
No. The ATO rule is that the ESIC tax offset is only available on newly issued shares that you subscribe for directly, because the money has to reach the company. Buying existing shares from another shareholder does not qualify, even if the company is an ESIC.
What happens to the ESIC tax offset if I cannot use it all this year?
Under the ATO rules, the ESIC tax offset is non-refundable, so it can reduce your tax to nil but cannot produce a cash refund on its own. Any unused amount can generally be carried forward and used in later income years, within the $200,000 annual cap that applies to you and your affiliates combined.
Can I claim a capital loss if an ESIC investment fails?
Generally not. Under the ATO rules, a capital loss on qualifying ESIC shares held for less than ten years must be disregarded, so it cannot reduce capital gains on your other investments. The upfront 20% offset is the main tax benefit you keep if the business fails.
What is the $50,000 limit for ESIC investors?
The ATO rule is that an investor who does not meet the sophisticated investor test can invest no more than $50,000 in qualifying ESICs in an income year. Investing more than that across all ESICs in the year can cost you the ESIC tax incentives on every one of those investments, not only the amount above the limit.
Considering an ESIC investment?
The best time to check the tax treatment is before you commit, while there is still time to address questions about eligibility or structure. We can help you understand how the ESIC rules apply to your circumstances and review the tax implications of a proposed investment.
Want to talk it through? Get in touch with our team before your next investment.
This article provides general information and does not constitute personal tax or financial product advice.
