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How to reduce your tax by investing in start ups

How to reduce your tax by investing in start ups

If you’re an investor or a start-up looking for an investor, you may have heard that the government has introduced a new tax break for investors investing in start-ups.

The way it works is fairly straightforward:  invest is a qualifying start-up (the technical term is “Early Stage Investment Company or ESIC”) and get a tax rebate equal to 20% of the amount invested (subject to certain caps).

The tax rebate comes straight off your tax bill.  So when you normally get your notice of assessment telling you that you paid, say, $40,000 in taxes.  Imagine you have a rebate of, say, $10,000.  This means your tax bill is reduced to $30,000.  In many cases it will probably will translate to a tax refund of $10,000.

What is an ESIC?

An ESIC is an Australian incorporated company that is:

– At the early stage of its development (i.e. be “early stage”); and

– Developing new or significantly improved innovations with the purpose of commercialisation to generate an economic return (i.e. be “innovative”)

I’ll explain these two requirements in more detail.

Early stage

To be early stage, the Australian incorporated company must:

– Have been incorporated in the last 3 years

– Have expenses of $1,000,000 or less in the previous year

– Have income of $200,000 or less in the previous year

– Not be listed on the stock exchange

Innovative

To be innovative, the Australian incorporated company must be developing a new or significantly improved type of innovation such as a product, process, service, marketing or organisational method.  There are two ways of being classified as “innovative”.

The first way is the “subjective test”.  This is where you decide whether the company is innovative or not having regard to the following practical factors:

– The innovation is new or significantly improved for the applicable addressable market. Examples of this would be doing something new in the market (e.g. implementing a cross-functional structure to reduce response times  when competitors currently use a different structure)

– The innovation must be being developed for a commercial purpose – i.e. to make money basically.

– The innovation must have high growth potential – this would be affected by the size of the potential market. Innovations that have global application, for example, will have high growth potential.

– The innovation must be scalable – this generally means that the profit margin is capable of increasing due to economies of scale. For example, an investment in software that can then be sold to multiple users would be scalable.  Conversely, setting up a dental clinic is not scalable, as each dental clinic is likely to have the same profit margin.

– The innovation must be able to service a market broader than simply the local market (though it does not have to be global)

– The innovation must give the company a competitive advantage over its competitors.

If you are not comfortable using the subjective test, the second way is to use the “objective test”.  This is a 100 point test, with points being allocated as follows:

– 75 points if the company spent 50% of its total expenses in the previous year on research and development

– 50 points if the company spent between 15 – 50% of its total expenses in the previous year on research and development

– 75 points if the company received an Accelerating Commercialisation Grant (Note: this grant is not included in income for the $200,000 or less income test)

– 50 points if it is undertaking or has completed an eligible accelerator programme

– 50 points if an independent third party has invited at least $50,000 in the company (and did not acquire the shares to assist with the ESIC qualification)

– 50 points if it has one or more enforceable rights on an innovation through a standard patent or plant breeder’s right that has been granted in Australia

– 25 points if it has one or more enforceable rights on an innovation through an innovation patent or design right or an equivalent intellectual property right granted in another country.

– 25 points if it has a written agreement to co-develop and commercialise an innovation with a research organisation or university

You do not have to meet both tests.  You can choose between the subjective test and the objective test.

What are the tax benefits?

The tax benefits are:

– A tax rebate of 20% of the invested amount – this is a direct reduction in your tax bill. For example, if you got a rebate of $10,000 and normally would have had a tax bill of $40,000, your tax bill will be reduced to $30,000.  If you’ve been paying tax as you go during the year (most people are in this category) then in this example this could translate to a tax refund of $10,000.

– No capital gains tax on selling the shares within the first 10 years (but you need to hold the shares for at least 1 year). There is also no capital loss if the shares are sold in the first 10 years.

How much can I invest?

You can invest up to $50,000 (which means a rebate of $10,000) each year if you are not a sophisticated investor.  You can invest up to $1m (which means a rebate of $200,000) each year if you are a sophisticated investor.  The investor cannot own more than 30% of the shares in the ESIC (including its connected entities).

The rebate is not refundable, so if the rebate is more than your tax bill you will pay no tax but will not be given a refund for the surplus.  For example, if you have a tax bill of $120,000 and you get a rebate of $200,000, you will pay no tax but will not be refunded the surplus $80,000.

Can I use a trust or partnership to invest?

Yes you can.  One great benefit of these rules is that even if you invest through a trust or partnership, the offset can still flow through to reduce your personal taxes.

Can I invest in my own company if it is classified as an ESIC?

Unfortunately not – this is to promote investments by third parties in other businesses, not to invest in your own business.  There are other grants and incentives available to your own business.

The above is just information and no substitute for legal advice.  If you are an investor looking to take advantage of these new rules, or a company looking for investors,  please contact us.  We can help you find a good lawyer or accountant if you need one (and if you don’t have one already). As mentioned on our about us page, we have a good network of different lawyers and accountants will help you find a lawyer or accountant that can assist you.  As we work with a number of lawyers and accountants, we are able to negotiate better rates for you.

Other resources

1. How to get through an ATO review or audit

2. Australian taxation law