AAT case highlights need for investors in ESICs to obtain certainty before claiming tax incentives

In a recent decision of the AAT, ZWBX v FCT [2024] AATA 2065, a taxpayer was denied a tax offset in respect of their investment in a company that was purporting to be an Early Stage Innovation Company (“ESIC”) based upon its self-assessment under the ‘principles-based test’. The AAT’s finding was that the company did not satisfy the test and was not an ESIC, largely due to it being a holding company. The decision highlights the need for investors to seek assurance that the company whose shares they are subscribing for is in fact an ESIC before claiming tax incentives.

A. What was the case about? 

The taxpayer was a beneficiary of a trust which subscribed and paid for approximately $100,000 of shares in a newly established company (“Holding Co”) during the 2017 income year. Holding Co had been established as part of a restructure of a company which developed and commercialised a cloud-based client communications management platform. The software had originally been developed by Trading Co. The restructure during the 2017 income year involved the interposition of Holding Co (as the head company of a consolidated group) as well as the establishment of a subsidiary (“IP Co”) to hold the intellectual property rights in patents, trademarks, copyrights and domain names. Following the restructure, Holding Co raised capital from investors including the taxpayer’s trust, which attempted to claim eligibility for an Early Stage Investor (“ESI”) tax offset for 20% of the amount of its investment during the year (approximately $20,000). The trust then allocated 100% of the tax offset to the taxpayer.

B. What was the decision in the case? 

The AAT found that Holding Co was not an ESIC, mainly because its activities were broadly to finance and oversee the corporate group by providing loans to Trading Co and generate income from potential dividends from its subsidiaries rather than trading in its own right. It was Trading Co that was undertaking the development and commercialisation of the software, not Holding Co. The AAT rejected the arguments that each company in the group carries on the same overall business, instead finding that each undertook a particular function, with those of Holding Co not meeting the criteria for being an ESIC.

C. Would the decision be different if the entities were tax consolidated? 

As the tax offset is claimed by an investor in the ESIC, the single entity rule should not apply for the purposes of the ESIC provisions. Accordingly, it is generally important that an ESIC structure should not consist of a holding company and an operational entity.

D. What are the key takeaways from the case?

1. In addition to highlighting a potential difficulty inherent in obtaining ESI tax incentives where investors subscribe for shares in a holding company of a corporate group, the case highlights the need for taxpayers to ensure the companies they are investing in (which are purporting to be ESICs) pass each of the relevant tests prior to claiming the ESI tax incentives.
2. Taxpayers and advisers alike should be conscious that the early stage and innovation tests are self-assessed, however, an ESIC is required to lodge an early stage innovation company report with the ATO if they issue new shares to one or more investors during a financial year that could lead to an investor being entitled to access the early stage investor tax incentives. Accordingly, claiming an offset without appropriate advice or a private binding ruling (“PBR”) can be high risk in many cases.
3. Where a taxpayer has claimed the ESI tax incentives in relation to their investments and the company is not an ESIC, the tax offset and modified CGT treatment could be denied in their entirety. A shareholder who does not obtain appropriate advice or a PBR, and relies solely on assertions by the company, are at a high risk of not taking reasonable care and thus could be subject to substantial penalties.

E. What are the ESIC rules about? 

From 1 July 2016, taxpayers who invest in a qualifying ESIC may be eligible for tax incentives as early stage investors. The incentives are designed to encourage innovation by fostering a taxation system which facilitates a culture of entrepreneurship and risk-taking. Critically, the regime provides tax incentives to investors in an ESIC rather than the ESIC itself, which may instead potentially qualify for other concessions such as the Research & Development (“R&D”) Tax Incentive.

The ATO has an ESIC decision tool that can help taxpayers determine if a company is an ESIC or if the investor is eligible for the ESIC tax offset (link here). The following sections provide an overview of these provisions.

F. What are the tax incentives? 
The tax incentives provide eligible investors who subscribe for shares in an ESIC with:

• a 20% non-refundable carry-forward tax offset on amounts invested in qualifying ESICs, with the offset capped at $200,000 per investor per year (on an affiliate-inclusive basis); and
• modified capital gains tax (“CGT”) treatment, offering a 10-year exemption from CGT for qualifying shares held for at least 12 months.

G. Requirements for an early state investor who is an individual?

Generally, an investor will qualify for the ESI tax incentives if:

1. the investing entity is none of the following:

1. a trust or partnership (however other rules apply);
2. an ESVLCP
3. a widely held company or 100% subsidiary of a widely held company; and

2. at a particular time during the income year, a company issues the investor with equity interests that are shares in the company; and

3. the company is a qualifying ESIC immediately after the shares are issued; and

4. neither the investor nor the company are affiliates of each other at the time the shares are issued; and

5. the issue of those shares is not an acquisition of ESS interests under an employee share scheme; and

6. immediately after the issue of those shares, the investor does not hold equity interests in the company, or an entity connected with the company, that carry the right to:

1. receive more than 30% of any distribution of income by the company or the entity; or
2. receive more than 30% of any distribution of capital by the company or entity; or
3.  exercise, or control the exercise of, more than 30% of the total voting power in the company or the entity.

Requirements for an early state investor who is a trust, partnership or superannuation fund? 

If the investor is a trust or partnership, special rules apply so that the entitlement to the tax incentives flows through to the beneficiaries of the trust or partner partnership. However, the tax incentives will not flow through to the member if the member is a widely held company or a wholly-owned subsidiary of a widely held company.
Further, if the investor is a superannuation fund, the trustee of the fund – not the fund members -would be entitled to the tax incentives.

What qualifies an as early stage innovation company? 

For an investor to be entitled to the tax incentives, the company must qualify as an ESIC immediately after the new shares are issued to the investor. To qualify as an ESIC, a company must satisfy both:

1. the early stage test; and

2. either:

1. the 100-point innovation test; or
2. the principles-based innovation test.

A.  The early stage test

To satisfy the early stage test, the company must meet four requirements. Such requirements are tested at the point in time immediately after the company issues shares to the investor. The four requirements are:

• The company must have been incorporated or registered in the Australian Business Register.
• The company (plus any wholly-owned subsidiaries of the company) must have total expenses of $1 million or less in the previous income year.
• The company (plus any wholly-owned subsidiaries of the company) must have assessable income of $200,000 or less in the previous income year.
• The company’s equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.

The ATO provides detailed guidance on these tests on its website. A link to further information is contained here.

B.1. 100-point innovation test

To meet the 100-point innovation test, the company must obtain at least 100 points by meeting specific objective innovation criteria. The test is applied immediately after the relevant shares are issued to the investor (the test time).

The 100-point innovation test is an objective test and generally can be self-assessed. Points are obtained where R&D expenditure meets a certain threshold (75 points or 50 points) or where certain programs are undertaken by the company (e.g. an Accelerating Commercialisation Grant can potentially give rise to 75 points).

Please refer to the ATO website here which lists and explains all of the 100-point innovation test criteria.

While a company may self-assess its compliance with the 100-point test, risks can still occur especially where the company qualifies but the programs are uncertain. For example, a company may claim R&D for software expenditure that the ATO may not agree with. Accordingly, self-assessment may accidentally result in claiming points incorrectly.

B.2. Principles-based innovation test

To satisfy the principles-based innovation test, the company must meet five requirements. Again, this is tested immediately after the new shares are issued to the investor.
The five requirements of the principles-based test are as follows:

• The company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation
• The business relating to that innovation must have a high growth potential
• The company must demonstrate that it has the potential to be able to successfully scale up that business
• The company must demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business
• The company must demonstrate that it has the potential to be able to have competitive advantages for that business.

The ATO has provided a significant amount of guidance and practical examples for each of these requirements in its website guidance (ATO link here). Furthermore, the ATO has issued a large number of private rulings (in a consistent format) that can assist in determining whether a company will meet the principles-based innovation tests.While an investor can self-assess whether the company is an ESIC using existing documentation, such as a business plan, commercialisation strategy or competition analysis, this can often be difficult to obtain and analyse from an investor’s perspective.

Accordingly, an investor should generally request that the company obtain advice on the ESIC status of the company. To the extent that there is any doubt, an investor should also request that the company obtain a private ruling from the ATO on whether it qualifies as an ESIC when applying the principles-based innovation test.

What are the next steps? 

Clients should contact their Pitcher Partners representative to review their existing arrangements and determine what action is required in light of the recent decision.