The ESIC tax incentives, explained

Both benefits are in the income tax law (Subdivision 360-A of the Income Tax Assessment Act 1997). The first is a tax offset equal to 20 per cent of the money the company received for issuing the shares to that investor, plus the value of anything non-cash they gave (s360-25(1)). Put $100,000 in and the offset is $20,000. It is capped at $200,000 in a year for the investor and their affiliates together, and the cap counts offsets carried forward from earlier years (s360-25(2)). Non-refundable means it can reduce tax to zero but not below; what is left carries forward.

The second is the capital gains treatment. If the investor holds the shares continuously and sells them on or after the first anniversary and before the tenth, they may disregard the capital gain (s360-50(4)). Any capital loss inside the ten years must be disregarded, which is the price of the concession (s360-50(3)). On the tenth anniversary the shares' cost base resets to their market value on that day, so only growth after that is ever taxed (s360-50(5)). The $200,000 cap limits the offset, not this treatment.

The investor has to tick every box in s360-15(1) at the moment the shares are issued.

• They bought new shares directly from the company. Shares bought from another shareholder do not qualify, and neither do shares issued under an employee share scheme (s360-15(1)(e)).
• They are not an affiliate of the company and the company is not an affiliate of theirs (s360-15(1)(d)).
• Immediately after the issue they do not have the right to more than 30 per cent of the company's income, its capital, or its votes, counting connected entities (s360-15(1)(f)).
• They are not a trust, a partnership, a widely held company or a venture capital partnership (s360-15(1)(a)). A trust or partnership cannot claim in its own name; the benefit flows through to its beneficiaries or partners under s360-15(2).
• If they are not a sophisticated investor for every one of the offers that year, their total ESIC investments for the year are $50,000 or less. Over that and they lose the offset and the capital gains treatment for every ESIC share issued to them that year, including the first $50,000 (s360-20). An investor covered by s708(8), (10) or (11) on each offer has no such limit.

The company, counting its wholly owned subsidiaries, has to meet all four of these immediately after the shares are issued (s360-40(1)(a) to (d)).

• Age. Incorporated in Australia within the last three income years (counting the current one); or incorporated within the last six and spent $1 million or less in total across the three income years before the current one; or registered on the Australian Business Register within the last three.
• Spending. Total expenses of $1 million or less in the income year before the current one. Expenses here are accounting expenses, and the ATO says depreciation is not counted.
• Income. Assessable income of $200,000 or less in the income year before the current one, ignoring an Accelerating Commercialisation grant and R&D clawback amounts (s360-40(2)).
• Not listed. None of the company's shares are quoted on any stock exchange, in Australia or anywhere else. The company must also not be a foreign company.

Having passed the early stage test, the company also has to show it is an innovation company, one of two ways. The 100-point test is a table of objective facts, each worth points, and the company needs 100 (s360-45). The items are:

• 75 points: at least 50 per cent of its expenses in the previous income year were eligible research and development spending. 50 points instead if R&D was at least 15 per cent but under 50 per cent. The two do not add.
• 75 points: it has received an Accelerating Commercialisation grant under the Entrepreneurs' Programme.
• 50 points: it has completed or is in an accelerator program that selects entrepreneurs competitively, run by a provider that has been running such programs for at least six months and has graduated at least one cohort.
• 50 points: it has already raised at least $50,000 in shares from investors who were not associates, at least one day before the test time, and not primarily so someone else could claim the offset.
• 50 points: it holds or licenses a standard patent or a plant breeder's right granted in the last five years, in Australia or the overseas equivalent.
• 25 points: it holds or licenses an innovation patent or a registered design from the last five years, if the 50-point item does not apply.
• 25 points: it has a written agreement with a university listed in the Higher Education Funding Act or a registered research service provider to co-develop and commercialise a new or significantly improved product, process, service or method.

A company that cannot reach 100 points can instead show all five of these (s360-40(1)(e)): it is genuinely focused on developing one or more new or significantly improved products, processes, services or methods for commercialisation; the business built on them has high growth potential; the company can show it has the potential to scale that business; it can show it has the potential to address a broader than local market, including global markets; and it can show it has the potential to have competitive advantages. These are judgement calls, which is why the ATO lets a company apply for a private ruling on the principles test. The ATO says the 100-point test is objective and should be self-assessed, and warns that a ruling must not be used in promotional material or treated as an endorsement.

Everything is judged immediately after the shares are issued. A company that qualifies at that moment and stops qualifying a year later does not affect its investors' claims, the ATO says. The other way round is also true: qualifying next year does not help shares issued this year.

That timing decides how convertible instruments are treated. A convertible note is not a share, so the ATO's position is that where shares are issued by converting notes, the date of the conversion is the one that counts, and the company has to be an ESIC then. The ATO has not written about SAFEs, but the same logic applies since a SAFE is not a share either. The SAFE vs convertible note explainer has more.

There is no application, no registration and no certificate. The company decides for itself whether it passed both tests when it issued the shares, keeps the evidence, and then reports. Any company that issued shares in a financial year that could give an investor these incentives has to lodge an Early stage innovation company report with the ATO within 31 days after the end of that year, which means by 31 July (s396-55 of Schedule 1 to the Taxation Administration Act). The report lists each investor and their shares, and lodging it is a declaration that the company met the ESIC requirements for those investments. Leave out investors you know cannot claim, such as affiliates and employees who got shares under a share scheme.

The ATO puts the final call on the investor: they decide whether to claim, and if the company turns out not to have been an ESIC they have to amend their return. So the honest thing a company can tell an investor is that it has self-assessed as eligible for that income year and what the assessment rests on. Promising the offset is a mistake, and using a ruling to encourage investment when the facts have changed can attract promoter penalties.

A company runs the self-assessment on its ESIC screen: the early stage limbs, then the points table with evidence attached or the five principles, and a director attests the outcome for the income year. A raise then shows an ESIC eligible badge marked self-assessed, each investor's statement records the shares, the amount and the company's self-assessed status with the cap note that fits their qualification, and the 31 July report is on the compliance calendar. Struck structures the tests and keeps the records. It does not decide eligibility, and nothing it shows is tax advice.