Australia: Early stage innovation companies - 10 months on

Last Updated: 9 May 2017
Article by Carlos Gouveia


In our August 2016 article, New tax incentives for start-up investors, we outlined the tax incentives available to investors in early stage innovation companies (ESICs) and the eligibility criteria. The incentives consist of a non-refundable tax offset and modified capital gains tax treatment for shares acquired on or after 1 July 2016. This article considers some of the developments that have occurred since the provisions were introduced.


It has become clear that satisfaction of the innovation test is a significant challenge for companies seeking to qualify as ESICs as well as investors. To recap, the innovation test can be satisfied through the 100 point test or the principles-based test. Many companies will be unable to satisfy the 100 point test because some of the criteria require material expenditure which many early stage companies will be unable to fund. Those companies will be forced to satisfy the principles-based test.

The criteria for the principles-based test are subjective and uncertain:

  • the company is genuinely focused on developing for commercialisation one or more new, or significantly improved, products, processes, services or marketing or organisational methods
  • the business relating to those products, processes, services or methods has a high growth potential
  • the company can demonstrate that it has the potential to be able to successfully scale that business
  • the company can demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business
  • the company can demonstrate that it has the potential to be able to have competitive advantages for that business

As the provisions have only been in place for a little over 10 months, there is limited guidance on the meaning of the criteria. Refer to the Australian Taxation Office (ATO) publication " Tax incentives for early stage investors", binding private ruling authorisation numbers 1013085852369, 1013110995435, 1013118195657, 1013125486489 and 1013128246718.

It is also important to keep in mind that the principles-based test (as well as the 100 point test) must be satisfied immediately after the shares are issued to an investor.

So what can companies and investors do to mitigate the risk that the ATO will take a different view on the principles-based test? For an investor, the consequences of getting it wrong are liability to pay the tax shortfall, interest and penalties.

Here are the options.


The Australian tax system requires taxpayers to determine how the tax laws apply to their circumstances. Here it is the investors being the persons to whom the incentives are available who must determine the company's compliance with the principles-based test. It will be of limited use to investors that the company itself determines that it complies. But investors face obstacles to make the determination, including access to relevant information and ensuring that compliance occurs immediately after the shares are issued to them. In most cases this is unlikely to be a viable option for investors.

Obtain an expert opinion

In theory this may be a viable option for the company but an expert engaged by an investor is likely to encounter the same difficulties discussed above. In practice it may be difficult to find an advisor with the necessary expertise who is prepared to provide an opinion for inclusion in an information memorandum. Even if an expert can be found, reliance on the expert's opinion of itself is no guarantee that an investor's exposure to pay the tax shortfall, interest and penalties will be reduced.

Obtain a private ruling

A private ruling is the ATO's written expression of how a relevant provision applies to a taxpayer in relation to a scheme. A private ruling is binding on the ATO if:

  • the taxpayer (or some other person authorised by the taxpayer) applied for the ruling
  • the scheme is implemented in accordance with the facts, assumptions and conditions set out in the ruling
  • the application contained all material facts and they were described in a way which was not misleading or inaccurate
  • there is no change in the relevant law since the ruling was issued
  • the scheme is implemented within the period that the ruling is valid

From the above it is clear that a ruling obtained by the company will technically not assist investors, at least where the company has not been authorised to apply for the ruling on behalf of an investor, as the ruling will not bind the ATO in relation to the investor. Practically, however, we expect that the ATO will not seek to avoid the application of the ruling to the investor provided the company's circumstances do not change.

An alternative is that the investor applies for the ruling, but once again the investor may not have access to all relevant information. The other difficulty with a private ruling (and class ruling discussed below) is that the process may take many months. This may mean that a ruling is not viable given the pace at which the parties wish to transact. The ATO has in place a priority ruling process but we expect that rulings on the principles-based test will still be a lengthy process, even if processed as a priority ruling, because the ATO may need to consult with the Department of Industry, Innovation and Science.

Obtain a class ruling

This is probably the best option for investors to minimise risk, although it is not without drawbacks. A class ruling is a public ruling (it is published on the ATO's website) about the application of a tax law in relation to a specific class of persons and their participation in a scheme. A class ruling is binding on the ATO in the same way as a private ruling except that it will bind the ATO in relation to the class of persons to which it relates, not just the applicant. This means that the company can apply for the class ruling (as it is best placed to present to the ATO all material facts and information) and nominate the investors as the class of persons to whom the ruling relates.

Apart from the timeframe to obtain a class ruling (which should be similar to the timeframe for a private ruling), the other drawback is that the company's circumstances may change to cause it to no longer satisfy the principles-based test after the ruling is issued. This problem is particularly acute if the company is seeking to attract a number of investors over a couple of years as the legislation requires the principles-based test to be satisfied immediately after the shares are issued to an investor. The class ruling may only be valid for a limited period. It may be necessary for the company to obtain multiple class rulings.


There was an oversight in the provisions relating to investors investing through fixed trusts being that a distribution of the disregarded capital gain from the trust to the investor would be clawed back through capital gains tax event E4. This event causes the cost base of the investor's units or interest in the trust being reduced by the amount of the distribution. If the distribution exceeds the cost base, the balance will be a capital gain to the investor. This position has been corrected by amendments contained in Treasury Laws Amendment (2017 Measures No. 1) Act 2017 (Cth) which apply from 1 July 2017.

The amendments only apply where the investment is held directly through a trust. If there is more than one interposed trust, the amendments do not apply. The explanatory memorandum states that extension of the provisions to indirect investments held through multiple trusts may be considered at a later date.

Carlos Gouveia
Corporate advisory
Colin Biggers & Paisley

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Carlos Gouveia
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