Startups with ESIC status offer investors attractive tax offsets. Here’s what you need to know

As end of financial year draws closer, I am getting a lot of queries from startups about ESIC status.

And for good reason. ESIC stands for early-stage innovation company and there are some fairly generous tax offsets available for people who invest in one. So becoming an ESIC is one way to make your startup more attractive to investors.

As with all things tax, the offsets people can claim for investing in an ESIC can get a bit technical.

To summarise, investors can claim an immediate tax offset of up to 20% of their investment in an ESIC. And if there’s an exit in the following one to 10 years, their investment won’t be subject to capital gains tax.

The offset is capped at $200,000 per year for sophisticated investors. Non-sophisticated investors are able to invest up to $50,000 per year, on which they can claim the 20% offset.

If you’re involved in capital raising discussions (or planning to be soon), ESIC status can give you an edge in the competitive funding market.

Or you might find yourself being asked if you’re an ESIC by someone who is already an investor in your company. And they might expect you to say yes — especially come end of financial year when tax is on their mind.

How do you become an ESIC?

It might seem obvious, but given what ESIC stands for, your startup needs to be a registered company to go down this path.

Then, as with most things tax-related in Australia, directors can self-determine their ESIC status, but you need to have clear grounds for it.

Also, investors often prefer an outside view and ask companies to apply to the ATO for a formal ESIC ruling. So, if you’re wanting to make your startup attractive to investors, then the onus usually falls on you to do this.

You can start by self-assessing to see if it’s worth your while applying to the ATO for a formal ruling. To do this, you need to do two tests:

An early-stage test; and
An innovation test.

The early-stage test is straightforward. Basically, you need to meet the rules for an early-stage emerging company.

The innovation test is more complex and has two options:

The 100-point innovation test; and
the principles-based innovation test.

The 100-point test includes an analysis of any R&D tax incentives claimed, participation in an accelerator program, any capital raised to date, and any enforceable rights you have, such as a patent.

If you don’t meet this test, that’s okay. An increasing number of startups are relying on the principles-based test instead. But while at a glance this might seem easier to meet, it is harder to confidently assess by yourself, and this option especially is where investors are looking for a successful ATO ruling.

For the principles-based test, you need to demonstrate your potential for high growth, your competitive advantage, and how you can scale, among other requirements. In an increasingly competitive startup environment, this can be difficult. So it’s probably no surprise this is where a guided service to help you assess this and lodge the ATO paperwork can come in handy.

Traps for new players

Becoming an ESIC isn’t a free ride to investment. It is a big tick for many investors, but not for everyone.

Going for ESIC status doesn’t mean you will definitely get it either. So while it’s usually best to get an official ATO ruling, it’s not something you’d want to spend thousands of dollars applying for, especially when you hold most of the info and will need to be involved in putting the paperwork together.

And remember, as with most things ATO-related, it takes time. So in order to have those immediate tax offsets available for investors before June 30, it’s best to be getting started sooner rather than later.

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