Tax Incentives for Early-Stage Investors

CONTEXT:

This entry is an excerpt from the OECD’s International Compendium of Entrepreneurship Policies (2020), which contains 16 case studies from 12 OECD countries. The Compendium examines the rationale for entrepreneurship policy, presents a typology of policy approaches and highlights principles for policy success. Case studies span policies for regulations and taxation, entrepreneurship education and training, advice and coaching, access to finance, internationalization, innovation, and holistic packages for ecosystem building. (OECD Publishing, Paris, https://doi.org/10.1787/338f1873-en.)

This case study illustrates how the Australian government responded to barriers that many small firms face accessing working capital, particularly during the period between firm creation and revenue generation. Because firms are usually unable to generate enough revenue to cover their operating expenses, failure rates are very high during this phase of the business life cycle (Bloch and Bhattacharya, 2016). Australia’s tax incentive aims to increase the supply of finance available to innovative start-ups by encouraging investors to make investments in new and existing Australian firms.

SUPPORT MECHANISM:

In July 2016, Australia introduced new tax incentives for early stage investors that offer those eligible:

  • A 20 percent non-refundable carry-forward tax offset on amounts invested in qualifying early-stage innovation companies (ESICs) (capped at AUD 200,000, approx. EUR 124,300, per investor per year) on an affiliate-inclusive basis; and
  • A 10-year exemption on capital gains tax for investments held as shares in an ESIC for at least 12 months (provided that the shares held do not constitute more than a 30 percent interest in the ESIC).

The incentive is designed to connect innovative start-ups with investors who have both the requisite funds and business experience to assist entrepreneurs in developing successful innovative companies, particularly during the pre-commercialization phase where a concept is in development but the company requires additional investment to assist with commercialization.

This initiative is part of a suite of tax incentives that seek to align Australia’s tax system with a culture of entrepreneurship and risk-taking.

IMPLEMENTING AGENCIES:
ELIGIBILITY:

Both the company receiving investment and the investors must be eligible. A company qualifies as an ESIC if it passes the “Early-Stage Test” and either the “100 Point Test” or the “Principles-based Innovation Test”. In addition, a company may seek a ruling from the Australian Taxation Office as to whether its circumstances meet the principles-based test of an innovation company.

To pass the Early-Stage Test, a company must:

  • Have had expenditures of AUD 1 million (approx. EUR 609,000) or less during the previous tax year;
  • Have had assessable income of AUD 200,000 (approx. EUR 124,300) or less in the previous tax year;
  • Not be listed on any stock exchange;
  • Be incorporated in Australia in the last three years; or have an Australian Business Number in the last three years; or be incorporated in the last six years with total expenditure reported in its three previous tax returns not exceeding AUD 1 million (approx. EUR 609,000).

The 100 Point Test is a self-assessment: the company must assess itself against a set of innovation criteria (e.g. R&D tax expenditure, undertaking an eligible accelerator program, enforceable rights in an innovation) using independently verifiable evidence, tax records and registration documents. The company is considered an ESIC if it obtains at least 100 points.

To qualify as an ESIC under the “Principles-based Innovation Test,” the company must demonstrate with existing documentation (e.g. business plan, commercialization strategy) that it meets each of the following requirements:

  • Is focused on developing a new or significantly improved innovations for commercialization;
  • Has innovation with a high growth potential;
  • Has the potential to scale up its business successfully;
  • Has the potential to scale beyond local markets; and
  • Has the potential for competitive advantages.

All types of investors may benefit from the tax incentive, regardless of the method of investment (see, OECD Library), i.e. directly as an individual or corporation, or through a trust or partnership. However, “widely held companies” (those whose shares are distributed over large numbers of shareholders and traded daily in a stock market) and wholly-owned subsidiaries of these companies) are not eligible.

Timeline:

Effective as of July 2016.

MONITORING + EVALUATION METHODS

The Treasury Department reports annually on the extent to which the tax provision is used based on administrative sources.

Several academic and tax policy specialists have independently assessed the tax incentive. Their evaluations examined the impact of the measures in Australia in comparison to similar measures in other countries.

KPIs monitored regularly:

  • Number of investments in ESICs
  • Value of investments in ESICs
  • Value of forgone tax revenue.

KPIs assessed to measure impact:

  • Estimated additional investment in ESICs
  • Estimated additional jobs created by ESICs
  • Estimated effective tax rate for investors.
RESULTS:

The measure came into effect on 1 July 2016 and during the first two years about AUD 630 million (approx. EUR 388 million) was invested in ESICs. Academic research on the impact of the intervention report increases in early-stage investment, but the evaluations note that it is difficult to attribute this directly to the new tax measures. Some researchers have suggested that guidance for investors issued by the Australian Taxation Office should be improved (Brass and Trewhella, 2017; Bloch and Bhattacharya, 2016).

Research comparing Australia’s tax incentive with similar initiatives in other countries using scenario analysis where an investor is faced with a choice of making an investment in an early-stage company in Australia or in the United Kingdom (UK) find that the effective annual return on net investment after three years is lower in Australia relative to the UK (18.5% vs. 38.6%) (Deloitte, 2019). Note, however, that Australia introduced its incentive more than 20 years after the UK did (1994).

CHALLENGES + LESSONS TO DATE:

In spite of the government’s efforts to promote the tax incentives when they went into effect, raising awareness among potential investors and innovative start-ups remained low (Financial Review, 2017).

In addition, some companies reported difficulties convincing the tax authorities that they qualified as an EISC. Further, the process to obtain a ruling from the Australian Taxation Office requires companies to present details of their intellectual property, which many were reluctant to do (Financial Review, 2017). This was mitigated by the self-assessment, which was used far more frequently and designed so that companies would not need to reveal their intellectual property.

Lessons for other ecosystems

Because this incentive is modelled on tax systems from the United Kingdom, Australia’s experience offers important lessons for other countries, which include:

  • Learn from international practices. The UK’s tax incentive was ranked by the European Commission as the most effective tax incentive for business angel and venture capital investment in new and small firms (European Commission, 2017). Adapting it reduced Australia’s development time.
  • Invest in stakeholder consultation. The heavy reliance on a self-assessment to determine eligibility requires that the government ensure that the criteria are clearly defined, easily understood and sufficiently flexible to capture all of the targeted activities in different sectors. Defining appropriate criteria requires a strong consultation process with business and research communities to ensure that as many scenarios as possible are considered.
  • Increase impact by putting resources into awareness raising. As noted above, a critical challenge was low awareness among targeted firms and investors. A larger promotion campaign would have increased take-up and, therefore, impact. At the same time, firms reported that guidance materials were not always clear even when they were aware of the tax incentive. In addition, some firms did not take advantage of the tax incentive because eligibility was difficult to obtain.

CURATED BY

Global Entrepreneurship Network
United States
Global Entrepreneurship Network
United States
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