The Administrative Appeals Tribunal has recently handed down the first ever decision of any Court or Tribunal on the application of the Early Stage Innovation Company (“ESIC”) measures.
This is the decision of ZWBX v Commissioner of Taxation [2024] AATA 2065 (“ZWBX”), in which access to the ESIC measures were denied.
The AAT has held in ZWBX that a head company must itself be engaged in innovative activities in order to qualify as an ESIC. The activities of a subsidiary company cannot be imputed to the head company. This result is not entirely unexpected and is consistent with the view the authors’ have taken with advising clients on a number of matters. All the same, it does highlight the need for a high degree of care when addressing ESIC issues.
What are the ESIC Measures?
Before diving into the decision, it is useful to briefly summarise the ESIC measures.
In broad terms, where available, the ESIC measures provide taxpayers who subscribe for new shares in an ESIC with the following tax concessions:
a non-refundable tax offset equal to 20% of the investor’s investment in the ESIC; and
concessional capital gains tax (“CGT”) treatment on the newly issued shares.
The non-refundable tax offset is capped at $200,000 for sophisticated investors (equivalent to a $1 million investment) and $10,000 for non-sophisticated investors.
As to the concessional CGT treatment, this can potentially result in any capital gain arising on the disposal of shares in an ESIC being entirely disregarded.
Central to the above tax concessions is that, at the time of the share issue to the investor, the investee company must qualify as an ESIC.
There is a two-limb test that needs to be satisfied for the company to be an ESIC. Those two limbs are the “early-stage limb” and the “innovation limb”.
In relation to the “innovation limb”, it can be met by the company satisfying the “principles-based test”.
In broad terms, the principles-based test requires that the company can demonstrate all of the following:
the company is genuinely focussed on developing for commercialisation one or more new or significantly improved products, processes, services, marketing or organisational methods;
the business relating to the above innovations 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 it has the potential to be able to address a broader than local market, including global markets through that business; and
the company can demonstrate that it has the potential to be able to have competitive advantages for that business.
The application of the principles-based test was at the core of the decision in ZWBX.
Structure Adopted
ZWBX involved a taxpayer that was one of a handful of developers of a cloud-based client communications management platform (“the Software”).
In 2016, the developers sought accounting advice in order to set up a new corporate structure to further develop and commercialise the Software.
As a result of that advice, the developers adopted the following corporate structure:
IP Co – which held the Software;
Trading Co – which licensed the Software from IP Co in order to carry on a business in relation to the software including the Software’s development and commercialisation; and
Holding Co – which wholly owned IP Co and Trading Co and therefore acted as the “head company” for the corporate group.
The taxpayer and other developers (via related entities) invested directly in Holding Co by subscribing for new shares on which the taxpayer (and its related entity) sought to claim the ESIC concessions outlined above.
In claiming the concession, the taxpayer self-assessed on its eligibility including that Holding Co, at the time of the share issue, qualified as an ESIC. In this regard, the taxpayer and Holding Co applied the principles-based test in satisfying the innovation limb.
The Decision
At issue was whether Holding Co qualified as an ESIC under the principles-based test. To this effect, the company was not itself directly carrying on any activities in relation to developing and commercialising the Software.
Although Holding Co was a passive holding company, the taxpayer reasoned that the principles-based test could still be satisfied by Holding Co on the basis that the objective purpose of the criteria allowed there to be a “unity of purpose” concept. In other words, the actions of a corporate group as a whole could be relied upon to satisfy the test’s criteria in relation to a particular company in that group (i.e. Trading Co and IP Co’s collective activities could be attributed to Holding Co).
The AAT, siding with the Commissioner of Taxation, rejected this approach finding that the principles-based test is to be applied to the activities of a specific company as opposed to a group of companies.
On this basis, when viewing Holding Co’s activities in isolation, there was no evidence that Holding Co in its own right was genuinely focused on developing for commercialisation the Software.
Further, there was no evidence of Holding Co undertaking or having the potential to undertake specific business activities for the scaling of the business relating to the Software, addressing broader markets or having a competitive advantage.
All activities in relation to the development and commercialisation of the Software and the associated business were carried on by Trading Co (in its own right, not on behalf of Holding Co) such that it was the relevant ESIC.
Therefore, the taxpayer’s investment in Holding Co was ineligible for the ESIC concessions.
Key Takeaways
We have noted below some of the key takeaways from the decision of ZWBX for clients and their advisers:
In order for a company to qualify as an ESIC, the company must itself be actively engaged in the development and commercialisation of the innovation.
In this respect, the company must be actively engaged in the business relating to the innovation and those matters which are directed towards the business having the potential to be high growth, scalable, being able to address a broader than local market and have competitive advantages.
The corporate structure adopted by the developers resulted from advice that had regard to asset protection, structural flexibility and tax-effectiveness. The structure is commonly deployed in the start-up industry and therefore the decision of ZWBX does serve as a warning to taxpayers that seek to access the ESIC measures in such circumstances.
It is important to note that there were no agency, joint venture or partnership agreements in place between Holding Co and Trading Co. If such agreements were in place, such that Holding Co was engaged in the innovative activities, then it remains to be seen whether this would suffice for Holding Co to qualify as an ESIC.
The decision of ZWBX also highlights the dangers in taxpayers and advisers electing to self-assess on the principles-based test. The criteria are inherently subjective and therefore, in the authors’ experience, if absolute certainty is required clients should seek a private binding ruling from the Australian Taxation Office. This approach is often favoured not only for investors, but the board of directors of the potential ESIC. In this regard, many investors may view the availability of the ESIC concessions as being one of their conditions of investment.
Don’t get caught out. Clients and advisers seeking to set up ESIC complying structures or investments in ESICs should contact our specialist tax team including the authors of this Insight, Jackson Jury and Joshua Pascale.
