Startup Tax Concessions: Employees, Investors and the Changing CGT Landscape

0:00

You’re listening to Explain That by Velocity Legal, the podcast that keeps business owners and professional advisers ahead of the curve in an ever-changing legal landscape.

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Welcome to another episode of Explain That. Today we’re talking about startup tax concessions and tax incentives. To do so, I’m joined by Special Counsel Ani Tuna. Welcome, Ani.

Thanks, Andrew. Lovely to be here again.

Likewise. It’s an interesting time for startups, right? The tax landscape is changing. I guess what we’re going to go through today is really the current landscape, and then what that looks like with the changes.

0:42

Yep. Lots going on. There are lots of new changes, but there are still quite a few things that have remained the same. So, we can go through all of that.

Okay. I guess what we’ll be going through are the big pillars, right? What are the big pillars?

0:55

Yeah. The way I look at startups is that there are concessions that are specifically for startups. There are the ones that are for startups generally, so all startups will get those, and then there are the ones that are for startups that are innovation-focused. That’s my first way of looking at them.

1:15

Another way of dicing them up is the way in which they apply. You’ve got some concessions that are directed at employees, for example. You’ve got some that are specifically for investors, and then others for the actual company or the business itself.

There are four that I could probably speak to. One of them is relatively new. I should say it’s proposed.

1:37

There are the Employee Share Scheme startup concessions. There are the Early Stage Innovation Company concessions, so ESIC. There is the R&D Tax Incentive, which is relatively well known.

Then there’s this exciting new proposed concession, which is called the Innovative Business CGT Concession. It’s very new and not yet law, but we can talk about that as well.

2:01

We’ve got so many acronyms. Tax is just all acronyms, I feel.

We’ve got ESS, Employee Share Schemes; ESIC, Early Stage Innovation Companies; R&D, which is a bit more obvious; and IBCC, which sounds like a corruption body.

It does. It sounds like a medical condition, actually.

Yeah, exactly.

2:28

I fear that when we get to talking about this, it may give some of us medical conditions having to go through the requirements.

We were talking on our way into this room about startup concessions that are designed for businesses that generally don’t have a huge amount of money to invest in compliance and are looking for funding. Sometimes, as we’ll talk through, the compliance cost of some of these can be a lot.

2:55

Well, I think that’s an important point to start with. What is the big-picture point around having these types of rules for startups generally?

If you look at something like the ESS, the Employee Share Scheme startup concessions, the design of those concessions is, firstly, supposed to reduce a lot of the compliance costs.

3:11

It’s supposed to make it easier for employers to provide these incentives to employees. In a startup environment, the idea is that, if you’ve got limited access to funds, you want to be able to incentivise employees in a way that’s meaningful and aligns them with your interests.

We’ve heard a lot about the employees who worked at Canva and have done quite well in those circumstances.

3:40

The good thing is that the rules are there to support that, but they should also be simple and incentivising.

The startup concessions for the ESS, for example, are a little bit better than the general concessions. If you were to offer something like shares at a discount in a startup that qualified for the ESS concessions, that discount in an ESS startup concession environment is completely tax-free.

That is quite enormous when you think about some of these offerings to employees.

4:13

Well, that’s the benefit in the ESS rules, right? One, the company might not have the money available to pay a certain salary. But even if it did, that would be taxed as salary and wages at marginal rates, potentially up to 47%.

Whereas a capital benefit under the current rules would receive the 50% CGT discount, assuming the conditions are met. Effectively, you’re looking at half of the tax rate.

4:46

Yeah. I guess the difference when you think about startups, as opposed to other businesses, is that the people who are starting those businesses, and even the employees, are there for that exit event. They’re looking for an exit.

One of the difficulties under the regular ESS rules is that, yes, you can design your ESS in a way that gives deferred taxation.

5:08

You can defer it to a point where there are no longer any conditions on the options or shares you acquire and things like that.

Sometimes it can be designed very well, but what will often happen is that the taxing event occurs before an exit. That means the employee doesn’t have the funds to pay the tax.

As I said, you can design it in a way that addresses that.

5:38

With the ESS startup concessions, you avoid that completely because it is deferred to the very end.

You don’t even have to worry about the question of, “I want to provide an employee incentive, but I don’t want them to have to pay tax on it.”

In a startup environment, you can say, “I want you to stay here until we have an exit event, and you won’t be taxed until that exit event happens.”

It’s happy days for the employer and the employee as well.

6:00

Yep. So, the ESS, particularly the startup concessions inside the ESS, potentially gives you the best of both worlds.

Let’s move on to the next one, ESIC.

Yeah. I’ve been saying this a lot lately. ESIC is the one that not a lot of people have known much about.

6:21

It’s relatively new. It’s the Early Stage Innovation Company concessions.

It isn’t well known because it has typically been used by large investors and angel investors. I’ll tell you a little bit about why, but in light of the changes we’re seeing with the CGT discount, I’m seeing it a lot more now.

6:38

ESIC is designed for investors. The idea is that there is an investment in a company that is early-stage, so generally three years, but in some circumstances you could get up to six years in, and the company is focused on innovation.

If you invest in that company, there are two concessions.

7:02

The first is a good one-ish, but when you compare it to the second, it’s not as great.

The first is an offset. You get a 20% non-refundable offset on your investment, capped at $200,000. That’s pretty good.

Yeah.

But the second is even better than that.

7:16

If you hold your investment in that ESIC for over 12 months, that’s to tap into the CGT discount. It will be interesting to see how that changes.

If you hold that investment or those shares for between 12 months and no more than 10 years, your capital gain is completely tax-free.

7:34

There’s very little of that in the tax system, right? Outside your main residence, maybe some small business concessions and pre-CGT assets, there aren’t really any other fully tax-free situations.

Absolutely.

Yep. And it’s completely uncapped, in the sense that it doesn’t matter what the payout on sale is.

7:51

I guess the only catch, and this is relevant in the startup context, is that for every startup unicorn that does really well, there are many that don’t.

Capital losses are also caught in there, so you’ve got to think about that risk. But it is a really amazing benefit.

8:12

But even then, you’ve got the tax offset, which goes some way to addressing that.

Absolutely. That’s right.

As I said, a lot of people didn’t know about this because it used to be big-end-of-town investors. It wasn’t really just smaller investors who were involved.

8:28

What we’re seeing now, though, is a lot of companies becoming more curious about whether they could qualify as an Early Stage Innovation Company and offer this as part of their capital raise.

If your investors aren’t going to get the CGT discount, and if we think about indexation, yes, indexation might be good as your capital raise goes on and the pricing goes up a little bit.

8:55

But it does mean that you’re losing the CGT discount, which might have been better. So, there’s a lot more interest in ESIC these days.

Yeah. Let’s take that as an example.

Let’s say you’re investing $100 in a company under the existing rules, being the rules ending on 1 July 2027, and you get the 50% discount.

9:19

Your effective tax rate will be 23.5%. But if we’re moving to indexation, we’re indexing $100. You can only index that so far.

Realistically, your actual tax rate might be 47%, or very close to it.

Zero is better than both of those, but it’s a long way better than 47% than it is from 23.5%.

9:41

I can understand that natural question: “This has existed for quite some time. Can we qualify?” The stakes are even higher now.

Absolutely. There are a couple of myths in hearing that.

The first is that, as I said, it seems like it is for big investments. Founders generally won’t qualify because there are investor eligibility requirements as well.

10:01

It is possible, though, in certain circumstances, depending on what that looks like. Sometimes founders can qualify.

There’s some commentary in an explanatory memorandum that perhaps suggests that’s not what was intended.

But if you look at the legislation, if you’ve got three or four founders, there’s no real controller, there’s independence and it’s structured in a particular way, it is possible that a founder who hasn’t invested a great deal, or has made a subsequent investment, might be eligible.

10:28

The other point is that you can potentially go back, in the sense that you might have had an investment that was qualifying for ESIC.

Depending on the circumstances, if you weren’t aware of it at the time, it may be possible or worth exploring whether it should have qualified for ESIC and whether an amendment is possible.

10:50

What I want to point out, though, is that it’s tested at a particular time. You can’t look at things that happened after the issue of the shares.

The really important point is that this doesn’t apply to a transfer of shares.

It has to be a share issue.

It has to be a share issue. It also can’t be related to your employment.

11:08

I was going to ask about employees.

The reason a lot of people don’t spend their time in this area, and it’s only just becoming of interest, is that it’s really complex.

There are so many requirements that, if you haven’t planned well, I’ve unfortunately had a lot of conversations with people where there are aspects that they can’t structure out of and, therefore, they won’t be eligible.

11:34

Had they received advice at the time of the issue, we probably could have structured it quite easily in a way that was eligible.

It’s one of those things you can’t really do retrospectively. You should get advice beforehand.

And then the third one, the R&D Tax Incentive.

11:50

Yeah. It’s a really specialised area, and I feel like it’s probably the one that is well known. It is super complex.

Often, businesses, or I should say companies, because only companies are eligible for the R&D Tax Incentive, tend to go to specialist providers.

12:05

The idea with the R&D Tax Incentive is that, when you think about the life journey of a business, you might have your investors. They put in the money, so they’re hopefully eligible for ESIC because there is innovation.

That money then lands in the company, and the company uses that money to do some research and development designed for commercialisation.

12:23

The tax incentive is that, if you’re under a certain aggregated turnover, which at the moment is $20 million, you can get a refundable tax offset for your investment in that R&D.

You can see how you go through the journey. We’re incentivising employees through the Employee Share Scheme. We’re incentivising investors to put their money in. Then we’re incentivising the company itself to do the innovation.

12:47

Yeah, that’s a good way of looking at it. It’s all three lenses, essentially.

Yeah.

And it helps defray some of those costs. You’ve got $100 of costs, but you’re getting back a certain percentage of those.

13:01

We’ve touched on each of those. I guess all the conversations in tax at the moment seem to involve the Budget.

I think we’ll look back on the May 2026 Budget as one of those big, “I was there,” moments.

The 50% discount, as we’ve already hinted, changes things massively.

What are your thoughts on how that changes things, and what is actually changing in relation to startups?

13:32

As we said, if you’ve spent any time on social media in the last couple of months, it has been very well publicised.

Having indexation replace the CGT discount, as you showed with your example, is unhelpful for investors who are effectively founders. Indexation is not going to help them.

13:55

They have now released a proposed concession.

At the time of the Budget, and I do wonder when we’re going to look back because I feel like there’s an update every week and we’re not really any closer to certainty, they announced that they were going to consult startups.

We didn’t know what that would look like, and we saw the backlash from the startup community.

14:16

Not long after, around June, they announced that they were going to release another type of concession for startups.

We’ve now seen that in exposure draft. It’s called the Innovative Business CGT Concession, so the IBCC that you mentioned earlier.

14:39

It is what I like to refer to as a mishmash of all the other rules we’ve got in different places, put together to create a concession that doesn’t currently exist.

The key thing is that it’s based on innovation. It has similar requirements to ESIC in terms of what is innovation, but I say similar because it’s not the same test.

15:04

It’s similar to ESIC in the sense that it has a CGT benefit, but instead of being a CGT exemption, it’s a CGT discount. Effectively, it’s replacing what would have been the 50% discount.

Opposite to ESIC, which requires you to hold and dispose of the investment within a certain time, this proposed concession says you need to have held it for at least three years.

15:30

We’ve got some things that are very similar to what we already have and some things that are very different.

Another difference is that, under the new proposed concession, ESS is okay, but a share transfer is still not.

Yes.

Under ESIC, the investor can only have 30% ownership, whereas my understanding under the innovation concession is that there’s no such requirement.

15:58

There are certain caps as well, but I don’t foresee a circumstance where you would end up with both.

It would be a question of choosing where you are more likely to satisfy the conditions. Is it the innovation concession, or is it the ESIC concession?

16:15

I guess, just to get technical on one thing, what is innovative?

What is innovative?

I don’t even know that I could get technical.

Under the ESIC concessions, what I like about the ESIC rules is that there are two tests. One of them is a really good way of structuring tax because it’s very quantifiable.

16:38

It’s called the 100-point test. It’s basically a table in the legislation, and it’s very clear. It says that if you meet 100 points on this test, then we consider you to be innovative.

Those requirements are things like whether you have done R&D of a particular capacity or been part of an accelerator program. They’re really clear tax rules.

17:02

It’s like an ID 100-point check, with a passport worth 40 points.

Exactly. It’s the way it should be for a startup that doesn’t want to come to somebody like a law firm or even an R&D or innovation specialist.

Yeah, that’s great.

17:12

Then there’s a second test in ESIC, which is called the principles-based test.

If you imagine a company really early on, it might not be eligible for any of those points, or it might not make 100. So, you have to do a principles-based test.

That’s when we get into the airy-fairy.

17:25

It has five questions, and they’re all about what you are developing. Is there the potential for this to be successful? Is there a potential market that is large enough? Can this be scaled? Can this be commercialised?

They’re super subjective questions around what is innovation.

17:46

Interestingly, under this new proposal, they’ve gone, “Those two are kind of okay,” but they’re not going to use the 100-point test. There’s nothing like that.

They’ve gone with a purely innovation-based test as part of the proposal so far.

18:01

They’ve then gone with something that sounds almost identical to what we already have, but have gone to pains to say that it’s not exactly the same.

The legislation is worded slightly differently. It’s in a whole new section and doesn’t reference the old test.

It’s very similar, but different.

Yeah. A recipe for disaster.

A recipe for disaster.

18:21

I still couldn’t tell you what innovation really means.

It’s really difficult, and it’s where we end up finding people having to go to specialists to work that out.

All I can say from a tax perspective, as somebody who often unfortunately looks at this when it’s too late, is that contemporaneous evidence is always best.

18:39

It’s my favourite word in tax or law: contemporaneous evidence.

It’s all tested at the time of the issue of the shares. You might have a really innovative product, but if it hasn’t been put in writing and you don’t have the evidence 10 years down the track, it’s going to be difficult to prove to the ATO that those were the actual facts at that particular point in time.

19:04

Also, who is going to remember exactly what the commercialisation plan or the market looked like 10 or 15 years ago?

Yeah, because they’re long time horizons. You might hold this for quite some time, and then you’re going to have to justify the tax treatment at the point of sale, which may be many years down the track.

19:23

With ESIC, you have to hold the investment for no more than 10 years.

With the new proposed innovation concession, at the time of the issue the company has to meet certain requirements around 15 years. I think it has to be younger than 15 years.

But it could issue shares to you at 15 years, and you have to hold them for at least three years. It could be quite some time before you actually sell.

So, there are huge horizons.

19:49

I wanted to ask you a question. Let’s say I’m a business that’s not innovative.

Let’s say I’ve come up with an idea and I’m going to open a hamburger chain. It’s probably not innovative, and you’re not meeting any of those tests.

But we’re going to create a great hamburger chain, and maybe I want to give some equity to people. Where does that leave businesses that are not innovative?

20:12

I guess that raises a question as to how much of your business needs to be innovative.

For example, even with a hamburger chain under ESIC, or under the new proposed change, it is going to be talking about dominant purpose.

Would you qualify if your hamburger chain spent some money and did some work on a plant-based burger or fries that could be innovative?

It absolutely could.

20:48

There is a question as to whether you would still qualify if you did some innovation.

Outside of innovation, for a sale or an equity holding and things like that, you would probably end up under the general rules.

That might include the small business CGT concessions, for example.

21:02

They’re not specific to startups, but depending on the circumstances, you might find yourself able to qualify for the small business CGT concessions on the sale of a business or perhaps your shares.

Do you think this will lead to uncertainty for businesses that want to issue equity?

We take this all with a grain of salt because, as you said, it’s a moving landscape.

21:27

Under the current rules, if I issue equity, we roughly know how that works. I could get the startup concessions, it’s on capital account and there’s the general 50% discount.

As opposed to this new world where, if it’s innovative, it will be good, but if it’s not innovative, there’s really no reason to do it. Why would you do it?

21:50

I guess that’s when you go back to the very start, which is who you’re providing the incentives to and why you’re providing them.

Is it about a capital raise? If it’s a capital raise, then you probably don’t have a great deal of room to move in terms of incentivisation if you aren’t innovative.

22:09

If it’s not about a capital raise and it’s more about incentivising or attracting really good employees, then you might be thinking more about the ESS.

But I still like to think proactively.

If I already know that there’s an exposure draft, even though it’s not law, and I know that an ESS could potentially fall within that, I would look at it as much as possible, provided it commercially aligns with what you’re seeking.

22:32

I’d be looking at the exposure draft even now and saying, “Okay, if it was possible and there was grandfathering, can we structure it in a way that means, down the track, we could actually be eligible for this if needed?”

That’s probably where I would go at the moment, with some certainty and some level of uncertainty.

22:48

I think that’s an excellent point. It really ties into what to do now as an adviser trying to advise in this landscape.

One of the real takeaways for me is the benefit of the ESIC rules.

They were already good. The ESIC rules haven’t changed, but if everything else is changing, their status is almost gold now.

23:10

It really is gold.

Going back to what you said, I think the 15-year exemption and ESIC are probably up there with the best concessions you can get.

As you’d know, they’re both very complex in terms of what you need to do to access them.

23:26

Without the 50% discount, I’m saying ESIC is now twice as valuable as it was previously.

It’s 100% valuable in the sense that it’s a full exemption, but it’s twice as valuable because you’re comparing it with having no CGT discount at all.

It’s amazing as far as that’s concerned.

23:46

Well, Ani, I want to thank you for your insights as part of this episode.

It’s a broad topic and an evolving landscape, but I think your points around assessing who is intended to benefit are important.

Is this for a founder? Is this for an employee? Is this for the business?

You need to assess the current rules and what’s proposed, and try to do your best to advise in that position.

24:08

If any listeners or startups have questions, I’d strongly encourage them to reach out to Ani.

Thank you. It was a pleasure to be here.

Hopefully, next time I’m back, we’ve got some certainty on that concession. But as I said, planning is always the number one way to go.

Fantastic. Thanks again.

Thanks.