ESIC scheme offsets may be disallowed under Part IVA

The Australian Taxation Office (ATO) has recently finalised TD 2025/3, which provides a warning on the application of the Part IVA general anti-avoidance rules (as per the Income Tax Assessment Act 1936 (ITAA 1936)) to certain schemes as they apply to early stage innovation company (ESIC) arrangements, as originally described in Taxpayer Alert TA 2024/1.

ESIC tax incentives

Broadly, investors who purchase new shares in a qualifying Australian-incorporated early-stage innovation company may be eligible for tax incentives as follows:

• A non-refundable carry forward tax offset equal to 20 per cent of the amount paid for their qualifying shares – capped at an annual maximum ESIC tax offset amount of $200,000 for the investor and their affiliates combined in each income year
• Modified capital gains tax (CGT) treatment, under which capital gains and capital losses on qualifying shares in the ESIC that are continuously held for at least 12 months and less than 10 years may be disregarded.

A total annual investment limit of $50,000 applies to retail investors who don’t meet the requirements of the sophisticated investor test (i.e. in s708 of the Corporations Act 2001). However, there are no restrictions on the amount that sophisticated investors can invest (but the offset is limited to $200,000 per year).

Circular financing arrangement warning

TA 2024/1 was issued in December 2024 due to the ATO becoming aware that tax avoidance schemes were being promoted involving taxpayers claiming the ESIC offset through tailored financing arrangements designed to claim the maximum offset, but with minimal or no investment risk. Specifically, the arrangements involved circular financing arrangements. Broadly, the scheme operators promoted investment opportunities to individual investors in a start-up company, which the scheme operators purported would qualify as an ESIC, to enable the investors to claim the ESIC offset.

TD 2025/3 provides further specificity on the financing arrangement as follows:

• It is offered to fund the individual's share subscription amount, less any required nominal deposit, to allow the individual to acquire shares in the start-up company typically up to an amount that qualifies for the maximum ESIC tax offset (capped at $200,000 for investors and affiliates)
• The start-up company deposits the subscription amount back to the financier who controls the start-up company’s use of the subscription monies, including limiting the amount the start-up company can use to further its stated innovation and commercialisation activities
• The individual claims the ESIC tax offset in their tax return and receives a refund, typically generated by the tax offset reducing the individual's tax liability on their salary and wage income, with the resulting tax refund used to partially repay the finance
• The remaining financing is repaid by the individual within a short period out of subscription monies returned to the individual by the start-up company, typically returned by way of selective share buy-back (or other disposal) of some or all of the individual's shares. That is, the individual did not pay for any residual shareholding they may continue to have in the start-up company, and the refunded tax offset is, in effect, shared between the individual, the start-up company and the entities facilitating and financing the individual's share subscription.

Part IVA could disqualify obtaining tax offsets

The TD outlines the possible application of Part IVA. The described arrangements would normally consist of some, or all, of the features described in the TD. It is noted that while these arrangements may assure investors of their ability to repay their financing through returned subscription monies by way of share buy-back or otherwise, the return of subscription monies to the investor is not essential for Part IVA to apply. Broadly, the tax benefit is the amount of the ESIC offset and the deduction for the interest expense. If Part IVA applies, the ATO will likely cancel the tax benefits so that neither the tax offset nor any interest expense deduction will be available.

Recommended action for existing or potential investors in such schemes

If you have made or are considering making an investment in a ESIC arrangement similar to the situation described above, it is recommended you contact your local BDO corporate and international tax specialist.