Australia’s ESIC rules are designed to do one thing: encourage fresh external capital into early-stage, high-growth Australian startups. 

The tax concessions offered by those rules are generally directed at new investors, not founders.

But what if a founder is putting their own capital into the startup? Does that change the picture? In some circumstances, it might. 

This article explores when, why, and what founders could do to seek further clarity. 

What are the tax concessions?

Broadly, the ESIC concessions provide eligible investors with: 

• A tax offset – this is non-refundable (meaning it reduces an investor’s tax bill but won’t generate a cash refund) and can be carried forward (if the investor doesn’t use it all in one year). This offset is equal to 20% of the investment amount (capped at $200,000 per annum per investor); and
  
• Modified CGT treatment – CGT won’t arise provided the investor has held the shares for more than 12 months and less than 10 years.

These are powerful incentives. If an investor is eligible, they effectively reduce their next tax bill by 20% and they pay no CGT on a gain on exit. Both can provide significant benefits if an investor qualifies.

Default position – founders are ineligible

The rules are aimed at attracting fresh external capital to early-stage companies, not subsidising existing investors. General information about qualifying under the ESIC rules is available at the ATO’s webpage: ATO – Tax incentives for early stage investors.

Two of the rules make it explicit that founders should not qualify. Broadly, the investor: 

• Must hold less than 30% of the shares/votes in the company immediately after their shares are issued; and
  
• Cannot be an “affiliate” of the company at the time the shares are issued.

This is where founders run into hurdles for claiming ESIC concessions. 

Founders typically own shares in and control the company (i.e. they are both a shareholder and a director). This means they tend to be treated as an affiliate of the company. That disqualifies them from the ESIC concessions on shares they receive in that capacity.

However, the rules contain an important qualification: a director and a company are not automatically affiliates just because of the director’s role in running the company. The affiliate relationship has to arise from something more than that.

Could that leave room (on the right facts) for a more nuanced analysis? 

When might founders qualify?

Not all shares issued to founders are the same. There is a distinction between:

• Incorporation shares – the ordinary shares issued to founders at the incorporation of a new Pty Ltd company. These are typically issued at a nominal paid-up amount. These clearly fall outside the ESIC concessions. At that point, the founder is not investing external capital, they’re simply taking their founder’s stake in the startup; and
  
• Subsequent investment shares – in some cases, a founder will later invest their own capital into the company. For example, they may participate in a pre-seed round alongside external investors. Here, the founder is acting more like an investor than a founder receiving equity for their role.

That second scenario raises an interesting question: if a founder is putting genuine external capital into the startup (and on the same terms as other investors) should that investment be assessed on its own merits, separately from the founder’s existing relationship with the company? 

We think yes, that founders have a reasonable basis to explore if they qualify for ESIC concessions.

How can founders seek clarity on their position?

Typically, venture investors qualify for ESIC concessions by self-assessing with the ATO. That is, we generally don’t need to engage with the ATO beforehand to confirm our tax position because we fall under the traditional policy intent of the ESIC rules. 

This is different for founders, given the nuances we’ve described above. So, for founders investing their own capital, it may be worthwhile to explore applying to the ATO requesting a confirmation of their tax position. 

Traditionally, a taxpayer can confirm their tax position by applying to the ATO for a private binding ruling (PBR). The ATO does not charge a fee for applying for a PBR, but the typical recommended route would be to engage a lawyer to prepare a strong application with supporting documentation. 

Can a founder lodge a PBR themselves, without a lawyer? Yes. 

It is not a guaranteed outcome. But, for founders investing significant capital into their startup, it is a question worth asking. For the right founder and the right facts, the potential tax savings could be significant.