Review of capital gains tax reforms for innovative start-ups
The Tax Institute welcomes the opportunity to make a submission to the Treasury in respect of its consultation regarding the capital gains tax reforms – arrangements for innovative start-ups (Consultation Paper).
We recognise the important role that innovative start-ups play in fostering productivity, economic growth, job creation, and Australia’s broader innovation ecosystem. We acknowledge the Government's objective of ensuring that the broader capital gains tax (CGT) changes do not inadvertently discourage investment in high-risk, high-growth innovative businesses. We also welcome the proposal to introduce a targeted Innovative Business CGT Concession (IBCC).
In particular, we support Treasury's recognition that founders, employees and early-stage investors play a crucial role in the start-up ecosystem, and that tax settings should continue to encourage participation in innovative businesses where growth potential may significantly exceed the initial investment or cost base.
While we support the policy objective of the proposed concession, we have concerns regarding several aspects of the proposed design. In particular, the current proposal relies on a number of subjective eligibility criteria that may create uncertainty for investors, increase compliance costs, and result in disputes many years after an investment has been made. Greater certainty at the time of investment will be crucial for the concession to achieve its intended objective.
Consultation timing and increasing complexity
We note that the consultation period for these proposals has been only three weeks. This has occurred while stakeholders are still grappling with the broader CGT changes, and other related measures announced by the Government. It has also coincided with the financial year-end period, when taxpayers, businesses and advisers are managing significant compliance obligations.
As a result, there has been limited opportunity to fully consider the proposed concession and its interaction with the broader CGT changes. We are of the view that the Government should undertake further consultation on the detailed design of the concession before the measures are finalised, taking into account preliminary feedback provided at this stage.
More broadly, The Tax Institute has consistently advocated for simpler, standardised eligibility rules across the tax system, including, where possible, a single definition of small business. While we support measures that encourage investment in innovative start-ups, the proposed concession introduces additional thresholds, tests and integrity rules that apply only to this concession. The small business and CGT concession regimes are already complex. Adding new tests and thresholds unique to a single concession will increase compliance costs and make the system more difficult for taxpayers and advisers to navigate.
The growing number of innovation-related concessions, each with their own eligibility criteria and integrity rules, increases the importance of ensuring that the proposed IBCC aligns with existing regimes wherever possible. These include the Employee Share Scheme (ESS) Start-Up Concession, the Early-Stage Innovation Company (ESIC) regime, the Research and Development Tax Incentive (R&DTI), and the Venture Capital Limited Partnership (VCLP) and Early-Stage Venture Capital Limited Partnership (ESVCLP) programs.
The Government should consider whether the thresholds and tests for the proposed concession can be aligned with existing rules. This would help reduce complexity, improve certainty, and make the concessions easier for taxpayers and advisers to apply.
Summary of key findings and recommendations
We consider that several aspects of the proposed IBCC require further refinement to ensure the concession can achieve its intended policy outcomes. Our key findings are summarised below.
Simplicity and alignment with existing regimes should be a key design principle
The proposed concession introduces additional eligibility criteria, thresholds and integrity rules into an already complex area of the tax law. The Government should consider aligning the thresholds and tests for the IBCC with existing innovation and small-business tax measures, wherever possible, to reduce compliance costs and improve certainty.
Investor certainty should be the primary design principle
The proposed concession relies heavily on subjective eligibility criteria that may not be tested until many years after an investment has been made. Investors require certainty at the time decisions are made, rather than retrospective assessment when a capital gain is eventually realised. We strongly recommend introducing a binding certification or approval mechanism to provide certainty regarding eligibility.
The proposed innovation test may be difficult to administer
The innovation principles may be particularly challenging for founders and early-stage businesses to satisfy and document. The proposed criteria rely on subjective concepts and may create uncertainty for businesses, investors and advisers. A more objective approach should be considered.
The proposed age and turnover thresholds require further consideration
There is merit in targeting the concession to businesses with turnover below $50 million and that are less than 10 years old, as businesses beyond these thresholds may generally be expected to have progressed beyond the start-up phase. However, a strict incorporation-age test may not adequately accommodate businesses with longer development and commercialisation timelines or those that undertake legitimate restructures as they grow. The operation of these rules should be reviewed to ensure they appropriately target innovative businesses without creating unintended outcomes.
Record-keeping obligations may be excessive
The proposed framework relies heavily on historical company records to substantiate eligibility many years after shares are issued. Investors may not have access to the information required to support their claims when a CGT event occurs. The legislation should provide clear evidentiary and record-keeping rules.
The proposed rules may discourage follow-on investment and create uncertainty for restructures
The consultation paper does not clearly explain how the concession will apply to subsequent funding rounds, corporate restructures, acquisitions and successor entities. Additional guidance and continuity rules may be required to ensure investors are not disadvantaged by legitimate commercial transactions.
Further consideration should be given to founders and significant investors
Founders are identified as a key target group for the concession. However, significant investors may be required to choose between the IBCC and the small business CGT concessions. It is unclear how much additional benefit the IBCC will provide in these circumstances, and further clarification is required.
The administration of the lifetime cap requires further consideration
The proposed lifetime cap may add to the growing number of tax attributes that taxpayers and advisers must track over extended periods. Clear administrative rules and reporting mechanisms will be required to minimise compliance costs.
Transitional arrangements should minimise valuation and compliance costs
While the proposed transitional rules are a welcome attempt to simplify eligibility for existing investments, they may introduce additional valuation dates and record-keeping obligations. Greater alignment with the broader CGT changes should be considered to reduce duplication and compliance costs.
Further guidance is required on interactions with existing innovation incentives
The proposed IBCC will operate alongside existing regimes, including the ESS Start-Up Concession, ESIC regime, R&DTI and VCLP/ESVCLP programs. Greater clarity is required regarding how these regimes interact and whether eligibility criteria can be better aligned.
Additional guidance is required for carried interest arrangements
The consultation paper proposes extending the IBCC to carried interest received by general partners of VCLPs and ESVCLPs. However, it does not explain how key features of the concession, including the holding period, innovation requirements and lifetime cap, will apply to carried interest arrangements. Specific rules may be required.
Foreign investment implications should be considered
The exclusion of foreign residents from the IBCC raises broader questions about the interaction between the concession and the Government's objectives to encourage investment in innovative Australian businesses. The Government should consider whether any unintended impacts on foreign investment may arise.
Our overarching recommendation is that the final design of the IBCC should prioritise certainty, administrability and objective eligibility criteria. A concession that can be relied on at the time of investment will be significantly more effective in encouraging participation in innovative Australian businesses than one that remains vulnerable to retrospective review many years later.
Our detailed responses to questions raised in the Consultation Paper are contained in Appendix A.