Startup funding

Can Australian startups use convertible notes to bridge the funding drought before 1 July?

The Australian Senate has now passed The Tax Amendment (Tax incentives for innovation) Act. The Act introduces a non-refundable, carry-forward tax offset for investors equal to 20% of the amount invested into ‘Early Stage Innovation Companies’ (ESICs), up to a cap of $200,000.

There are a number of criteria to ensure that the investment meets the requirements of the Act. One of those requirements is that the ESIC must issue the investors new shares on or after 1 July 2016. The concern has been that the delayed start date will lead to a ‘funding drought/strike’ for startups, with investors holding off until 1 July.

Now that the start date for these measures has been set the question arises as to whether it is possible to provide funds to the company before 1 July and still qualify for the tax concessions.

One idea that has been floated is to structure the investment to provide the funds by way of a convertible note now, which will convert into shares on or after 1 July

The Explanatory Memorandum to the enacting Bill stated that “investors that acquire equity interests from the conversion of convertible notes and not precluded from qualifying for the tax offset, where the company issuing those equity interests is a qualifying ESIC at the time of the conversion into shares”.

On its face this would seem to indicate that it would be possible to provide funds to qualifying ESIC now by way of a convertible note which converts into new shares post 30 June and obtain the tax offset.

However this is not the end of the story. The Australian Tax Office has wide discretionary powers to deny a tax benefit where an entity enters into a scheme for the dominant purpose of providing a taxpayer with that tax benefit. The Act expressly amended the general anti-avoidance rules to address the tax offset provided under the Act. The relevant question is then, is the purpose of the ‘scheme’ (being the provision of funds to the company by way of a convertible note) to make a commercial investment in the company or to obtain the benefit of the tax offset?

While this article is too short to fully explain the intricacies of these provisions, in summary in determining the ‘dominant purpose’, the ATO focuses on a number of factors including the structure of the scheme and the time it was entered into.

While as any lawyer will tell you, “it depends on the facts”, the following may be a useful guide:

  1. If the company was always seeking to raise funds by way of a convertible note which will convert on the next fundraising based on a reasonable time horizon, the terms of which incorporate typical features such as a market conversion discount, coupon rate and a capped limit on the valuation price, then it is difficult to see how the ATO could seek to apply the anti-avoidance provisions if the note converts post 30 June 2016.
  2. If the company was seeking equity, but restructures the offering to be a convertible note issued pre 1 July but which will automatically convert on 1 July into shares with no or only a nominal discount, then it is highly likely that the ATO could deny the tax offset to the investor.

As always, the difficult part is advising on the ‘grey’ between these black and white extremes. Any companies or investors looking to use convertible notes to bridge the funding drought period should obtain advice on this issue before finalising the funding.


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Toby Eggleston