Can A Dual Company Structure Affect ESIC Eligibility?

A dual company structure can make a lot of sense for a growing business. By keeping valuable assets such as intellectual property (IP) separate from day-to-day trading activities, you can create an additional layer of protection around some of the business's most important assets.

However, if you're an innovative startup planning to raise capital, there's another issue worth considering: Early Stage Innovation Company (ESIC) eligibility.

A 2024 decision, ZWBX and Commissioner of Taxation, highlighted a potential problem where investors subscribe for shares in a holding company but the innovative activities happen elsewhere in the group.

That doesn't mean dual company structures can't qualify for ESIC. It does mean that if ESIC is important to your funding plans, it's worth considering before deciding on or changing your structure.

What Is A Dual Company Structure?

A Dual Company Structure generally involves two separate companies with different roles.

For example:

Holding Company (HoldCo)
Owns valuable assets such as IP and holds the shares in the operating company.

Operating Company (OpCo)
Runs the day-to-day business, enters contracts, works with customers and suppliers and takes on much of the business's operational risk.

One of the main reasons businesses use this structure is asset protection. If valuable assets such as software, trade marks or other IP sit outside the company taking on everyday trading liabilities, they can have an additional layer of separation from those risks.

Because HoldCo and OpCo are separate legal entities, the relationship between them should also be properly documented. For example, where HoldCo owns IP that OpCo needs to run the business, an Intercompany IP Licence can set out how OpCo is allowed to use it.

There can be good reasons for setting a business up this way. However, once different parts of the business sit in different legal entities, that distinction can also become important when ESIC eligibility enters the picture.

What Is ESIC And Why Does It Matter When Raising Capital?

ESIC stands for Early Stage Innovation Company.

Broadly, the ESIC regime is designed to encourage investment in qualifying early-stage innovative companies by providing certain tax incentives to eligible investors.

That can make ESIC eligibility relevant during a capital raise, particularly where potential investors are considering whether those incentives may apply to their investment.

However, a company doesn't qualify simply because it is new, operates in technology or considers itself innovative.

Under the Income Tax Assessment Act 1997 (Cth), a company must satisfy an early-stage test and also meet an innovation test. The innovation requirement can be satisfied through either a 100-point test or a principles-based test.

Importantly, ESIC is a tax regime. Whether your company qualifies, and whether an investor can access any associated tax incentives, should be confirmed with an appropriately qualified accountant or tax professional.

From a legal structuring perspective, though, there is an important point founders should understand: the company issuing the shares matters.

Where Can A Dual Company Structure Create A Problem?

Imagine your business looks something like this:

Investors
↓
HoldCo
↓
OpCo

Your investors subscribe for shares in HoldCo.

However, OpCo is the company employing your team, developing your product, signing customers and commercialising the business.

From a founder's perspective, you may see all of this as one startup. The same people are involved, the companies form part of the same group and everything is working towards the same commercial goal.

Legally, though, HoldCo and OpCo are separate companies.

For ESIC purposes, that distinction can matter. The fact that one company in the group is carrying out innovative activities does not necessarily mean another company in the group can rely on those activities to qualify.

That was the issue at the centre of ZWBX and Commissioner of Taxation [2024] AATA 2065.

What Happened In ZWBX And Commissioner Of Taxation?

The business in ZWBX was developing and commercialising a cloud-based software platform.

Its corporate structure involved three companies:

• A holding company at the top of the group
• An IP company that held the software
• A trading company that licensed the software and carried out the development and commercialisation activities

Investors subscribed for shares in the holding company.

The holding company had satisfied the early-stage part of the ESIC test. This is important because, for some parts of that test, the legislation specifically takes wholly owned subsidiaries into account.

The problem arose under the principles-based innovation test.

Unlike parts of the early-stage test, the principles-based test focuses on the particular company being assessed. The question was therefore whether the holding company itself satisfied the relevant innovation requirements - not whether the corporate group, taken together, was innovative.

The taxpayer argued that the activities happening across the group should effectively be considered together because the companies were all working towards the same innovative purpose.

The Administrative Appeals Tribunal did not accept that approach.

The holding company itself was not carrying out the activities involved in developing and commercialising the software. Those activities were being carried out by the trading company, while another company in the group held the IP.

The Tribunal found that the innovative activities of those subsidiaries could not simply be treated as activities of the holding company for the purposes of the principles-based innovation test.

As a result, the holding company did not qualify under that test, and the investor could not access the ESIC concessions for the relevant investment.

For founders, the practical takeaway is simple:

Just because your corporate group is developing an innovative business doesn't necessarily mean the company your investors are investing in will satisfy the ESIC innovation test.

Does This Mean Dual Company Structures Can't Qualify For ESIC?

No.

The ZWBX decision does not create a blanket rule that every startup with a holding company or dual company structure is automatically excluded from ESIC eligibility.

The case dealt with the particular structure and activities before the Tribunal, and specifically with the principles-based innovation test.

The alternative 100-point innovation test was not the basis on which the taxpayer sought to establish qualification in the case, so ZWBX should not be read as deciding every possible pathway to ESIC eligibility.

Different structures may also operate differently. The key point is that founders should not assume a holding company will qualify simply because an innovative operating company sits underneath it.

It also matters when you consider the issue. ESIC eligibility is relevant at the time the qualifying shares are issued, so waiting until an investment round is underway before looking at how the structure interacts with ESIC can create unnecessary complications.

Should You Still Use A Dual Company Structure?

Potentially, yes.

A dual company structure can still provide useful benefits for the right business. Separating valuable assets from day-to-day trading activities can help manage risk, protect important IP and create clearer ownership arrangements as the business grows.

The lesson from ZWBX isn't that founders should avoid dual company structures.

It's that asset protection and fundraising strategy shouldn't be considered separately.

There isn't one structure that is automatically right for every startup. If ESIC eligibility could be important to your investors, that should form part of the conversation before you settle on the structure - alongside issues such as where your IP will sit, which company will carry on the business and where investors are expected to hold their shares.

Planning To Raise Capital? Consider ESIC Before You Restructure

If you're considering a dual company structure and expect to seek external investment, it's worth thinking about where your IP and development activities will sit, which company investors are expected to invest in and whether ESIC eligibility is important to your funding plans.

If ESIC could be relevant, it’s wise to speak to a tax professional before setting up or restructuring the group. Once you understand the tax position, a legal expert can help make sure the structure itself is properly put in place.

This might include setting up your Dual Company Structure, documenting how IP is used across the group through an Intercompany IP Licence, and making sure ownership and decision-making arrangements are properly documented.

If you're bringing new investors or shareholders into the business, a tailored Shareholders Agreement can also help set out everyone's rights, responsibilities and expectations from the outset.

What If You Already Have A Dual Company Structure?

If you're already operating through a HoldCo and OpCo, ZWBX doesn't mean you suddenly need to dismantle your structure.

For many businesses, ESIC may not be relevant at all. A dual company structure can still provide useful separation between valuable assets and the risks involved in running the business, and those benefits haven't disappeared because of the ZWBX decision.

However, if you're preparing for an investment round and ESIC eligibility could be important to potential investors, the case is a good reminder not to assume that your existing structure will automatically work for both purposes.

Companies within a group remain separate legal entities. As ZWBX demonstrated, for the principles-based ESIC innovation test, a holding company cannot simply rely on innovative activities being carried out by its subsidiaries as though they were its own.

This doesn't mean a dual company structure cannot qualify for ESIC. It does mean that your existing structure, your future fundraising plans and ESIC eligibility are worth considering together before you issue shares or make further structural changes.

If ESIC could be relevant to your business, get appropriate tax and legal advice before making those decisions.

If you'd like to speak to us about the legal side of your business structure, you can reach us at 1800 730 617 or team@sprintlaw.com.au for a free, no-obligations chat.