Startup, stand down? The impact of CGT changes on defence innovation

In an environment of increasing global instability, heightened by the recent conflict in Iran and governments globally rearming in response to the growing risk, Australia’s need for sovereign capacity and defence capability has been brought into sharper focus. Following the supply chain disruptions exposed during COVID-19, Australia continues to face challenges in local production, manufacturing capability and innovation in critical sectors. Against this backdrop, the Australian government is increasing its investment in defence. Notably, the Minister for Defence recently described funding under the 2026 National Defence Strategy (and the earlier 2024 Strategy) as representing 'the largest peacetime increase in defence spending in our nation’s history.' These efforts extend to initiatives aimed at accelerating defence innovation and supporting the domestic startup ecosystem.

However, the proposed changes to the CGT regime announced in the 2026–27 Budget may have unintended consequences, potentially discouraging investment in Australian startups at a time when strengthening sovereign capability is a key policy objective. While the government has recognised the unique characteristics of the startup sector and committed to consulting on how these changes will apply, prolonged consultation and limited concessions may risk slowing investment and innovation activity, and could weaken broader efforts to enhance Australia’s defence and productive capacity.

Existing defence startup initiatives

A healthy startup ecosystem is essential for the short-term and ongoing development of Australia’s sovereign capacity. Innovative ideas in key focus areas need to be developed, progressed, and retained in Australia. In particular, startups with defence related capabilities need to be incentivised to remain and attract investment onshore. The Australian government is cognisant of this, and accepts that the existing startup environment and tax settings have been insufficient to drive innovation in this area. 

In recent years the government has responded with a range of programs targeted at supporting innovation and defence. For example, the establishment of the A$15 billion National Reconstruction Fund Corporation in 2023 to invest (through debt, equity and guarantees) in projects across seven priority areas, including defence capability and in early-stage startups, the Defence Industry Development Grants Program in 2024, and the establishment of the Advanced Strategic Capabilities Accelerator (ASCA) in 2023 which takes a mission oriented approach to accelerating innovation to meet the priority needs of the Australian Defence Force. The ASCA missions include the 2025 Mission Syracuse, focussed on the development of counter-drone solutions, in respect of which ASCA recently announced the entry into two contracts providing a combined A$31.7 million to strengthen this capability.

More recently, the government has released the 2026 National Defence Strategy (NDS) and associated 2026 Integrated Investment Program. In accordance with the NDS, the government has announced its intention to develop a sovereign missile manufacturing industry to enhance Australia’s long-range strike capability, and it has been reported that investment from private investors, including superannuation funds, will be sought to supplement the government’s contribution. The government has also recently announced that they will be seeking proposals from Australia’s private capital market to co-invest alongside government in ‘defence and dual-use advanced capabilities’ more broadly, in order to ‘turbo charge our home-grown defence industry’. The CGT changes outlined in the 2026/27 budget will, if adopted without exception for startups, undermine the government’s clearly stated objectives with respect to defence innovation.

Changes to CGT regime announced in the 2026/27 Budget

Last Tuesday, as part of the 2026/27 Budget, the government announced changes to the capital gains tax (CGT) regime that apply broadly across asset classes and capture all investment activity, including investment in startups and other businesses, despite the clear focus on improving the housing market for first home buyers. The 50% CGT discount will be replaced with an indexing mechanism, coupled with a 30% minimum tax on capital gains accruing from 1 July 2027. These changes apply to CGT assets held by individuals, trusts and partnerships. Broadly, the capital gain will first be adjusted for inflation, and the remaining amount taxed at the higher of the individual’s marginal rate and 30%. Acknowledging the unique characteristics of the startup sector, the government intends to consult with the startup community on the proposed changes. 

Impact on startups and innovation

These changes, if implemented as proposed, could have a significant and adverse effect on the Australian startup ecosystem and undermine the government’s efforts to stimulate defence-focussed innovation. 

Founders

The startup ecosystem relies on founders to create and drive new ideas and businesses. The proposed changes to the CGT regime would result in a system that fails to appropriately value the contributions founders make to startups and could effectively double the tax paid by them on the sale of their companies. 

Founders of startups do not always contribute significant monetary capital to their companies. They contribute their ideas, energy and time and they assume significant financial and other risks, but those contributions are not reflected in the cost base of their investments in their companies, which may be zero or near zero. As a result, they would not benefit to the same extent or at all from the indexation of their cost base and could bear tax on the total amount of the proceeds received on the realisation of their investments in their companies, whereas under the current rules that gain would be reduced by 50%. 

This potential doubling of tax borne by founders greatly disincentivises founders to take the risks that they take and to innovate as they do, and encourages them to move to more friendly tax jurisdictions. It also puts them in a less advantageous tax position than many of their investors who either bear tax at lower rates (eg superannuation funds and foreign investors) or benefit more from indexation. 

Employees 

In 2015, the government introduced concessional tax arrangements applicable to employee share and options schemes of startup companies, and this concession is frequently relied upon in the startup sector. 

The whole architecture of that concessional arrangement was designed to ensure employees will benefit from a 50% CGT discount upon disposal of start-up company employee options or shares. This compensates for, and encourages, commitment to employment with an enterprise that may be riskier and cash-poor, but one which drives innovation and economic growth. By contrast, employees would obtain virtually no benefit from indexing, as an option would typically be granted for no issue price, and the exercise price, if paid at all, would often be paid contemporaneously with disposal of the option or share and so there will be little or no benefit from cost base indexation.  

Investors

Many investors in startups will be significantly affected by the proposed changes, which may reduce their willingness or ability to support the sector. High net worth individuals and others that are not excluded from the proposed changes (cf superannuation funds) will be exposed to a much higher level of tax on their successful investments. Investing in venture capital is a numbers game; many investments will fail and investors rely on outsized returns from rare successes to make the strategy viable. If taxes on successful investments are significantly increased, the overall expected return of venture capital investment portfolios could be adversely affected. Investors may reallocate capital away from venture capital to other asset classes that have risk and return profiles that are better aligned with the changed tax environment, thereby reducing capital in the startup ecosystem. 

Fund managers of VCLPs and ESVCLPs

Venture capital funds and early stage venture capital funds are critical sources of capital to the local startup industry. They are professional and generally efficient allocators of capital, helping to steer capital to the best ideas and the best founders.

Many venture capital funds and early stage venture capital funds in Australia are established as either a VCLP or an ESVCLP, which offer tax benefits to investors and fund managers. Fund managers benefit because they can receive carried interest (being a share of the upside generated by the fund) on capital account, up to now entitling them to a 50% discount on their pre-tax carried interest gains.

Similar to founders and employees, the cost base applicable to carried interest is effectively zero. If the proposed changes are made without tempering, fund managers will likely see the tax on their carried interest through VCLPs and ESVCLPs double. If fund managers lose the current tax benefit that applies to their carried interest through VCLPs, we may see that particular vehicle used less often as it offers few other advantages to fund managers and investors (when compared with other structures). 

Where to from here?

In light of the above and feedback from the startup community, the government could consider retaining the 50% CGT discount for investments in startups as a simple and effective solution. Alternatively, it may be useful to consider comparable international regimes, including more tailored concessions, such as reduced tax rates, threshold-based exemptions, or concessional treatment for lifetime gains, to better support early-stage investment. Ultimately, government should have regard to ensuring that Australia’s regime is sufficiently competitive to retain founders and innovative businesses in Australia. 

At a time of heightened global uncertainty and increased policy focus on strengthening domestic capability, the proposed CGT changes may create some uncertainty for the defence startup sector. While consultation is welcome, timely clarity will be important, as innovators and investors are likely to sit tight until the full effects of changes are confirmed. The government may wish to consider not only preserving the existing CGT regime for these activities but also increasing the incentives for the country's innovators and investors, beyond the current incentives, to focus their energy and capital in these areas. Ongoing consultation is not a solution: without appropriate concessions, the changes will slow momentum at a time when growth is critical.