Principles-based innovation test
To qualify under the principles-based innovation test, the company must meet five requirements. This is tested immediately after the new shares are issued to the investor.
The company must be able to demonstrate how it meets each of the requirements and can use existing documentation, such as a business plan, commercialisation strategy or competition analysis. The company must be able to show that tangible steps have been or will be taken in relation to each of the requirements.
The principles-based innovation test has different requirements to the eligibility tests for the research and development tax incentive. Spending a significant amount on research and development activities is only an indicator that the company may be eligible under the principles-based test.
A company can choose to seek a ruling on whether they qualify under the principles-based innovation test. Refer to information on requesting a ruling, for both companies and investors.
The legislation also contains regulation-making powers that can be used to alter the application of the principles-based test.
Principles-based innovation test requirements
There are five requirements of the principles-based innovation test:
The company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation
The innovation that is being developed by the company must be either new or significantly improved in relation to the addressable market. For example, if the addressable market is the Australian market, then the innovation must be new or significantly improved in relation to that market.
An innovation could be a product, process, service, or marketing or organisational method.
A company's addressable market refers to the available revenue opportunity or market demand arising from the innovation, or from the business that relates to that innovation. The addressable market identified by the company must be objective and realistic.
Examples of improvements that are unlikely to be considered new or significantly improved innovations include:
- customising an existing product
- a minor extension, such as an update to existing equipment or software
- changes to pricing strategies
- changes to goods resulting from cyclical or seasonal change
- trading of new products for a wholesaler, retail outlet or distribution business where the activities are similar to the approach of competitors
- ceasing to utilise a process or method.
The company must be genuinely focused on developing the innovation for a commercial purpose in order to generate economic value and revenue for the company. This requirement draws the distinction between simply having an idea and commercialising an idea.
'Commercialisation' includes a range of activities that involve the implementation or sale of a new or significantly improved innovation that will directly lead to the generation of economic value for the company.
Example – A company that is not developing a new or significantly improved innovation for commercialisation
PQ Technology Co is a new wholesale distribution company specialising in wearable technology products. It begins to sell a new product that was released by one of their offshore suppliers.
Even though the product is new to the Australian market, PQ Technology has not developed a new or significantly improved innovation for commercialisation. Therefore it would not meet the principles-based innovation test.
End of example
The business relating to that innovation must have a high growth potential
The company must be able to demonstrate that it has the potential for high growth within a broad addressable market.
This can be distinguished from typical small to medium sized enterprises such as a café, local retail store or local service provider that services a local market. As these enterprises are limited to supplying to local customers, they do not have the potential for high growth within a broad addressable market.
Example – A business relating to an innovation has a high growth potential
Allen Co is a company that is developing a new mobile app that provides specialised on-demand concierge services for the convenience of its users. While Allen Co is initially testing its service in Melbourne, it can demonstrate its high growth potential through its ability to expand the use of its mobile platform and the location of the services to include all major cities in Australia and beyond.
The company has outlined this expansion strategy in its business plan and has started to contact service providers in other major cities. Therefore, Allen Co can demonstrate that the business relating to its innovation has a high growth potential.
End of example
The company must demonstrate that it has the potential to be able to successfully scale up that business
The company must have the potential to successfully scale up its business. This means that the company must have operating leverage as it increases its market share or enters into new markets, where its existing revenues can be multiplied with a reduced or minimal increase in operating costs.
Example – A company with the potential to successfully scale up the business
Siegel Co is a start-up manufacturing company that is developing a new formula for a perishable consumer goods product that allows the product to have an extended shelf life.
The company has outlined its strategy to purchase its own manufacturing plant as the demand for its product grows. If production is increased, the company has indicated that the cost per unit can be reduced by leveraging the existing operating costs of the plant as it sells the product into new markets.
Therefore Siegel Co will be able to demonstrate that it has the potential to successfully scale up the business.
End of example
Example – A company that doesn't have the potential to successfully scale up the business
Balthazar Co is a new local service provider of dental care. The company's growth strategy is to expand its number of clinics. However, as Balthazar Co opens more clinics, its operating costs (such as rent and wages) increase in proportion to the additional revenue generated. Consequently, Balthazar Co does not meet the principles-based innovation test as it does not have the potential to successfully scale up its business.
End of example
The company must demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business.
The company must demonstrate that it has the potential to address a market that is broader than a local city, area or region.
While the company does not need to have a serviceable market at a national, multinational or global scale at the test time, it does need to show that it is capable of addressing a market that is broader than a local market. It must also show that its business can be adapted to a national, multinational or global scale in future.
Example – A company with potential to address a broader than local market
Allen Co, the developer of the new mobile app providing an on-demand concierge services, plans to initially test and sell its new product to Victorian consumers. If the test is successful, it plans to eventually adapt its product for the Asia-Pacific market. As a result, Allen Co has the potential to service a broader than local market and to adapt its business to access global markets.
End of example
The company must demonstrate that it has the potential to be able to have competitive advantages for that business.
The company must demonstrate that it has the potential to have competitive advantages over its competitors, such as cost or differential advantages, that are sustainable for the business.
For example, if a product provides unique benefits to the customer, this may be a differential advantage that sets the company apart from its competitors.
One method of testing whether the company has competitive advantages could be to measure the level of value provided to customers relative to its competitors, or to consider whether the product is rare, whether it is capable of being imitated and whether substitute products are readily available.
Example – A company with the potential to have competitive advantages
STS Tech Co is developing a new peer to peer service providing website for the Australian market. After conducting a competition analysis of the marketplace, a differentiating competitive advantage identified was the website's use of a marketplace platform.
STS Tech Co has identified that this feature will allow the company to outperform its competitors. In addition, the company has taken initial steps in developing the platform and has also started to engage with service providers to be part of the website's network. As a result, STS Tech Co can demonstrate that it has the potential to have competitive advantages.
End of example
Regulation-making powers in legislation
The legislation contains regulation-making powers that can be used to:
- exclude a particular activity or form of type of innovation from being able to meet the principles based test
- exclude a company from qualifying as an ESIC if it carries on a particular type of activity
- add points to the 100-point innovation test for meeting certain additional criteria.
This is intended to provide flexibility should the government wish to more tightly target the tax incentives in the future, or if the incentives are being used for inappropriate purposes. If the rules are tightened by regulation, any exclusions will apply going forward, rather than applying retrospectively.
For early stage innovation companies (ESICs)
Can a company request a ruling on the tests?
Companies may choose to apply for a ruling from the ATO about whether they meet the 100-point innovation test or principles-based innovation test. We may need to consult with the Department of Industry, Innovation and Science when providing the ruling.
The ruling is only about how the tax law applies to the facts that you have provided - if the facts change, this may lead to a different outcome under the tests.
The ruling should not be used in promotional materials to imply that we guarantee or endorse investment in your company.
The promoter penalty laws may apply if you use a ruling to encourage investors to invest in your company, when the company's circumstances at that time are materially different to those covered by the ruling.
What do you need to report to us?
Companies are required to report information to us if they issue new shares to one or more investors during a financial year that could lead to an investor being entitled to access the early stage investor tax incentives.
The form to report information is being developed. Visit our Let's Talk pageExternal Link for more information and to get involved in our consultation.
In the meantime, for each investment that you receive during the year that may give rise to an investor accessing the tax incentives, you should keep the following information to report to us:
- ABN, name and address for the investor (plus the date of birth for investors that are individuals)
- number of new shares issued to the investor
- amount paid for the new shares
- date the shares were issued
- percentage of shares in the company held by the investor immediately after the shares were issued.
When you submit the form, you are declaring that the company meets the requirements to be an ESIC for all of the reported investments. You will be asked to specify whether the 100-point innovation test or principles-based innovation test has been applied, and whether you have received a ruling on your eligibility.
Submitting the form when you are aware that the company does not meet these requirements could result in penalties, including possible criminal penalties, under the tax law.
If you are aware that a particular investor is not entitled to access the early stage investor tax incentives, then you should not include the details for that investor on the form. For example, this will be the case if the investor is an affiliate of yours, or if the shares are provided through an employee share scheme.
How do you report to us?
You must report the information to us by 31 July each year for new shares issued in the previous year.
We use this information to assess whether investors qualify for these tax incentives. Providing this information early may help your investors to demonstrate to us that they are entitled to the early stage investor tax offset, if they lodge their tax return early.
Companies will report this information electronically. When the form becomes available, we will provide further instructions on how to complete the report.