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  • Qualifying as an early stage innovation company

    For an investor to be entitled to the tax incentives, the company must qualify as an early stage innovation company (ESIC) immediately after the new shares are issued to the investor. If the company no longer meets the ESIC requirements after this test time, this won't affect the investor's entitlement to the early stage investor tax incentives.

    A company will qualify as an ESIC if it is not a foreign company under the Corporations Act 2001 and meets both:

    In practice, if a company undertakes activities that meet the 100-point innovation test, this is likely to be the simplest way to determine its eligibility, when compared to the principles-based innovation test. The 100-point test is an objective test and should be self-assessed.

    A company can instead choose to request a ruling from the ATO on whether it qualifies as an ESIC applying the principles-based innovation test. Refer to companies and investors for more information on requesting a ruling.

    The investor must determine whether they are eligible for the early stage investor tax incentives, which means that the onus is on the investor to confirm that the company qualifies as an ESIC at the relevant test time. If a company is later found not to be an ESIC at the relevant test time and the investor has already claimed for tax incentives, the investor will need to amend their claims. The investor should keep records to support their entitlement to the early stage investor tax incentives.

    Example: Early stage investor tax offset

    On 1 June 2017, Thomas (a sophisticated investor) pays $100,000 for new shares issued in Sweeney Co, an ESIC. If Thomas meets all of the eligibility requirements, he is entitled to an early stage investor tax offset of $20,000.

    In determining whether Thomas is entitled to early stage investor tax incentives for the shares, Sweeney Co's status as an ESIC is tested at the point in time immediately after Thomas was issued with the new shares on 1 June 2017.

    If there is a change that means Sweeney Co no longer qualifies as an ESIC after this point in time, this won't affect Thomas' entitlement to the tax offset or the modified CGT treatment for the shares.

    End of example

    Early stage test requirements

    To meet the early stage test, the company must meet four requirements.

    These requirements are tested at the point in time immediately after the company issues the shares to the investor. If a company doesn't meet all of the requirements at that time, the investor won't qualify for the tax incentives in relation to those shares.

    The four requirements are:

    The company must have been incorporated or registered in the Australian Business Register

    The company must have been within the last three income years (the latest being the current income year in which the requirement is tested):

    • incorporated in Australia, or
    • registered in the Australian Business Register (ABR).

    If neither of these apply, both of the following requirements must be met:

    • the company was incorporated in Australia within the last six income years (the latest being the current income year at the test time)
    • the company and its wholly-owned subsidiaries had expenses of $1 million or less across the last three income years before the current income year.

    See also:

    The company (plus any wholly-owned subsidiaries of the company) must have total expenses of $1 million or less in the previous income year

    Draft Taxation Determination TD 2019/D5 Income tax: tax incentives for early stage investors: what is an 'expense' that is 'incurred' for the early stage test? explains 'expenses' and 'incurred' in more detail.

    The company (plus any wholly-owned subsidiaries of the company) must have assessable income of $200,000 or less in the previous income year

    Companies that had no assessable income in the previous income year will meet this requirement. In determining the company’s assessable income, any amount of Accelerating Commercialisation GrantExternal Link that the company received in that year is disregarded.

    The company's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.

    100-point innovation test requirements

    To qualify under the 100-point innovation test, the company must obtain at least 100 points by meeting certain objective innovation criteria. This is tested immediately after the relevant shares are issued to the investor (the test time).

    If a company doesn't meet either the 100-point innovation test or principles-based innovation test at the test time, the investor will not qualify for any early stage investor tax incentives in relation to those shares.

    Table: 100-point innovation test

    Points

    Criteria

    75 points

    At least 50% of the company's total expenses for the previous income year are eligible notional deductions for the research and development tax incentive.

    75 points

    The company has received an Accelerating Commercialisation GrantExternal Link at any time. The amount of this grant is also excluded from the company's assessable income for the purposes of the early stage test.

    50 points

    At least 15% but less than 50% of the company's total expenses for the previous income year are eligible notional deductions for the research and development tax incentive.

    50 points

    The company has completed or is undertaking an eligible accelerator program that provides time-limited support for entrepreneurs with a start-up business. This support may involve providing mentorship, training, education and access to networks.

    The program must be provided to entrepreneurs that are selected in an open, independent and competitive manner. It is likely that an entity that has been selected through this process would also meet the principles-based innovation test.

    The entity providing the program has to have been providing eligible programs for at least six months, and the programs must have been completed by at least one cohort of entrepreneurs.

    50 points

    One or more third parties have previously paid a total of at least $50,000 for the issue of new shares in the company.

    These points are only available if:

    • the third party was not an associate of the company immediately before it was issued with the shares
    • the company issued the third party with the shares at least one day before the test time
    • the third party did not purchase those shares primarily to assist another entity to become entitled to early stage investor tax incentives.

    Examples of entities that would be an associate of a company include:

    • a partner of the company or a partnership in which the company is a partner
    • a trustee of a trust estate under which the company or associate benefits
    • another entity (including a person) that, acting alone or with another entity or entities, sufficiently influences the company
    • an entity (including a person) that, either alone or together with associates, holds a majority voting interest in the company
    • a second company that is sufficiently influenced by the company or the company's associates
    • a second company in which a majority voting interest is held by the company or the company's associates. 

    50 points

    A company has enforceable rights on an innovation through:

    A company that holds a licence to intellectual property owned by another party is able to obtain these points.

    25 points

    A company has enforceable rights on an innovation through:

    A company that holds a licence to intellectual property owned by another party is able to obtain these points.

    These points are only available if the company did not receive 50 points for holding a standard patent, plant breeder's right or equivalent right overseas under the previous criterion.

    25 points

    The company has a written agreement to co-develop and commercialise an innovation with:

    The legislation contains a regulation-making power which provides flexibility for further points to be added for meeting additional innovation criteria.

    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, using 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 innovation test.

    A company can choose to seek a ruling on whether it qualifies under the principles-based innovation test. Refer to information on requesting a ruling, for both companies and investors.

    The legislation also contains regulation-making power that can be used to alter the application of the principles-based innovation 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 its offshore suppliers.

    Even though the product is new to the Australian market, PQ Technology Co 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 that 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 1: 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 2: 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 (such as cost or differential) over its competitors 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 innovation 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 retrospectively.

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    Last modified: 07 Apr 2021QC 48899