ato logo
Search Suggestion:

Qualifying as an early stage innovation company

Tests that determine if a company will qualify as an early stage innovation company (ESIC).

Last updated 8 September 2024

Qualify as an ESIC

For an investor to be entitled to the early stage investor tax incentives, the company they invest in 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 these tax incentives.

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

When compared to the principles-based innovation test, the 100-point innovation test is likely to be the simplest way to determine a company's eligibility. The 100-point test is an objective test and should be self-assessed.

A company can choose to request a ruling from the ATO on whether it qualifies as an ESIC under 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. The onus is on the investor to confirm that the company qualifies as an ESIC at the relevant test time. If the investor has claimed for tax incentives and the company is later found not to be an ESIC at the relevant test time, 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 after this point in time which results in Sweeney Co no longer qualifying as an ESIC, this won't affect Thomas' entitlement to the tax offset or the modified CGT treatment for the shares.

End of example

Early Stage Innovation Company test requirements

To meet the Early Stage Innovation Company test, the company must meet 4 requirements.

These requirements are tested at the point in time immediately after the company issues the shares to the investor. A company must meet all requirements at that point in time to qualify as an ESIC. If they do not qualify, the investor won't qualify for the tax incentives for those shares.

The 4 requirements are:

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

The company must have been within the last 3 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 the these apply, both of the following requirements must be met:

  • the company was incorporated in Australia within the last 6 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 3 income years before the current income year (see below for the meaning of 'expenses').

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

'Expenses' for the purposes of the early stage requirements are accounting expenses incurred by the company. This doesn't include depreciation expenses, and provisions and reserves of a kind that are not incurred expenses.

Taxation Determination TD 2023/6 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 total of expenses reported at item 6 of the company tax return, if correctly reported, can be used to show that total expenses requirements are met.

However, you don't need to use the total at item 6 Expenses. You can choose to work out total expenses directly if:

  • the company wasn't required to lodge tax returns in relevant years; or
  • the item 6 expenses total includes amounts that are not accounting expenses incurred by the company

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.

Any amounts which are required to be included as a clawback amount in assessable income for a Research & Development entity is also to be disregarded from the $200,000 assessable income threshold.

The company's equity interests are not listed on any stock exchange

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 won't 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 must have been providing eligible programs for at least 6 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 can 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 5 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 one 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 5 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 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 don't 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 doesn't 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 doesn't need to have a serviceable market at a national, multinational or global scale at the test time, it needs 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. It can also consider whether the product is rare, whether it is capable of being imitated or 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 target the tax incentives more tightly 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.

For more information see:

 

QC48899