Edited version of your written advice

Authorisation Number: 1013110995435

Date of advice: 21 October 2016

Ruling

Subject: Early Stage Innovation Company eligibility

Question 1

Does Company A satisfy subsection 360-40(1) of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 20YY

The scheme commences on:

1 July 20XX

Company A

1. Company A was incorporated in Australia in 20XX. It is a private company with none of its equity interests listed on any stock exchange.

2. Company A is a start-up company in the early stages of a product development program.

3. A Taxpayer is the sole director and shareholder of Company A.

4. Company A was formed to undertake development activities leading to commercialisation of potential product.

5. Company A will be seeking equity investment from arm's length third party investors to fund its development and commercialisation program.

6. Company A's business proposition document provides an overview of the company's business at incorporation.

Company A's foundational technology

7. A Taxpayer has negotiated an agreement in-principle to licence the technology from Organisation B. The foundational technology is considered a good starting point for a development program.

8. Organisation B has filed an Australian provisional patent application with respect to such intellectual property.

Proposed licence agreement for the foundational technology from Organisation B

9. Company A will enter into a license agreement with Organisation B for the foundational technology for the purpose of undertaking development and commercialisation activities.

Program and key milestones

10. Your business proposition outlines critical milestones Company A are planning to meet in each of the specified years.

11. It is envisioned that following success in the development stages, partners will be sought to establish a collaborative research and development (R&D) program to complete development, undertake manufacturing and carry out marketing and distribution activities.

12. Company A intends to seek an alliance with a company who can assist in accelerating its development program. A Taxpayer has already been approached by a company which is interested in commercially partnering with Company A.

13. Alternatively, Company A could pursue licensing agreements to realise value from its program. If a licensee is able to bring Company A's product to market, Company A may receive upfront payments, milestone payments and/or royalties on the sale of products brought to market.

Early stage business activities of Company A

14. Company A commenced business activities upon incorporation in 20XX. In the early stages of Company A, the company is governed by A Taxpayer as the sole director and shareholder. A Taxpayer will be directing the R&D program.

15. Company A is in the process of employing an assistant. As the R&D program progresses, Company A will utilise additional resources and certain activities will be outsourced to commercial third party providers.

16. In the early stages of the R&D program, research activities and trials will be conducted at A Taxpayer's workplace.

17. Company A has received a quotation for equipment required for the program. You have provided a copy of this quotation.

18. As part of the development and commercialisation program, Company A has identified a third party to assist in the program and a services agreement is currently being drafted.

Information provided

19. You have provided a number of documents including:

a. business proposition of Company A

b. certificate of registration

c. historical company extract

d. copy of a quotation for purchase of instrumentation, and

e. narrative responses to ATO questions.

We have referred to the relevant information within these documents in applying the relevant tests to your circumstances.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 section 360-45

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Qualifying early stage innovation company

20. Subsection 360-40(1) outlines the criteria required for a company to qualify as an Early Stage Innovation Company (ESIC) at a particular time in an income year. This time is referred to as the test time. Broadly, the criteria are based on a series of tests to identify if the company is at an early stage of its development and it is developing new or significantly improved innovations to generate an economic return.

'The early stage test'

21. The early stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d).

Incorporation or Registration - paragraph 360-40(1)(a)

22. To meet the requirement in paragraph 360-40(1)(a), at a particular time (the test time) in an income year (the current year) the company must have been either:

i. incorporated in Australia within the last three income years (the latest being the current year); or

ii. incorporated in Australia within the last six income years (the latest being the current year), and across the last three of those income years the company and its 100% subsidiaries incurred total expenses of $1 million or less; or

iii. registered in the Australian Business Register (ABR) within the last three income years (the latest being the current year).

23. The term 'current year' is defined in subsection 360-40(1) with reference to the 'test time'; the 'current year' being the income year in which the company issues shares to the investor.

24. It is considered that a company will satisfy the incorporation test in subparagraph 360-40(1)(a)(i) where, immediately after the issue of shares to the investor, the company had been incorporated in either:

• that part of the current year which precedes the issue¹ of shares; or

• one of the two income years prior to that year

25. A company that does not meet any of these conditions will not qualify as an ESIC.

Total expenses - paragraph 360-40(1)(b)

26. To meet the requirement in paragraph 360-40(1)(b), the company and its 100% subsidiaries must have incurred total expenses of $1 million or less in the income year before the current year.

Assessable income - paragraph 360-40(1)(c)

27. To meet the requirement in paragraph 360-40(1)(c), the company and its 100% subsidiaries must have derived total assessable income of $200,000 or less in the income year before the current year.

No stock exchange listing - paragraph 360-40(1)(d)

28. To meet the requirement in paragraph 360-40(1)(d), the company must not be listed on any stock exchange in Australia or a foreign country.

Innovation tests

29. If the company satisfies the early stage test, the company must also satisfy one of two innovation tests.

'Test One- paragraph 360-40(1)(e) and section 360-45

30. To satisfy the test the company must obtain points by meeting the innovation criteria in the table within section 360-45. The criteria are tested at a time immediately after the relevant shares are issued. If a company satisfies this test it does not need to satisfy the principles-based test.

'Test Two - subparagraphs 360-40(1)(e)(i) to (iv)

31. To satisfy the test, the company must meet the requirements in paragraph 360-40(1)(e). This is tested at a time immediately after the relevant new shares are issued to the investor.

32. The company can demonstrate that it meets each requirement through existing documentation such as a business plan, commercialisation strategy, competition analysis or other company documents. The company must be able to show that tangible steps have been or will be taken in relation to each of the requirements.

33. The requirements of the Test Two have been outlined in paragraph 360-40(1)(e) are:

i. the company must be genuinely focused on developing for commercialisation one or more new or significantly improved, products, processes, services or marketing or organisational methods

ii. the business relating to that innovation must have a high growth potential

iii. the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation

iv. 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, and

v. the company must demonstrate that it has the potential to be able to have competitive advantages for that business.

Developing new or significantly improved innovations for commercialisation

34. For the purposes of Subdivision 360-A, an innovation is considered to be a new or significantly improved product, process, service, marketing or organisational method.

35. The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. The company's addressable market is the revenue opportunity or market demand arising from the innovation or the related business. The addressable market must be objective and realistic.

36. Improvements must be significant in nature to meet this requirement. Customising existing products or minor changes resulting from software updates, pricing strategies or seasonal changes are examples of improvements that would not be considered significant.

37. 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.

38. '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.

High growth potential

39. The company must be able to demonstrate that it has the potential for high growth within a broad addressable market. This refers to the company's ability to rapidly expand its business. Companies that are limited to supplying local customers will not meet this requirement.

Scalability

40. The company must be able to demonstrate that it has the potential to successfully scale up the business. The company must have operating leverage, where as it increases its market share or enters into new markets, its existing revenues can be multiplied with a reduced or minimal increase in operating costs per unit.

Broader than local market

41. The company must be able to demonstrate that it has the potential to address a market that is broader than a local city, area or region. The company does not need to have a serviceable market at a national, multinational or global scale at the test time. However, it does need to show that the business is capable of addressing a market that is broader than a local market and that the business can be adapted to a broader scale in the future.

Competitive advantages

42. The company must be able to demonstrate that it has the potential to have competitive advantages, such as a cost or differential advantage over its competitors which are sustainable for the business as it expands. The company can analyse what competitors in the market offer, and consider whether the company has a differentiating advantage that would allow it to outperform these competitors.

Application to your circumstances

Test time

43. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date on or after 1 July 20XX, but before 30 June 20YY.

Current year

44. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the income year before the current year will be the year ending 30 June 20XX (the 20XX income year).

Early stage test

45. Company A was incorporated in 20XX, which is within the current income year. Company A was not in existence and as such did not incur any expenses or derive any assessable income during the income year ending 30 June 20XX. Company A is privately owned and none of its equity interests are listed on any stock exchange.

46. Company A will satisfy the early stage test for the 20YY income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

100 point test

47. Company A has not provided any evidence of satisfying the point test under section 360-45 for the year ending 30 June 20YY. For Company A to be a qualifying ESIC it will need to satisfy the principles-based test.

Principles based test

Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i)

48. The product being developed by Company A has been specifically defined. Your business proposition highlights a need for this product.

49. Company A has identified its addressable market. This market is on a global scale and is not confined to a local city, area or region.

50. Organisation B is the owner of the intellectual property of the foundational technology and has filed an Australian provisional patent application with respect to this intellectual property. Under licence agreement, Company A will have worldwide exclusive licence to commercialise the patent rights in relation to the foundational technology.

Genuinely focussed on developing for commercialisation

51. Company A is currently at the stage of discovery and development. This will involve a program for a specified number of years.

52. Some of the Company A activities already underway include:

a. A Taxpayer taking an active role in directing the R&D program

b. in the process of employing an assistant

c. arranging for research activities and trials to be conducted, and

d. obtaining quotation for instrumentation required for initial discovery program.

53. The discovery program will commence shortly. As part of the development and commercialisation program, Company A has identified a third party to assist with the program.

54. It is envisioned that following success in the development stages, partners will be sought to establish a collaborative R&D program to complete development, undertake manufacturing and carry out marketing and distribution activities.

55. These partners will enable Company A to bring its products to market. Returns for Company A may be in the form of upfront payments and through progress-based milestone payments and royalties on any sales.

56. Company A has already been approached by a company which is interested in commercially partnering with the Company A.

57. The above facts demonstrate that Company A is taking tangible steps to lead to the development of the product. This demonstrates a genuine focus on developing for commercialisation a new product.

58. Company A has prepared and supplied a business proposition document that outlines the potential of the foundational technology, business proposition, target markets, business strategy and risks.

Conclusion on subparagraph 360-40(1)(e)(i)

59. Company A is genuinely focussed on developing for commercialisation a product. The product will be a new product compared to current products used around the world. Given the timeframe for development of the foundational technology, the product is not expected to be fully developed within year ending 30 June 20YY. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the year ending 30 June 20YY.

High growth potential - subparagraph 360-40(1)(e)(ii)

60. There is a demand for the product being developed by Company A.

61. There is potentially a large commercial value in the addressable market.

62. Company A intends to seek an alliance with a company who can assist in accelerating its development program.

63. The product being developed by Company A will be new. Company A's business relating to the development of the product has a high growth potential in a global market. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied.

Scalability - subparagraph 360-40(1)(e)(iii)

64. It is common in the industry for such companies to enter into a partnership to fund development and provide access to a global marketing and distribution network.

65. Company A intends to seek an alliance with a company who can assist in accelerating its development program. A Taxpayer has already been approached by a company which is interested in commercially partnering with Company A.

66. The global demand for the product requires the product to be able to be manufactured in an efficient and scalable manner.

67. Further, as Company A achieves the critical milestones outlined in the business proposition document, it has the potential to raise further funding by way of equity capital, which can be used to scale the business. Company A intends to fund new developments in addition to the initial program.

68. The majority of Company A's funding is projected to be expended in the development stage of the product. As Company A expands sales of a developed product, it will generate increased revenue with minimal increase in its operating costs.

69. Company A has the potential to successfully scale its business, therefore, subparagraph 360-40(1)(e)(iii) will be satisfied.

Broader than local market - subparagraph 360-40(1)(e)(iv)

70. The product being developed by Company A has the potential to address the relevant global market. This addressable market is on a global scale and is not confined to a local city, area or region. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

Competitive advantages - subparagraph 360-40(1)(e)(v)

71. Company A will have rights to the intellectual property underpinning the foundational technology. This intellectual property is currently the subject of a provisional patent pending. Further, Company A has the benefit of the knowledge of the founder of the foundational technology, being A Taxpayer.

72. Additional intellectual property protection will be sought for the products developed through the research and development program of Company A. Company A will own all new intellectual property developed and will have full rights to commercially exploit this intellectual property. Company A could pursue licencing agreements to realise value from its discovery and development program.

73. These intellectual property rights represent a competitive advantage for Company A over its competitors.

74. Additionally, the knowledge required of the foundational technology along with the discovery and development timeframes and costs, present a high barrier to entry for any competitor to replicate the product being developed by Company A.

75. Company A has demonstrated the potential for the developed product to have competitive advantages within the global market, satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

76. Company A satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the income year ending 30 June 20YY.

Conclusion

77. Company A meets the eligibility criteria of an ESIC under subsection 360-40(1) for the income year ending 30 June 20YY.

¹ Note that this test is separately applied on each subsequent issue of shares.

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