Edited version of your written advice

Date of advice: 20 December 2017

Ruling

Subject: ESIC Eligibility

Question

Does Company A satisfy the criteria of an Early Stage Innovation Company (ESIC) pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 (‘ITAA 1997’)?

Answer

Yes

This ruling applies for the following period:

1 XX 20XX to 30 YY 20YY

The scheme commences on:

1 XX 20XX

Relevant facts and circumstances

1. Company A is a proprietary company incorporated and registered in the Australian Business Register on X XX 20XX.

2. Company A lodged a company income tax return for the year ending 30 XX 20XX, and declared the following:

(a) total expenses at item 6 of $xx

(b) total income at item 6 of $yy

3. Company A’s equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.

4. Company A is developing a product, called Product Z, which aims to offer a service to businesses that will allow them to increase their productivity and to deliver the best returns.

5. In a private ruling for a previous period, Company A qualified as an ESIC at relevant test times. The basis for the decision was that Company A satisfied the principles based test in respect of Product Z being developed.

6. Since the ruling issued, Company A has continued to develop their Product Z. They predict that there is still approximately x months of development left to be completed before the product is fully developed and ready for general release. Company A expect a usable prototype by XX 20XX and a completed product closer to YY 20YY.

Information provided

7. You have provided a number of documents containing detailed information in relation to Company A, including:

a. Private Binding Ruling (‘PBR’) Application, dated 7 XX 20XX

b. Company Tax Return 20XX

c. An Extension of Ruling for 20YY document

d. A copy of Company A’s Working Prototype Screens

e. Responses to further information as requested by the ATO

f. Responses to numerous emails

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

Assumption(s)

Not applicable.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-15

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 section 360-45

Further issues for you to consider

Not applicable.

Reasons for decision

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

QUESTION:

Does Company A satisfy the criteria of an Early Stage Innovation Company (ESIC) pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 (‘ITAA 1997’)?

SUMMARY

Company A meets the eligibility requirements of an ESIC pursuant to subsection 360-40(1).

DETAILED REASONING

Qualifying Early Stage Innovation Company

9. 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’. 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’

10. 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)

11. 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).

12. 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.

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

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

14. 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)

15. 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)

16. 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

17. If the company satisfies the early stage test, the company must also satisfy one of two innovation tests: the objective (100 point) test or the principles-based test.

‘100 point test’ – paragraph 360-40(1)(e) and section 360-45

18. To satisfy the 100 point test the company must obtain at least 100 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.

‘Principles-based test’ – subparagraphs 360-40(1)(e)(i) to (iv)

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

20. 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.

21. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are:

i. the company must be genuinely focussed 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.

APPLICATION TO YOUR CIRCUMSTANCES

TEST TIME

22. For the purposes of this ruling, the ‘test time’ for determining if Company A is a qualifying ESIC, will be upon the issue of qualifying shares on a particular date or dates on or after 1 XX 20XX, and on or before 30 YY 20YY.

Current year

23. Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending 30 XX 201XX (the 20XX income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending 30 June 20XX, 20YY and 20ZZ, and the income year before the current year will be the year ending 30 June 20YY (the 20YY income year).

THE ‘EARLY STAGE TEST’ – paragraphs 360-40(1)(a) - (d) ITAA 1997

Incorporation or Registration – paragraph 360-40(1)(a) ITAA 1997

24. Company A was incorporated on X XX 20XX, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) are satisfied.

Total expenses – paragraph 360-40(1)(b) ITAA 1997

25. In applying the requirements of paragraph 360-40(1)(b), Company A and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20XX income year, being the income year before the current year.

26. Company A incurred expenses of $xx in the 20XX income year. Consequently, paragraph 360-40(1)(b) is satisfied.

Assessable income – paragraph 360-40(1)(c) ITAA 1997

27. In applying the requirements of paragraph 360-40(1)(c), Company A and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20XX income year, being the income year before the current year.

28. Company A earned $yy assessable income in the 20XX income year. Consequently, paragraph 360-40(1)(c) is satisfied.

No Stock Exchange listing – paragraph 360-40(1)(d) ITAA 1997

29. In applying the requirements of paragraph 360-40(1)(d), Company A must not be listed on any Stock Exchange in Australia or a foreign country at the test time.

30. Company A was not listed on any Stock Exchange in Australia or a foreign country at either test time, so paragraph 360-40(1)(d) is satisfied.

CONCLUSION FOR EARLY STAGE TEST

31. Company A satisfies 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.

THE ‘100 POINT TEST’ – paragraph 360-40(1)(e) and section 360-45

32. Company A has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending 30 YY 20YY. For Company A to be a qualifying ESIC, it will need to satisfy the principles-based test.

THE ‘PRINCIPLES-BASED TEST’ – paragraph 360-40(1)(e) ITAA 1997

33. In a ruling from a previous period, the Commissioner concluded that Company A passed the principles based test in respect of Product Z being developed. Company A is continuing with the development of Product Z previously commenced, into the 20YY year, so while Product Z is still being developed, Company A will continue to satisfy the requirements of the principles based test, within subparagraphs 360-40(1)(e)(i) to (v).

34. Since the previous ruling was issued, Company A has plans for a number of additions to Product Z, including the following functionalities:

a. Function A – the introduction of functions which will allow a company to reflect on historical projections to gauge success of an activity and will be a powerful tool to project forward.

b. Function B – Company A have identified the ability to enhance the visualisation of Product Z by adding functions which allow the user to define an “ideal customer” and to identify potential customers who share some or all or the attributes of the “ideal customer”.

35. Company A envisages the development priorities will be driven by the market and by early adopter customers. Company A’s development plan includes the functionality listed below with new releases anticipated on a quarterly basis. Development plans for 20YY include:

a. Function C - Extend the user function beyond authentication, allowing a site to independently manage their functions.

b. Function D - Introduce functions and attributes to allow for more detailed comparisons.

c. Function E - Incorporate a new feature when comparing functions to facilitate analysis where the user may consider certain functions as more important in their projections on an ad-hoc basis.

d. Function F - Allow for a market analysis to be saved to allow retrospective comparisons.

e. Function G - Introduce functions and attributes to facilitate projections for changing market factors.

f. Function H – This function encompasses the resourcing and assets of the company using Product Z. Once a potential market has been identified, a company can obtain a unique understanding of the requirements of their organisation relating to a number of factors.

CONCLUSION FOR PRINCIPLES BASED TEST

Company A satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 XX 20XX until 30 YY 20YY, or the date when Product Z has been fully developed and is ready for client use, whichever occurs earlier.

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