Edited version of your written advice

Authorisation Number: 1051296284400

Date of advice: 23 October 2017

Ruling

Subject: Early Stage Innovation Company (ESIC) eligibility - renewal

Question

Does Company A meet the criteria of an Early Stage Innovation Company under subsection 360-40(1) of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following period<s>:

1 July 20XX to 30 June 20YY

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Company A

1. Company A was incorporated and registered in the Australian Business Register on XX XX 20XX.

2. Company A owns 100% of the shares in Company B. The sole director of Company B is Taxpayer. Company B does not own shares in any subsidiary companies.

3. Company A is developing a software system (‘the system’).

4. During the year ending 30 June 20XX (‘20XX income year’), Company B owned the intellectual property and software related to the system. In July 20XX, Company B transferred this intellectual property and software to Company A.

The system

5. The system provides a solution and method particularly suited for a variety of customers.

6. Effective from July 20XX, Company A is the company developing the system. Company A has engaged Company B to undertake the development of the software for, and on behalf of, Company A.

7. All expenditure relating to the development of the system is capitalised in the financial accounts of Company A. No impairment testing will be done on the value of the intangible assets until the software development has been finalised.

8. The Company A balance sheet shows fixed and non-current assets of $K as at 30 June 20XX, relating to software development and intangible assets.

9. Company A holds a provisional patent relating to the system. Company A holds all trademarks associated with the system.

10. There are new concepts currently being drafted by Company A’s patent attorney which will further add to the functionality of system existing capabilities.

11. Company A are planning to market the system.

12. The software based system has been designed to be used as a global system. It has the capacity to trade and service customers immediately in multiple markets. Only minor software modifications would be needed to use the system outside the Australian market.

13. The system is not expected to be fully developed before 30 June 20XX. However, this date is subject to change following end-to-end testing along with finishing additional designs.

20XX income year

14. Company A lodged a company income tax return and research and development (R&D) schedule for the year ending 30 June 20XX, and declared the following:

a. total income at item 6 of $C, and

b. total expenses at item 6 of $D.

15. The Company A’s audited financial statements for the year ending 30 June 20XX report the following:

a. total income of $E declared as ‘Government grants’ in the profit and loss statement

b. total accounting expenses of $F, and

c. capitalised software development costs totalling $G at 30 June 20XX, and increase from $H as at 30 June 20XX.

16. Company B lodged a company income tax return and research and development (R&D) schedule for the year ending 30 June 20XX and declared the following:

a. total income at item 6 of $H, and

b. total expenses at item 6 of $J.

17. The Company B’s audited financial statements for the year ending 30 June 20XX report the following:

a. total income of $K declared as ‘interest’ in the profit and loss statement

b. total accounting expenses of $L, and

c. non-current intangible assets totalling $M at 30 June 20XX, a decrease from $N as at 30 June 20XX.

18. During the 20XX income year, Company B owned the intellectual property related to the system.

Incurred expenses

19. As at the date of this ruling, Company A and Company B have incurred total expenses of $P. You have forecast total incurred expenses for the two companies to be less than $1 million for the period 1 July 20XX to 30 June 20YY.

Information provided

20. You have provided a number of documents containing detailed information in relation to the system, including:

a. An updated Private Binding Ruling application

b. Document regarding application for registration of R&D activities

c. Appendix to application for registration of R&D activities

d. Notice of registration for R&D incentive

e. Copy of R&D Tax Incentive application

f. 20XX Company Tax Return for Company A

g. 20XX Company Tax Return for Company B

h. Company A’s audited financial statements for the year ending 30 June 20XX

i. Company B’s audited financial statements for the year ending 30 June 20XX

j. Company C’s audited financial statements for the year ending 30 June 20XX

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

21. You propose to issue new shares in Company A to various investors to assist in funding the continued development and commercialisation of the system.

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

Income Tax Assessment Act 1997 section 975-150

Income Tax Assessment Act 1997 section 975-505

Reasons for decision

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

Qualifying early stage innovation company

22. 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’

23. 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)

24. 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 within the last three income years (the latest being the current year).

25. 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.

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

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

27. 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)

28. 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)

29. 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

30. 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

31. 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)

32. 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.

33. 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.

34. The five requirements of the principles-based test, as 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

35. For the purposes of Subdivision 360-A, the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (‘EM’) provides the following at paragraph 1.76 in relation to the definition of innovation:

“Implicit in the definition of innovation is the requirement that the company is developing a new or significantly improved type of innovation such as a product, process, service, marketing or organisational method. This list of various types of innovations provides flexibility for innovation companies and is adaptable to current and future innovations. The Oslo Manual, published by the Organisation for Economic Co-operation and Development (OECD) provides a description of these different types of innovations…”

36. 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.

37. Improvements must be significant in nature to meet this requirement. Significant is defined in the online Macquarie Dictionary as “important; of consequence.” 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.

38. 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.

39. For a company to qualify as an ESIC under the principles based test, the company must be “genuinely focussed on developing for commercialisation” their innovation. That is, the central activities of the company must be truly concentrated on developing their innovation for a commercial purpose. ‘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

40. 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

41. 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

42. 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

43. 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

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

Current year

45. For the purposes of subsection 360-40(1), the current year is the year ending 30 June 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last six income years will include the years ending 30 June 2018, 2017, 2016, 2015, 2014 and 2013.

100% subsidiary

46. Company A owns all of the shares in Company B, satisfying the definition of 100% subsidiary in subsection 975-505(1). No person is or will be in a position to affect rights in relation to the shares held by Company A in Company B. This means that:

a. subsections 975-505(2) and (3) will not exclude Company B from being a 100% subsidiary of Company A; and

b. Company B is a 100% subsidiary of Company A for the entire 20ZZ and 20XX income years.

Early stage test

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

47. Company A was incorporated and registered in the Australian Business Register on XX XX 20XX.. This is not within the last 3 income years and therefore, subparagraphs 360-40(1)(a)(i) and (iii) are not satisfied during the 20YY income year.

48. As Company A’s incorporation date is within the last six income years, subparagraph 360-40(1)(a)(ii) will be satisfied if, at each time qualifying shares are issued to investors in the 20YY income year, Company A and Company B have incurred total expenses of $1 million or less across the period commencing on 1 July 20VV and ending at each test time (the relevant period). Expenses incurred by Company A and Company B, during parts of the 20YY income year in the relevant period, are included in the incurred total expenses $1 million amount.

49. At each test time in the 20YY income year Company A will qualify as an ESIC if Company A and Company B have incurred total expenses of $1 million or less for the relevant period. As at XX XX 20XX, Company A and Company B have incurred total expenses of less than $1 million since 1 July 20ZZ. Company A and Company B forecast total incurred expenditure of less than $1 million between 1 July 20ZZ and 30 June 20YY and expect to satisfy the requirement in subparagraph 360-40(1)(a)(ii) at any test time in the 2018 income year.

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

50. To meet the requirement in paragraph 360-40(1)(b), Company A and its 100% subsidiary, Company B, must have incurred total expenses of $1 million or less in the 20XX income year. Company B did not own any 100% subsidiaries during the 20XX income year.

51. Company A incurred $A in expenses during the 20XX income year.

52. Company B reported total expenses of $B at item 6 of their 20XX company tax return. This amount closely corresponds to the total accounting expenses incurred by Company B in the audited financial statements provided for the year ending 30 June 20XX.

53. As the incurred total expenses for Company A and Company B during the 20XX financial year is less than $1 million, paragraph 360-40(1)(b) is satisfied.

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

54. To meet the requirement in paragraph 360-40(1)(c), Company A and its 100% subsidiary, Company B, must have derived total assessable income of $200,000 or less in the 20XX income year. Company B did not own any 100% subsidiaries during the 20XX income year.

55. Company A derived $C in assessable income during the 20XX income year.

56. Company B did not derive any assessable income at item 6 of their 20XX company tax return.

57. As the total assessable income derived by Company A and Company A in the 20XX income year is less than $200,000, paragraph 360-40(1)(c) is satisfied.

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

58. Company A is privately owned and is not listed on any stock exchange in Australia or a foreign country. Therefore, paragraph 360-40(1)(d) is satisfied.

Conclusion on early stage test

59. Company A will be able to satisfy the early stage test for the 20YY income year if it meets the requirement in subparagraph 360-40(1)(a)(ii) as explained in paragraph 48 of this ruling. Each of the requirements within paragraphs 360-40(1)(b) to (d) have been satisfied. Consequently, at each test time in the 20YY income year Company A and Company B will need to have incurred total expenses of $1 million or less for the relevant period, in order to qualify as an ESIC at that test time.

100 point test

60. Company A has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 2017. 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)

61. In Company A’s previous 20XX ESIC Ruling, we considered them to be developing a significantly improved innovation for commercialisation.

62. Company A is continuing to develop a system during the 20YY financial year. Company A will continue developing the system.

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

63. Company A is genuinely focussed on developing the system, for a commercial purpose. The system will be a significantly improved product compared to systems currently used in the Australian market.

64. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied, for the time period from 1 July 20XX until 30 June 20YY or the date when the system has been fully developed, whichever occurs earliest. Once the system has been fully developed, Company A will no longer be ‘developing’ the system for commercialisation and subparagraph 360-40(1)(e)(i) will no longer be satisfied.

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

65. The system will continue to appeal to customers within the Australian market.

66. The business relating to the system has the potential to rapidly expand its customer base across the Australian market. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied.

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

67. The core of the system is the framework to provide a system.

68. As Company A expands its sales, it will be able to generate increased revenue with only a minimal increase in its operating costs, due to the system already being completed.

69. This operating leverage ensures Company A has the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied.

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

70. The software based system has been designed to be used as a global system. It has the capacity to trade and service customers immediately in multiple markets. Only minor software modifications would be needed to use the system outside the Australian market. This makes Company A well placed to internationalise the system.

71. Company A has demonstrated the system has the potential to address a broader market than just the Australian market, including international markets. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

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

72. Company A has identified a number of differential advantages the system will have over its competitors.

73. Company A has demonstrated the potential for the system to have competitive advantages for customers within the market, satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

74. 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 July 20XX until 30 June 20YY or the date when the system has been fully developed and is ready for sale, whichever occurs earlier.

Conclusion

75. At each test time in the 20YY income year, Company A will meet the eligibility criteria of an ESIC under subsection 360-40(1) subject to the following conditions:

a. Company A and Company B have incurred total expenses of $1 million or less at that test time under subsection 360-40(1)(a)(ii);

b. Company A meets the principles based innovation test under subsection 360-40(1)(e)(i) – (v) at that test time; and

c. Company A has complied with all other applicable requirements of Division 360 Income Tax Assessment Act 1997.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).