Edited version of your written advice

Authorisation Number: 1051313431445

Date of advice: 28 November 2017

Ruling

Subject: Assessable income and early stage innovation company status

Question 1

Is the funding received from the Fund A assessable income for the purposes of determining whether Company A meets the assessable income criterion of being an Early Stage Innovation Company (ESIC) under paragraph 360-40(1)(c) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

This ruling applies for the following period:

Year ended 30 June 2018

The scheme commences on:

1 July 2017

Relevant facts and circumstances

1. Company A was incorporated on Date A and registered on the Australian Business register on Date B.

2. Company A has entered into an agreement with a Government Body in which funding will be provided from Fund A (the Fund).

3. The amount was provided to Company A in the 2017 income year.

4. Copies of the funding agreement and the terms of conditions were provided with the ruling application. These documents were referred to when making this ruling.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 6-15

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 15-10

Income Tax Assessment Act 1997 section 17-10

Income Tax Assessment Act 1997 section 17-30

Income Tax Assessment Act 1997 subsection 59-30(1)

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 paragraph 360-40(1)(c)

Income Tax Assessment Act 1997 subsection 360-40(2)

Income Tax Assessment Act1997 section 995-1

Income Tax Assessment Act 1986 paragraph 26(g)

Income Tax Assessment Act 1986 section 170(10AA)

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise indicated.

Summary

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.

One of these tests is stated in paragraph 360-40(1)(c) where 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. The funds received are assessable income under section 15-10 in the year they are ‘received’. The funds are not ‘received’ until they become unconditional which will be at some point after 30 June 2017.

Therefore for the year ended 30 June 2018 the amount received is not assessable income in the year ended 30 June 2017 and is not included when examining paragraph 360-40(1)(c).

Detailed reasoning

Background

Assessable income

1. Taxation Ruling TR 2006/3 Income tax: government payments to industry to assist entities (including individuals) to continue, commence or cease business looks at when payments from government is assessable income and uses the term government payment to industry (GPI).

2. In looking at the payment Company A received is to develop its minimal viable product.

3. Assessable income is a defined term under section 995-1 and ‘has the meaning given by sections 6-5, 6-10, 6-15, 17-10 and 17-30’.

4. Paragraph 4 of TR 2006/3 discusses three broad categories. One of these categories is ‘government payments to continue business’. In respect of payments to continue business paragraph 10 concludes:

A GPI to assist a business to continue operating, except where the payment is for agreeing to give up or sell part of the profit yielding structure, is included as assessable income of the recipient under section 6-5 or section 15-10.

5. Following this paragraph Company A’s payment will be assessable income under either section 6-5 or section 15-10.

6. Section 15-10 states:

Your assessable income includes a bounty or subsidy that:

(a) you receive in relation to carrying on a *business; and

(b) is not assessable as *ordinary income under section 6-5

7. This is paraphrased in paragraph 16 of TR 2006/3 which states:

A GPI that assists a business to carry on its activities and is:

● a bounty or subsidy;

● capital in nature; and

● received in relation to carrying on a business,

is assessable under section 15-10 in the income year in which it is received.

8. Therefore, the payment is a bounty or subsidy, is capital in nature and is received in relation to carrying on a business it will be assessable under section 15-10. If it is not capital in nature it will be assessable under section 6-5 as ordinary income.

Bounty or subsidy

9. ATO Interpretative Decision ATO ID 2010/147 Income Tax Bounties and subsidies: whether a repayable government payment a 'bounty or subsidy', looked at whether a government payment that is received to undertake activities to develop a new product to the stage where it can be taken to market was a bounty or subsidy for the purposes of section 15-10. In respect of repayment of the funding the facts of the ATO ID stated:

The funding agreement provides that the receipt of the government payment is subject to a repayment obligation that aligns with the success of the project. The project is considered successful if a specified accumulated sales level arising out of or in connection with the project is achieved.

Where the specified accumulated sales level is not met within a certain period, no obligation to repay the funding arises unless or until notified by the government. Where the specified accumulated sales level is met, the obligation to repay will arise; however the government has the discretion to modify the obligation which will nevertheless conclude after ten years. That is, there is no obligation to repay outstanding funding amounts after the tenth anniversary of the project end date.

10. The reasons for decision in ATO ID 2010/147 stated:

Section 15-10 of the ITAA 1997 provides that assessable income includes a bounty or subsidy that is received in relation to carrying on a business and that is not assessable as ordinary income under section 6-5 of the ITAA 1997. Not all government grants are bounties or subsidies for the purposes of section 15-10 of the ITAA 1997. Taxation Ruling TR 2006/3 Income Tax : government payments to industry to assist entities (including individuals) to continue, commence or cease business sets out the Commissioner's view on circumstances in which a government payment will be considered to be a bounty or subsidy.

The terms 'bounty' or 'subsidy' are not defined terms for the purposes of either the ITAA 1997 or Income Tax Assessment Act 1936 (ITAA 1936). However, the Courts in their consideration of how the terms were used in paragraph 26(g) of the ITAA 1936 (the predecessor to section 15-10 of the ITAA 1997) have provided some guidance as to their meaning which are equally relevant for section 15-10 of the ITAA 1997 (see Plant v. FCT 2004 ATC 2364; 58 ATR 1070.)

In Reckitt and Colman PTY LTD v. FCT (1974) 4 ATR 501, 74 ATC 4185; Mahoney J said that the terms 'bounty' or 'subsidy' include a financial grant made by the State for the purpose of encouraging a particular activity in the field of trade and commerce. In First Provincial Building Society Ltd v. Commissioner of Taxation (1995) 30 ATR 207; 95 ATC 4145, Hill J referred to Jowitt's Dictionary of English Law's observation that the word subsidy generally means 'financial assistance granted by the Crown' and said that 'This is the meaning which the word truly has in the present context'.

In this case, the government payment was provided to the taxpayer to undertake project activities to develop the product to the stage where it can be taken to market. The government payment is financial assistance granted to the taxpayer as it not only increased the financial capacity of the taxpayer to undertake the relevant activities but also reduced the taxpayer's risk of economic loss because the obligation to repay the payment only arises either if the project is successful or in very limited circumstances if the project is not successful.

While some or all of the government payment may be repayable, this is not a case where the substance of the transaction is the provision of funds in consideration of a promise to repay that sum (c.f. AAT Case 9472 94 ATC 225; (1994) 28 ATR 1155 Case 22 / 94 ). That is, the provision of the government payment is not characterised as a loan (which would not be a bounty or subsidy for the purposes of section 15-10 of the ITAA 1997) as the essential feature of a loan (a definite obligation to repay the principal sum) is absent on entering the agreement. The provision of the government payment is subject to a contingent liability that may result in repayment in limited circumstances that might or might not ever eventuate. Whether or not the contingency occurs, the obligation to repay the funding did not exist at the time the funding agreement was entered into. In Smart v. Lincolnshire Sugar Co. Ltd (1933-1937) 20 TC 643, the court found that the presence of a similar contingent liability to repay a subsidy in a certain event did not in any way affect the characterisation of the receipt as a subsidy. Therefore, the fact that the government payment in the present case may become repayable does not change the substance of the transaction which is the provision of financial assistance.

Accordingly, a government payment received to undertake activities to develop a new product to the stage where it can be taken to market is a bounty or subsidy for the purposes of section 15-10 of the ITAA 1997, even though the receipt is subject to a repayment obligation that may arise in certain events.

Note : Where the taxpayer's receipt of funding is assessable under section 15-10 of the ITAA 1997 (because it is received in relation to carrying on a business) it is assessable in the income year in which it is received but subject to amendment to exclude any amount repaid as non-assessable non-exempt income if the repayment is not otherwise deductible (section 59-30 of the ITAA 1997).

11. In looking at facts quoted from the above ATO ID, Company A is being funded to develop their product so it can be taken to market and once the funds are received any repayment is based on the financial success of their product.

12. At the time Company A receives the payment they are under no obligation to repay the funds that were ‘received’.

13. The payment will only become repayable if the product is financially successful and the repayment clause in the agreement is triggered.

14. If the repayment clause is never triggered then Company A will never have an obligation to repay the money.

15. Following ATO ID 2010/147 the payment received by Company A is a bounty or subsidy for the purposes of section 15-10 even though a repayment obligation may arise it will only arise at some unknown point in the future.

Is the payment capital in nature?

16. The test for determining whether a payment is capital in nature is an objective test and is not decided by determining whether the expenditure by the payer is revenue or capital in nature. Nor decided by determining whether any expenditure the recipient is required to make is revenue or capital in nature.

17. In this case the payment made by will allow Company A to develop their product to a point they can begin to earn assessable income from it.

18. By receiving the payment Company A has increased their financial capacity and the payment will either supplement or replace capital Company A was planning to raise from investors to develop their product. In return the fund provider does not receive anything other than a financial repayment if the product is economically successful.

19. In other words under the agreement Company A is not providing a service in return for the funds received. In return for the funds provided the Government Body receives a share of the profits that Company A may make from the product at some point in the future. If there is no profit there is no return to the Government Body.

20. Returning to First Provincial, the Full Federal Court held that the payment in that case was made in relation to the carrying on of its business but it lacked the necessary connection with the taxpayer's business activities to constitute ordinary income.

21. Like the decision in First Provincial the payment received by Company A lacks the necessary connection with the taxpayer's business activities to constitute ordinary income and be assessable section 6-5. The Government Body is investing in the future profitability of Company A.

22. Therefore the payment is capital in nature.

In relation to carrying on a business

23. In First Provincial Building Society Limited v. Federal Commissioner of Taxation (1995) 56 FCR 320; (1995) 95 ATC 4145; (1995) 30 ATR 207(First Provincial), Hill J. considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936 (ITAA 1936). He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient.

24. ATO Interpretative Decision ATO ID 2002/1084 Income Tax Income: Bounty or subsidy - whether received in relation to carrying on a business examines whether a Commonwealth Government grant was received in relation to carrying on a business the reasons for decision in ATO ID 2002/1084 states in part:

. . .Even though the taxpayer was not carrying on a business at the time the payment was received section 15-10 of the ITAA 1997 can still apply if the payment was received '...in relation to the carrying on of a business' either in the past or in the future. . .

25. In looking at the payment to Company A it will be used to develop their product and at some point in the future they will use that product in their business.

26. Following Hill J’s consideration of the phrase ‘in relation to’ in First Provincial and the above quote from ATO ID 2002/1084, even though the product being developed may not currently be in use in Company A’s business, it will be once it is developed and as a result the a sufficient connection between the payment and Company A’s business

Conclusion assessable income.

27. The payment satisfies all of the conditions outlined in section 15-10 and will be assessable in the year it is received.

When will the payment be ‘received’?

28. Paragraph 23 of TR 2006/3 examines when conditional grants are received and states:

Government financial assistance to business is sometimes provided on terms where the amount must be repaid unless the recipient meets agreed conditions within a specified period. The grant becomes unconditional when the recipient satisfies the required conditions of the agreement with the funding authority. It is at this time that a GPI is taken to be received, not at the time the conditional grant was paid.

29. In addition paragraphs 118 and 119 of TR 2006/3 state:

Conditional grants made by government that are convertible to a grant after a specified period or on attainment of milestones and subject to agreed performance criteria are not in themselves a GPI at the time they are received.

Where a recipient satisfies the terms of a conditional grant and is entitled to have the conditional grant converted to a grant, a GPI has been earned in the income year of conversion to the extent that the amount is no longer conditional or subject to repayment. Depending on the terms of the agreement, this might be at different points during the period. If the grant is assessable as ordinary income the amount is included as assessable income in the year in which it is derived (subsection 6-5(2)).

30. The terms and conditions contain clauses that allow for the funds to be recovered if certain conditions are not met.

31. Once these conditions are met there will no longer be any conditions attached to retaining the funds provided and the funding becomes unconditional.

32. As per paragraph 119 of TR 2006/3 it states in part ‘a GPI has been earned in the income year of conversion to the extent that the amount is no longer conditional or subject to repayment’. The paragraph then goes onto say ‘Depending on the terms of the agreement, this might be at different points during the period’.

33. At the time the funds are received (i.e. when the grant becomes unconditional) none of the funds are subject to repayment. They only become subject to repayment at an unknown point in the future. In addition only some of the original amount becomes subject to repayment at any given time.

34. Therefore it will be assessable when the funding becomes unconditional even though there may a point in the future where some of it will become subject to repayment.

Year income is assessable

35. In this case the payment will be received at some point after the project is complete.

36. As the timeframe to complete the project is after 30 June 2018 the date that the payment will be received is not in the 2017 year of tax.

37. As a result the payment will not be included as assessable income in the 2017 year of tax and does not need to be included when examining paragraph 360-40(1)(c) for the 2018 year of tax.

Repayment of initial funding

38. Subsection 59-30(1) states an amount you receive is not assessable income and is not exempt income for an income year if:

(a) you must repay it; and

(b) you repay it in a later income year; and

(c) you cannot deduct the repayment for any income year.

39. If a repayment event is triggered under the agreement then Company A will be required to repay an amount as calculated under the agreement.

40. When Company A starts paying amounts back they will also be able to amend the relevant income tax assessment to reduce the amount of assessable income in that year by the amount that must be repaid.

41. Under section 170(10AA) of the ITAA the time limits that normally apply to assessment an assessment do not apply to amendments made as a result of section 59-30.

42. Therefore the relevant income tax assessment can be amended at any time Company A is required to repay an amount under the agreement.

Payment of Grant funding – capitalised interest

43. Under the agreement Company A will be charged interest based on the annual CPI which is capitalised and added to the total balance. Therefore the balance owing will include an amount that represents interest and an amount that represents the initial funding received.

44. Like the repayment of the initial funding the interest is only required to be paid if the product is financially successful. However although the interest component will be added to the account the interest was not an amount being ‘repaid’ so subsection 59-30(1) of the ITAA 1936 will not apply to the interest component.

45. Under section 8-1 you can deduct from your assessable income any loss or outgoing to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income unless it is capital or private in nature.

46. It the amount being paid is a payment of interest rather than a repayment of the initial funding received then the payment of interest is deductable under section 8-1.

Other matter – subsection 360-40(2).

47. For the purposes of the assessable income test under paragraph 360-40(1)(c) section 360-40(2) disregards any relevant Grants under the program administered by the Commonwealth known as the Entrepreneurs' Programme.

48. The Entrepreneurs' Programme was established using the Entrepreneurs’ Programme Direction No.1 of 2016 under section 19 of the Industry Research and Development Act 1986.

49. It is only funds provided in accordance with this Direction that are disregarded under paragraph 360-40(1)(c).

50. Although Company A is receiving funds to commercialise a product the funding was not provided as part of the Entrepreneurs' Programme.

51. Therefore 360-40(2) does not apply to disregard funds provided to Company A.

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