Edited version of your written advice

Authorisation Number: 1051410372167

Date of advice: 2 August 2018

Ruling

Subject: Early Stage Innovation Company 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 periods

1 July 20WW to 30 June 20XX

1 July 20XX to 30 June 20YY

The Scheme commences on

1 July 20WW

RELEVANT FACTS AND CIRCUMSTANCES

Background

1. Company A (the “Company”) is a proprietary company, limited by shares, incorporated in Australia on XX/XX/20XX.

2. The Company directors are Apple and Orange.

3. The Company has no subsidiaries.

4. The Company has incurred less than $1 million in total expenses in the 20XX financial year.

5. The Company has less than $200,000 assessable income for the 20XX financial year.

6. 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.

7. The Company share structure is detailed in the table below:

Description of the Company’s business premise

8. The Company is a business within an industry.

9. The Company is developing a product (the “Product”).

10. The Company is in the process of taking steps to develop the intellectual property underpinning the Product. The Company directors and the Product designer have made an assignment of their intellectual property rights to the Company.

Information provided

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

a. Private Ruling Application (the “Application”), dated XX/XX/20XX.

b. Numerous emails and telephone conversations with the Company director during XX and XX 20XX, including attachments.

12. 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 360-15

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.

QUESTION:

Summary

The Company meets the eligibility requirements of an ESIC under subsection 360-40(1).

DETAILED REASONING

Qualifying Early Stage Innovation Company

13. 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’

14. 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)

15. 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).

16. 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.

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

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

18. 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)

19. 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)

20. 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

21. 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

22. 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)

23. 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.

24. 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.

25. 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.

Developing new or significantly improved innovations for commercialisation

26. 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…”¹

27. 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.

28. 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.

29. The OECD Oslo Manual, in relation to defining innovative services, states at paragraph 161 that “innovations in services can include significant improvements in how they are provided (for example, in terms of their efficiency or speed), the addition of new functions or characteristics to existing services, or the introduction of entirely new services.”

30. The company must be genuinely focussed 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.

31. 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

32. The company must be able to demonstrate that the business relating to the innovation has a high growth potential 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

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

Broader than local market

34. 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

35. 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

20XX financial year

36. For the purposes of this ruling, the ‘test time’ for determining if the Company is a qualifying ESIC will be a particular date during the income year ending 30 June 20XX. In particular the company issued shares on XX/XX/ 20XX and XX/XX/20XX. Each date is a ‘test time’ for the purposes of the tests in section 360-40.

20YY financial year

37. For the purposes of this ruling, the ‘test time’ for determining if the Company is a qualifying ESIC will be a particular date during the income year ending 30 June 20YY.

Current year

20XX financial year

38. Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending 30 June 20XX (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, 20WW and 20VV, and the income year before the current year will be the year ending 30 June 20WW (the 20WW income year).

20YY financial year

39. Therefore, for the purposes of subsection 360-40(1) ITAA 1997, 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 last 3 income years will include the years ending 30 June 20YY, 20XX and 20WW, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year).

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

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

20XX financial year

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

20YY financial year

41. The Company was incorporated on XX/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

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

20XX financial year

43. The Company was incorporated in the 20XX financial year, and therefore the Company had total expenses of $0.00 in the 20WW financial year. Consequently, paragraph 360-40(1)(b) is satisfied.

20YY financial year

44. The Company has incurred total expenses of less than $1 million in the 20XX financial year. Consequently, paragraph 360-40(1)(b) is satisfied.

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

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

20XX financial year

46. The Company was incorporated in the 20XX financial year, and therefore the Company had total income of $0.00 in the 20WW financial year. Consequently, paragraph 360-40(1)(c) is satisfied.

20YY financial year

47. The Company has less than $200,000 assessable income for the 20XX financial year. Consequently, paragraph 360-40(1)(c) is satisfied.

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

20XX financial year

48. As the Company is privately owned and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(d) is satisfied.

20YY financial year

49. As the Company is privately owned and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(d) is satisfied.

CONCLUSION FOR EARLY STAGE TEST

20XX financial year

50. The Company satisfies the early stage test for the 20XX income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

20YY financial year

51. The Company 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

52. The Company has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the years ending 30 June 20XX and 30 June 20YY. For the Company 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

Developing new or significantly improved innovations – subparagraph 360-40(1)(e)(i) ITAA 1997

53. In applying the requirements of subparagraph 360-40(1)(e)(i), the Company must be developing an innovation which is either new or significantly improved for an applicable addressable market.

54. The Company is currently developing a product (the “Product”).

55. While there are other products available in the market, the unique features of the Product provide a significant degree of improvement in relation to the addressable market.

Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997

56. In applying the requirements of subparagraph 360-40(1)(e)(i), the Company must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company.

57. Since XX 20XX, even prior to incorporation of the Company, the Company directors and the Product designer have undertaken numerous steps to develop the Product. Since incorporation, there has been assignment of these intellectual property rights to the Company.

58. It is anticipated that initial prototypes should be completed by XX 20XX, with testing of those prototypes to be completed by YY 20YY.

59. The Company will continue to develop the Product throughout the period of testing.

60. It is anticipated that a version of the Product should be available during 20YY.

61. Further, it is anticipated that the production of another version of the Product should commence in approximately YY 20YY.

62. It is clear that the Company is genuinely focussed on developing the innovation for commercialisation.

63. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from XX/XX/20XX until YY/YY/20YY or the date when the suit has been fully developed, whichever occurs earliest. Once ‘The Innovation’ has been fully developed, the Company will no longer be ‘developing’ the product for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied.

High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997

64. In applying the requirements of subparagraph 360-40(1)(e)(ii), the Company must be able to demonstrate that it has the potential for high growth within a broad addressable market.

65. The company has two distinct markets, with the suit having various applications.

66. In one market, the Company is well geared to expand its reach, with a very strong chance at securing funding, support, and sales in a short time frame.

67. The Company has partnered with a former director of an organisation to secure funding, and access to resources, systems and personnel to take the suit from detailed concept to full integration over the next two years. The partner is consulting with stakeholders to identify the level of interest.

68. Moreover, this offers enormous potential to market the suit to international organisations with similar needs.

69. In the other market, there is an increasing global focus on the industry.

70. At this time, the Company has established an internet and social media presence, and has started acquiring followers.

71. The Company has demonstrated a high growth potential for the innovation, so subparagraph 360-40(1)(e)(ii) is satisfied.

Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997

72. In applying the requirements of subparagraph 360-40(1)(e)(iii), the Company must be able to demonstrate that it has the potential to successfully scale up the business.

73. In one market, small scale production will be done locally for market testing, marketing and promotional work. However, small scale local production will give way to large scale offshore production when the Product is commercialised.

74. The Company has links to manufacturing in various countries, through its contacts.

75. Offshore production will lead to significant decreases in costs in storage, shipping, insurance and oversight, reducing the price per unit of manufacturing.

76. Projected manufacturing costs will be reduced by approximately 95% per unit once offshore production commences.

77. Given the above, subparagraph 360-40(1)(e)(iii) will be satisfied.

Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997

78. In applying the requirements of subparagraph 360-40(1)(e)(iv), the Company must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets.

79. In one market, if the Product proves effective, it will be able to be easily implemented by international organisations.

80. In the other market, the Company’s target market in first instance is X, however, the Company has the potential to rapidly expand its customer base internationally.

81. The Company has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied.

Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997

82. In applying the requirements of subparagraph 360-40(1)(e)(v), the Company must demonstrate that it has potential to be able to have competitive advantage for that business.

83. While there are numerous competitors in the industry generally, and a number of competing products, the Company has identified a number of competitive advantages it has due to its differentiating features.

84. The Company is in the process of taking steps to protect the intellectual property underpinning the suit to ensure the device is unique and patentable.

85. The Company has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied.

CONCLUSION FOR PRINCIPLES BASED TEST

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

CONCLUSION

The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing XX/XX/20XX until YY/YY/20YY or the date when the suit has been fully developed and is ready for sale, whichever occurs earlier.

Other references (non ATO view)

Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016

Key words

Early Stage Innovation Company

Tax incentives for Early Stage Investors

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).