Edited version of private advice

Authorisation Number: 1051816588607

Date of advice: 16 March 2021

Ruling

Subject: Early stage innovation company - principles-based test

Question

Is the Company an early stage innovation company (ESIC) as defined in section 360-40 of the Income Tax Assessment Act 1997 for the income year?

Answer

Yes. The Company is an ESIC under section 360-40 of the Income Tax Assessment Act 1997 for the 2021 income year.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Company was incorporated in the state of Z in Australia during the 20XX income year.

The Company:

•         is not listed on any stock exchange

•         had total expenses of less than $X million and total assessable income of less than $XXX during the 20XX income year

•         has no subsidiaries.

The Company's total expenses exclude capital expenditure connected with the development of X technology.

The Company applies generally accepted accounting principles to determine the proper treatment of relevant items in its Financial Statements.

The Company is focusing on developing X technology for use in the bulk commodities export industry. The Company's objective is to use X technology to:

•         digitalise trade processes

•         reduce large operational costs currently incurred under the traditional paper-based system

•         operate an end to end supply chain for bulk commodity logistics and trade settlements.

The Company believes that X technology will provide substantial cost and time savings to participants in the bulk commodity industry by:

•         improving efficiency and speed for transactions

•         provide real time secure information

•         increasing security and reducing fraud

•         improving liquidity and cashflow

•         allowing for an increased number of participants.

The Company has completed trial shipments of commodity A using its X technology with suppliers ABC Co and DEF Co. The Company has engaged in discussions with:

•         another 10 Australian producers and 3 overseas buyers of commodity A

•         the XYZ project, for commodity B

•         GHI Co and JKL Co, for overseas exports of commodity C.

The Company plans to:

•         undertake further pilot shipments with commodity A and commodity C exporters in several states in Australia

•         apply X technology to other commodity segments such as commodity D and commodity E

•         build a commercial scale business based on the innovation

•         develop existing relationships and networks to gain a global market presence.

The Company's Directors are experienced in industries relevant to bulk commodities. The Company has established partnerships with:

•         overseas trading houses which are experienced in the bulk commodity process

•         a university, and global consulting firms.

The Company expects that their target market could include international commodity entities, shipping and rail operators, logistics entities and trading houses.

There are currently no businesses in the bulk commodity industry which use X technology to verify bulk commodity trade data. The Company expects to be the 'first to market' in this industry, and believes that its partnerships and experienced management give it a competitive advantage. There is only one competitor, based in an overseas country, providing X technology to digitalise bulk commodity trading. The Company believes its industry experience and partnerships will give it an advantage over this competitor, and other potential competitors.

Based on its projected profit & loss statement, the Company expects to generate sales of approximately $X and an operating profit of $Y over the 18 months from July 20XX to December 20XX.

Relevant legislative provisions

Section 360-40 of the Income Tax Assessment Act 1997

Section 6 of the Corporations Act 2001

Reasons for decision

Legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated.

Broadly, Division 360 provides a tax offset to entities which make qualifying investments in 'early stage innovation companies.'

A company will qualify as an early stage innovation company (ESIC) if it meets requirements in section 360-40 including:

•         at least one of three alternative incorporation/business registration requirements in paragraph 360-40(1)(a). One is that the company was incorporated in Australia within the last 3 income years, the latest being the current year.

•         in the previous income year, the company, and its 100% subsidiaries:

-        incurred total expenses of $X million or less: paragraph 360-40(1)(b)

-        had total assessable income of $XXX or less: paragraph 360-40(1)(c)

•         its equity interests are not listed on a stock exchange at the test time: paragraph 360-40(1)(d)

•         at the test time, it meets at least one of two alternative tests in paragraph 360-40(1)(e):

-        it has 100 points under section 360-45 ('the 100 points innovation test'), or

-        it meets all the requirements in subparagraphs 360-40(1)(e)(i) through 360-40(1)(e)(v) ('the principles-based innovation test')

•         at the test time, the company is not a foreign company within the meaning of the Corporations Act 2001: paragraph 360-40(1)(f).

The principles-based innovation test

Paragraph 360-40(1)(e) requires that at the test time, all the following are met:

•         the company is genuinely focussed on developing for commercialisation one or more new, or significantly improved, products, processes, services or marketing or organisational methods: subparagraph 360-40(1)(e)(i)

•         the business relating to those products, processes, services or methods has a high growth potential: subparagraph 360-40(1)(e)(ii)

•         the company can demonstrate that it has the potential to be able to successfully scale that business: subparagraph 360-40(1)(e)(iii)

•         the company can demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business: subparagraph 360-40(1)(e)(iv)

•         the company can demonstrate that it has the potential to be able to have competitive advantages for that business: subparagraph 360-40(1)(e)(v).

Genuinely focussed on developing a new/significantly improved innovation for commercialisation: subparagraph 360-40(1)(e)(i)

Paragraphs 1.79 to 1.81 of the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 say that:

•         the relevant innovation must be new or significantly improved for the applicable 'addressable market'

•         the addressable market means the available revenue opportunity or market demand arising from the innovation

•         the addressable market must be objective and realistic

•         the 'commercialisation' requirement means the innovation must be developed for the purpose of generating economic value and revenue for the Company.

The company's objective is to use X technology to digitalise trade processes, reduce operational costs, and operate an end-to-end supply chain for logistics and trade settlements in the bulk commodities industry. The company has completed trial shipments with Australian commodity A suppliers, and is in discussions with other entities in the commodity A, commodity B, commodity C and commodity D industries, both in Australia and overseas.

The relevant applicable market for the Company would be the bulk commodity export market. There is only one competitor providing X technology to digitalise bulk commodity trading, and this competitor is located overseas. There are currently no businesses in the bulk commodity industry which use X technology to verify bulk commodity trade data. Therefore, the Company's innovation is 'new'.

The Company has completed trial shipments using the innovation, is in discussions with other exporters, and intends to develop a commercial scale business based on that innovation. Therefore, the Company is genuinely focussed on commercialising the innovation.

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

The Company expects that its innovation will produce substantial cost savings for the bulk commodity industry. The Company has completed trial shipments of commodity A using the X technology, and plans to apply its innovation to other commodity industries, and to other businesses in the bulk commodity industry in Australia and overseas. The Company plans to develop into a commercial scale business based on the innovation. Therefore, the Company's business has high growth potential.

Scaleability: subparagraph 360-40(1)(e)(iii)

This requires the company to demonstrate the potential to successfully scale the business. The Explanatory Memorandum at paragraph 1.83 suggests this means the expanding business must be able to have 'operating leverage', through multiplying existing revenues while incurring reduced or minimal increases in operating costs.

The Company believes that it has the experience and partnerships to successfully scale the business as it expands. The Company's projected profit and loss statement shows it expects to increase its sales at a greater rate than its expenses over the 18 months from July 2021 to December 2022. Therefore, the Company can demonstrate potential to successfully scale its business.

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

The Explanatory Memorandum at paragraph 1.84 says that this doesn't require the entity to have a national, multinational or global market at the test time, simply that it has the capability to be adapted to a national, multinational or global scale in the future. The Company has established partnerships with overseas trading houses, and is targeting its innovation at bulk commodity entities both within Australia and overseas. Therefore, the Company's business has the potential to address the innovation towards a broader than local market, including global markets.

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

The Explanatory Memorandum at paragraph 1.85 says the entity needs to demonstrate the potential to have competitive advantages, such as a cost or differential advantage over its competitors, which are sustainable for the business.

The Company expects to be the 'first to market' in this industry. It believes that its partnerships and experience in the bulk commodities industry will give it a competitive advantage.

All requirements in subparagraphs 360-40(1)(e)(i) through (360-40(1)(e)(v) are met, so the Company has passed the principles-based innovation test. There is no need to consider the 100 points innovation test.

Other requirements in subsection 360-40(1)

Income and expense requirements

Paragraphs 360-40(1)(b) and 360-40(1)(c) require that the company and its 100% subsidiaries:

•         incurred total expenses of $X million or less, and

•         had total assessable income of $XXX or less.

Draft Taxation Determination TD 2019/D5: Income tax: tax incentives for early stage investors: what is an 'expense' that is 'incurred' for the early stage test? provides the Commissioner's preliminary view that the meaning of 'expenses' in the context of subsection 360-40(1) is consistent with general accounting concepts. Expenses would usually be expense amounts taken from the company's financial statements, and would exclude outgoings properly capitalised and recognised as an asset under accounting concepts.

The Company had no subsidiaries. Since the Company's capital expenditure connected with the development of X technology was capitalised, these outgoings are excluded. The company's total expenses for the 2020 income year, determined under accounting standards, was below $X million.

The company had total assessable income of below $XXX for the 20XX income year.

These requirements are met.

Incorporation/registration, stock exchange, residency requirements

These requirements are met because:

•         the Company was incorporated in September 20XX (the 20XX income year), which is within the last 3 income years: paragraph 360-40(1)(a)

•         the Company's shares were not listed on a stock exchange: paragraph 360-40(1)(d)

•         the Company was incorporated in the state of Z, Australia, so it is not a foreign company for the purposes of the Corporations Act 2001: paragraph 360-40(1)(f).

Note that broadly, section 6 of the Corporations Act 2001 defines 'foreign company' as a body corporate that is formed or incorporated in an external territory or outside Australia.

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