Edited version of private advice

Authorisation Number: 1051984027417

Date of advice: 19 May 2022

Ruling

Subject: Early-stage innovation company qualification

Question

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

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

10 November 20XX

Relevant facts and circumstances

1.      The Company was incorporated in Australia in 20XX. Its equity interests are not listed for quotation in the official list of any stock exchange.

2.    The test time for the Company will be immediately after the shares are issued in 20XX.

3.    The Company has no subsidiaries and has expenses of less than $1 million in the previous income year. The total assessable income earned by Company for the income year ended 30 June 20XX is nil.

4.    The Company's goal is to provide a product and process that is degradable ('the Innovation'). The Company has identified its ultimate market as the niche sub-market, with its initial target being both Australian and International markets. The Company is at an advanced stage of developing the Innovation. Currently they have a product which is partially degradable.

5.    Market position: the Company started to develop their initial innovation in early 20XX. This innovation is not fully degradable but is now ready for wholesale sale. They are currently selling through a few specific countries. Innovation is ongoing with new products and new methods for components that are currently available in partially degradable form. The company aims to have their product fully degradable by 20XX.

6.    The Innovation was originally developed by Old Co. Old Co undertook all preliminary work in respect of developing the degradable product. The business was transferred to the Company by way of a Business Sale and Purchase Agreement. Relevant trademarks were also assigned at the same.

7.    No other company currently offers a fully degradable product in the relevant market.

8.    The Company has identified its addressable market as the niche sub-market and if the product meets market expectation, the Company forecasts healthy sales numbers within five years.

Commercialisation strategy

9.    The Company has completed its first partially degradable product and is ready for wholesale sale into several countries coupled with a direct-to-consumer model.

10.  The line will be commercialised by way of the following process:

a.    Conduct market research and consultation to ensure market need.

b.    Assess the addressable market and test financial returns against this.

c.     Assemble a highly experienced management team.

d.    Secure funding:

•   Funding has been secured to date. Further funding is to be sought.

e.    Source, trace and test various components.

f.      Source, trace or develop and test various components.

g.    Testing of degradability of whole of product.

h.    Secure IP:

The Company has secured all IP and trademarks. Further IP will be secured as its developed.

i.      Set product parameters, revenue points and distribution model.

j.      Marketing:

A marketing program is being developed with basic websites and social media for the Company.

k.     Product launch:

Product launch is planned in three stages.

11.  The first range of degradable product is now being sold at wholesale in specific countries.

12.  The Company has engaged with multiple partners globally, who have expressed their interest in the Innovation.

13.  The Company is initially targeting relevant niche sub-markets. They will pursue product sales through:

a.    They are currently selling both globally and domestically. The Company has a global sales agent.

b.    Simultaneously, the Company will be launching an online store with a digital marketing strategy and exclusive products.

14.  The following market segments have been identified as initial targets:

a.    Sustainable

b.    Fully degradable product

15.  Within each of the above segments, the Company has identified the specified market as their customer base.

16.  The product offering:

The Company's products have been carefully developed in line with the Company's commitments to product principles, community and innovation. The Company wants to ensure that impact from production on people and planet is minimised.

17.  The Company states it does not have any direct competitors. There are other companies that have degradable products, but they are not competitors in the relevant market. You propose to issue new shares in the Company to investors to assist in funding the continued development and commercialisation of the Innovation.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 Subdivision 360-40

Reasons for decision

Qualifying Early Stage Innovation Company

18.  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'

19.  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)

20.  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:

1. incorporated in Australia within the last three income years (the latest being the current year); or

                ii.       incorporated in Australia within the last 6 income years (the latest being the current year), and across the last 3 of those income years before the current year it and its *100% subsidiaries (if any) 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).

21.  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.

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

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

23.  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)

24.  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)

25.  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

26.  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.

'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (iv)

27.  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.

28.  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.

29.  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 one or more new or significantly improved innovations for commercialisation

                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

30.  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]

31.  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.

32.  Improvements must be significant in nature to meet this requirement. 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.

33.   The OECD Oslo Manual defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. However, it is important to recognise that an innovation can also consist of a series of smaller incremental changes that together constitute a significant change.[2]

34.   In discussing services innovation activity, paragraph 111 of the OECD Oslo Manual states,

"Innovation activity in services also tends to be a continuous process, consisting of a series of incremental changes in products and processes. This may occasionally complicate the identification of innovations in services in terms of single events, i.e. as the implementation of a significant change in products, processes or other methods."

35.   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."

36.  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.

37.  '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

38.  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

39.  The company must be able to demonstrate that it has the potential to successfully scale up the business. The company must have operating leverage, whereas 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

40.  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

41.  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.

Foreign Company test - paragraph 360-40(1)(f)

42.  At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001.

43.  The dictionary in section 9 of the Corporations Act 2001 defines a foreign company to mean:

(a) a body corporate that is incorporated in an external Territory, or outside Australia and the external Territories, and is not:

(i) a corporation sole; or

(ii) an exempt public authority; or

(b) an unincorporated body that:

(i) is formed in an external Territory or outside Australia and the external Territories; and

(ii) under the law of its place of formation, may sue or be sued, or may hold property in the name of its secretary or of an officer of the body duly appointed for that purpose; and

(iii) does not have its head office or principal place of business in Australia.

Application to your circumstances

Test time

44.  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. The Company was incorporated in 20XX and the shares will be issued in the same year.

Current year

45.  For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX (the 20XX income year).

Early-stage test

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

46.  As the Company was incorporated in 20XX, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is met.

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

47.  As the Company had expenses of $1 million or less in the prior income year (the 20XX income year) paragraph 360-40(1)(b) is satisfied.

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

48.  As the Company's assessable income in the prior income year (the 20XX income year) is $200,000 or less paragraph 360-40(1)(c) is satisfied.

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

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

Conclusion on early-stage test

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

100-point test

51.  The Company has not provided any evidence of satisfying the 100-point test under section 360-45 for the year ending 30 June 20XX. For the Company 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)

52.  According to the Company the Innovation is the world's first fully degradable product in the relevant sub-market. Although it will initially be targeted at the Australian and International markets through a few specific countries, the Innovation has been identified as having a wider global addressable market.

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.

The Company has developed an innovation which is a significantly improved product offering for the identified market. The innovation ensures that the product is fully degradable. The Company's product is not yet fully degradable, but they are improving their product to be the first fully degradable product.

Of the companies that the Company has identified, some already produce degradable items, but they are not necessarily in the same addressable market. That is, while some of the other companies offer degradable products, those products are offered in different markets to that of the Company. Also, if we consider the relevant market, the Company seems to have the only offering that is fully degradable.

53.  The Innovation will be the first to offer such a product.

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

54.  The Company has taken the following steps in developing The Innovation:

a.    Conduct market research and consultation to ensure market need;

b.    Assess the addressable market and test financial returns against this;

c.     Assemble a highly experienced management team;

d.    Secure funding;

e.    Source, trace and test the product;

f.      Source, trace or develop and test various components;

g.    Testing of degradability of whole of product

h.    Secure IP;

i.      Set product parameters, revenue points and distribution model;

j.      Marketing; and

k.     Product launch.

55.  This has led to the Company to develop a range of products that are partially degradable, which is ready for sale internationally.

56.  The timeline provides that the Company expects testing which is currently ongoing to continue.

57.  The Company will develop contracts and seek potential customers to increase direct sales and also move into the online market.

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

58.  The Company is genuinely focussed on developing the Innovation for a commercial purpose. The Innovation will be a significantly improved product compared to existing products.

59.  Therefore subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XX until 30 June 20XX or the date when the Innovation 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)

60.  The Company expects the Innovation to appeal to a niche sub-market within the relevant market. This aids decision making and is particularly useful when assessing product viability in particular markets.

61.  Through its commercialisation and marketing strategy, the Company hopes to foster widespread use of its product. Hence, if the Company's commercialisation strategy is successful, the company has the potential to rapidly expand in the relevant market in various countries followed by worldwide expansion and adding a direct-to-consumer model.

62.  The Company is developing the Innovation themselves. They will make their revenue through wholesale sales initially, with a plan to include online sales eventually.

63.  If the commercialisation strategy is successful, this may give the Company the ability to increase sales through further retail outlets and online.

64.  Therefore subparagraph 360-40(1)(e)(ii) will be satisfied.

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

65.  The Innovation projections provided illustrates the increase in projected sales.

66.  Given that the Innovation will be available globally, it is expected that the Innovation has the potential to successfully scale up its business.

67.  The Company's strategy for the use of the Innovation will be able to generate increased revenue by having a global sales agent. The Company will also be launching an online store with a digital marketing strategy and exclusive products. This operating leverage affords the Company 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)

68.  The Innovation will initially be targeted at specific International markets but is intended for worldwide use. It will be released further globally once it gains traction in the initial targeted markets.

69.  The Innovation can be sold worldwide by any business within the relevant market. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region.

70.  The Company has demonstrated the Innovation has the potential to address a broader market than just the local market, including international markets. Therefore subparagraph 360-40(1)(e)(iv) will be satisfied.

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

71.  The Innovation is differentiated from existing offerings which may give it a competitive advantage by being the only/first company to offer a fully degradable product.

72.  Being the first to offer such innovation, the Company has the first mover advantage. The Company has demonstrated the potential for the Innovation to have competitive advantages within the 'addressable market' satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

73.  The Company satisfies the principles-based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20XX until 30 June 20XX or the date when the Innovation has been fully developed and is ready for sale, whichever occurs earlier.

Foreign Company Test

74.  As the Company was incorporated in Australia it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied.

Conclusion

75.  The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until the earlier of 30 June 20XX or the date when the Innovation has been fully developed and is ready for sale, whichever occurs earlier.

[1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76.

[2] OECD Oslo Manual, paragraph 124 and paragraph 151.

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