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Edited version of private advice

Authorisation Number: 1052164732643

Date of advice: 5 September 2023

Ruling

Subject: Early stage innovation company eligibility

Question

Does the Company 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) for the income year ended 30 June 20YY?

Answer

Yes.

This ruling applies for the following period

Income year ended 30 June 20YY

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

  1. The Company was incorporated in Australia on DD MM YYYY. Its equity interests are not listed for quotation in the official list of any stock exchange.
  2. On DD MM YYYY, Company A was incorporated as a wholly owned subsidiary of the Company.
  3. On DD MM YYYY, the Company acquired 100% of the shares in Company B. Company B has X wholly owned subsidiary entities that were established on DD MM YYYY.
  4. On DD MM YYYY, the Company issued new shares to its shareholders.
  5. Total expenses incurred by the Company and its 100% subsidiaries in the last three income years before the year in which the new shares were issued were less than $1 million.
  6. The Company and its 100% subsidiaries had total assessable income of less than $200,000 in the income year before the year in which the new shares were issued.
  7. The Company's executive team comprises of a range of experts with deep experience in the relevant industries.

Innovation

  1. The Company is in partnership with its business partner to manufacture and supply a product.
  2. The product is new to Australia. The technology was developed and is owned by the Company's business partner. The Company has entered into agreements with the business partner under which the Company will develop a manufacturing facility in Australia and be granted exclusive rights and licenses to develop, manufacture and supply the product in Australia and certain overseas markets.
  3. The Company has been in an innovation and research & development (R&D) phase. Its activities to date have primarily consisted of development and improvement of the technology. The existing technology has many limitations and require significant development and improvement work to improve its efficiency and achieve localisation of the product in the Australian and overseas markets.
  4. Further, significant research, development and improvement are required to develop a product with large scale applications of the technology that has no proven history of how it will operate.
  5. Specifically, the Company's innovation is primarily focussed on:

a)    improving the base technology and technical design of the innovation,

b)    redesigning the technology for large scale applications, and

c)    localisation of the technology for the target markets and customers.

  1. The Company undertakes the innovative activities in collaboration or partnership with a group of key Australian stakeholders with the relevant knowledge and expertise.
  2. The Company and its 100% subsidiary have incurred significant expenses on R&D in the relevant income years.

Market position

  1. The Company's goal is to provide the target markets with an Australian-made product independent of overseas supply chains and factories.
  2. The Company has identified its ultimate market as being Australia and certain overseas countries.
  3. At the time when the Company issued new shares on DD MM 20YY, the Company has identified its initial target market and the addressable market as Australia.
  4. The Company predicts that Australia will be in great demand for its product. The Company plans to occupy XX% of the Australian market with its product over the next 20 years.

Commercialisation strategy

  1. The Company has detailed construction plans for its manufacturing facilities and commercialisation strategy for its product.
  2. At the time the Company issued new shares on DD MM 20YY, the Company was managing several sales targets across multiple industries and users.
  3. To date, the Company is already working with several major customers in Australia that are looking to purchase its products.
  4. Further, the Company aims to develop a second manufacturing facility and supply to broader global markets.

Scalability and future growth potential

  1. It is projected that the Company's revenue will experience an exponential growth over the next decade.
  2. In the 20ZZ financial year, the construction of the first manufacturing facility will be completed and become operational, that is predicted to be capable of producing XXXX units of the product per year.

Competitive advantages

  1. The Company is on the cutting edge of the technology development in Australia and internationally. The product will deliver unique competitive advantages and benefits in comparison with alternatives in the market.
  2. Building on the existing innovation, the Company is undertaking world-first research, development and innovation activities to further improve the base technology and design of the innovation to achieve better efficiency, large scale installation and localisation for the Australian market.

Intellectual property (IP) strategy

  1. The Company holds both the IP rights licensed by its business partner in relation to the existing technology and the IP developed and generated in its own research, development and improvement activities.
  2. Under the agreement between the two parties, exploitation and protection of the licensed IP rights will be governed by the agreement. Any IP developed by the Company (except certain IP defined in the agreement) on the project will belong to the Company.
  3. The Company will own any IP generated during conducting its research and development activities.
  4. The Company will decide on the IP protection strategy on a case-by-case basis. Specific IP protection strategies may include copyright, patent, trade secrets, non-disclosure agreements, employment agreements and contractor agreements.

Information provided

  1. You have provided information in a number of documents in relation to the business and innovation of the Company, including:

a)    the private ruling application,

b)    responses to the request for further information,

c)    your email correspondence to us.

  1. We have referred to the relevant information within these documents and conversations 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 360-40

Reasons for decision

Summary

The Company meets the eligibility requirements of an ESIC under subsection 360-40(1) of the ITAA 1997 for the period 1 July 20XX to 30 June 20YY.

Detailed reasoning

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

Qualifying Early Stage Innovation Company

1.     Subsection 360-40(1) outlines the criteria required for a company to qualify as an 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 is developing new or significantly improved innovations to generate an economic return.

The early stage test

2.     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)

3.     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 6 income years (the latest being the current year), and across the last 3 of those income years before the current year it and any 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).

4.     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.

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

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

6.     To meet the requirement in paragraph 360-40(1)(b), the company and any 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)

7.     To meet the requirement in paragraph 360-40(1)(c), the company and any 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)

8.     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

9.     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

10.  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 (v)

11.  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.

12.  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.

13.  The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are:

            i.        the company is genuinely focussed on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods; and

           ii.        the business relating to those products, processes, services or methods has a high growth potential; and

          iii.        the company can demonstrate that it has the potential to be able to successfully scale that business; and

          iv.        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; and

           v.        the company can demonstrate that it has the potential to be able to have competitive advantages for that business.

Developing new or significantly improved innovations for commercialisation

14.  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]

15.  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.

16.  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.

17.  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]

18.  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."

19.  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."

20.  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.

21.  '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

22.  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

23.  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

24.  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

25.  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)

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

27.  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

28.  For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC is immediately after the Company issued new shares to the investors on DD MM 20YY.

Current year

29.  For the purposes of subsection 360-40(1), the current year will be the income year ended 30 June 20YY.

Early stage test

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

30.  The Company was incorporated within the last six income years. Subparagraph 360-40(1)(a)(ii) is satisfied if the total expenses incurred by the Company and its 100% subsidiaries for the last three income years before the current year is $1 million or less.

31.  The Company and its 100% subsidiaries incurred total expenses of less than $1 million in the last three income years before the current year. Subparagraph 360-40(1)(a)(ii) therefore is satisfied.

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

32.  The Company and its 100% subsidiaries had total expenses of $1 million or less in the income year before the current year. Paragraph 360-40(1)(b) is satisfied.

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

33.  The Company and its 100% subsidiaries had total assessable income in the income year before the current year of $200,000 or less. Paragraph 360-40(1)(c) is satisfied.

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

34.  The Company 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

35.  The Company satisfies the early stage test for the entire income year ended 30 June 20YY, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

100 point innovation test - paragraph 360-40(1)(e) and section 360-45

36.  The Company is not able to meet the 100 point innovation test under section 360-45 at the test time. The Company therefore is electing to seek ESIC eligibility by satisfying the principles-based test under subparagraphs 360-40(1)(e)(i) to (v).

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

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

37.  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.

38.  The Company has been undertaking research and development activities to develop innovation which will significantly improve an existing technology for Australia, which was the addressable market the Company identified at the test time.

39.  The Company has provided details demonstrating that it is genuinely focussed on developing a product that is significantly improved for an applicable addressable market.

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

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

41.  The Company's goal is to provide its target markets with an Australian-made product independent of overseas supply chains and factories.

42.  To achieve this goal, the Company has detailed construction plans for its manufacturing facilities and commercialisation strategy for its product.

43.  Further, the Company is working with key stakeholders to identify opportunities in both Australia and the overseas markets.

44.  The Company predicted that its projected revenue would experience an exponential growth over the next decade.

45.  The Company has provided details demonstrating that it is genuinely focussed on developing its innovation for a commercial purpose in order to generate economic value and revenue for the company.

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

46.  The Company is genuinely focussed on developing its innovation for commercialisation initially within Australia and ultimately in certain overseas markets. The Innovation will be a significantly improved product compared to existing products.

47.  Therefore subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XX to 30 June 20YY.

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

48.  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.

49.  The Company has provided details demonstrating a high growth potential for its business. Therefore subparagraph 360-40(1)(e)(ii) will be satisfied.

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

50.  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.

51.  The Company has provided details demonstrating that it 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)

52.  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.

53.  The Company has provided details demonstrating that it has the capacity and 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)

54.  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 its business.

55.  The Company has provided details demonstrating that it has competitive advantages for its business and products. Therefore subparagraph 360-40(1)(e)(v) will be satisfied.

Conclusion on principles test

56.  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 to 30 June 20YY.

Foreign Company Test

57.  The Company was incorporated in Australia. It is not a foreign company and paragraph 360-40(1)(f) is satisfied.

Conclusion

58.  The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX to 30 June 20YY.


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[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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