Edited version of your written advice

Authorisation Number: 1013128393407

Date of advice: 25 November 2016

Ruling

Subject: Income Tax: Tax Incentive for Early Stage Investors

Question

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

Answer

Yes

This ruling applies for the following periods:

1 July 201X to 30 June 201X

The scheme commences on:

1 July 201X

Relevant facts and circumstances

Background facts

1. Company A is an Australian resident company incorporated in 201X.

2. Company A has been incorporated as a vehicle for the development and commercialisation of a novel technology that has been developed by a government agency.

3. The government agency has received a Certificate of Grant of Patent with respect to the technology.

4. All activities undertaken by the business to date and for the foreseeable future are in relation to the development of this technology.

5. The government agency and Company A executed a Term Sheet in 201X setting out obligations of each party regarding intellectual property (IP) rights and a shareholders agreement.

6. Further to paragraph 5 above, the various Agreements are now pending ministerial approval prior to sign off by the government agency (referred to herein as the 'final Agreements').

7. According to Agreement, the government agency assigns to Company A its entire right, title and interest in all Project IP and Service Results created or developed. Also, all Project IP and all Service Results shall be owned by Company A and will vest in Company A immediately upon creation. This is subject to licence-back provisions enabling the government agency to use the IP for other commercial projects.

8. Further the government agency assigns to Company A all the government agency's right, title and interest in and to the Assignable Patent Rights, Assignable System Designs and to the Commercialisation Materials. Also, the government agency grants to Company A a licence to technology Know-How and Improvements. This is subject to licence-back provisions enabling the government agency to use the IP for other commercial projects.

9. Company A is not a subsidiary of another company. The current shareholders are the Company A Founder, Mr X and Company B through its affiliate, Company C.

10. Following the transfer of the intellectual property from the government agency to Company A, the ownership will be X0% the government agency, X0% Company A Founder, X0% Company B, no other shareholders are anticipated to hold more than X0%.

11. Company A does not own shares in another subsidiary.

12. Company A is not part of a consolidated tax group, nor does it plan on joining a consolidated group for the 201X income year.

13. Company A's potential investors are sophisticated investors and new shares are offered without a disclosure document (section 708 of the Corporations Law (Cth)).

14. Company A is not listed for quotation in the official list of any stock exchange in Australia or a foreign country.

15. Company A is seeking investment to continue to develop and commercialise the technology.

Information provided

16. You have provided us with the following:

● A Private Ruling application for Company A.

● Responses to our queries in emails.

● Certificate of grant of patent (the government agency).

● World intellectual published property specification (the government agency).

● Company A's financial statements.

● The Term Sheet between the government agency and Company A.

● Various draft Agreements between Company A and the government agency.

17. We have referred to the relevant information within these documents in applying the principles based test to your circumstances.

18. You propose to issue shares in Company A to various investors to assist in funding the continued development and commercialisation of the technology.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

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.

Detailed reasoning

Qualifying early stage innovation company (ESIC)

19. Section 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. Broadly, 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

20. 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)

21. 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).

22. 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.

23. It is considered that a company will satisfy the incorporation test in subparagraph 360-40(1)(a)(i) where, immediately after the issue of shares to the investor, the company had been incorporated in either:

● that part of the current year which precedes the issue of shares; or

● one of the two income years prior to that year.

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

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

25. 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)

26. 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.

27. In determining the company's assessable income, any amount of Accelerating Commercialisation Grant that the company received in that year can be disregarded.

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

28. 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

29. 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

30. 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 - paragraph 360-40(1)(e)

31. 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.

32. 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.

33. 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 - subparagraph 360-40(1)(e)(i)

Developing new or significantly improved innovations for commercialisation

34. For the purposes of Subdivision 360-A, an innovation is considered to be a new or significantly improved product, process, service, marketing or organisational method.¹

35. 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.

36. 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.

37. 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.

38. '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 - subparagraph 360-40(1)(e)(ii)

39. 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.

40. The company should be able to demonstrate the factors that have the potential to drive high growth, such as the company's ability to enter into new markets or the strength of the appeal of its products or services to customers across a broad area.

41. The company should have a strategy that sets out the tangible steps that will be taken, or have been taken, to capitalise on these growth opportunities. Evidence that the company is experiencing early traction, for example by developing key relationships with customers or suppliers, could be used to support its high growth potential.

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

42. The company must be able to demonstrate that it has the potential to successfully scale up the business. 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 per unit.

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

43. 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- subparagraph 360-40(1)(e)(v)

44. 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.

45. 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

46. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date on or after 1 July 201X, but before 30 June 201X.

Current year

47. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 201X (the 201X 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 201X, 201X and 201X.

The early stage test

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

48. Company A was incorporated in 201X, which is within the last 3 income years, therefore subparagraph 360-40(1)(a)(i) is satisfied.

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

49. To meet the requirement in paragraph 360-40(1)(b), Company A must have incurred total expenses of $1 million or less in the 201X income year, being the income year before the current year.

50. Company A did not incur any expense for the income year ended 30 June 201X.

51. As Company A did not incur any expenses during the 201X income year, paragraph 360-40(1)(b) is satisfied.

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

52. To meet the requirement in paragraph 360-40(1)(c), Company A must have derived total assessable income of $200,000 or less in the 201X income year.

53. Company A did not derive any income for the income year ended 30 June 201X.

54. As Company A did not receive any income during the 201X income year, paragraph 360-40(1)(c) is satisfied.

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

55. Company A is privately owned and is not listed on any stock exchange in Australia or a foreign country. Therefore, paragraph 360-40(1)() is satisfied.

Conclusion on early stage test

56. Company A will satisfy the early stage test for the entire 201X income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

100 point test

57. Company A has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 201X. For Company A 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)

The addressable market

58. Company A market relating to the technology is on a global scale and not limited to the Australian market. Also, according to the patent document, the technology received an international patent classification.

59. Based on the above, we are of the view the addressable market is the global market.

New or significantly improved in the addressable market

60. The government agency developed a technique that offers a much faster, more accurate way to detect a mineral than traditional methods.

61. As per above, the government agency has developed the science behind the technology, Company A will be further developing the science further to the Term Sheet between the government agency and Company A and the final Agreements. There is also significant development that is being undertaken by Company A with regards to how to use the technology.

62. The technology is also very adaptable. While most of the work Company A has done has been based on the industry, the technique can be modified for other valuable commodities.

63. Based on the above, we are of the view the technology being developed is a new technology.

Developing an innovation for commercialisation

64. The majority of input into development and commercialising the technology is via negotiations with marketing partners, development partners, manufacturers etc. Also, the existing Company A team is coordinating the development of the unit with regard to the first prototype including designs and specifications for the individual sections of the unit. Company A's focus will be on development and deployment of the prototype unit as well as developing the technology itself (further element capabilities outlined above). Once the first unit is operational and has gone through a period of validation, the focus will shift to development and improvement of the onsite prototypes.

65. The activities that are required for development of the technology relate to development of the commercial unit and development of the underlying science. There will be further R&D undertaken on developing the science to allow the analysis of other elements as well as improving the accuracy of technology analyses. With regard to development of the product, Company A has provided the outline of the near term requirements.

66. The above facts demonstrate that Company A has taken tangible steps to lead to the sale of its products, which demonstrate a genuine focus on developing the technology for commercial sale.

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

67. Company A is genuinely focussed on developing the technology for commercialisation.

68. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied, for the time period from 1 July 201X until 30 June 201X or the date when the technology has been fully developed, whichever occurs earliest. The Commissioner considers that once the technology has been fully developed, Company A will no longer be 'developing' the technology and subparagraph 360-40(1)(e)(i) will no longer be satisfied.

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

69. Company A has the potential to rapidly expand its number of customers across its addressable market, i.e. the global market.

70. Company A also expects to publish a journal article on the technology and have some marketing related activities when the technology is successfully proven (i.e. the initial prototype is commissioned successfully).

71. Company A has provided an illustrative example of the unit below as well as the system overview.

72. The business relating to the technology has the potential to rapidly expand its customer base across the global market. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied.

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

73. The company has a staged approach to commercialisation of the technology, consisting first of the development of a high volume unit at a commercial laboratory. The company is in the final stages of negotiation with a commercial client to this effect.

74. The second stage of commercialisation is development of the on-site units. The initial units are expected to be leased to the same company that will lease the initial high volume unit.

75. Manufacturing of the unit is currently under negotiation with a major supplier based in country A and development negotiations are ongoing with this party also.

76. The company is currently raising capital through a placement for $X million. It is considered that this will be sufficient to develop the technology. The company is also applying for government grants to allow acceleration of this development.

77. Company A 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)

78. Under the current negotiations for rollout of the initial units it is envisaged that the on-site units will be rolled out in country B for grade control drilling purposes. The mobility of the technology allows it to be globally applicable for a range of potential customers. Manufacture of a significant part of the units, as well as assembly, is expected to take place in country A under contract with the manufacturer and the units will be shipped to global markets from there. Applications of the technology are global in nature and will not be limited to Australia.

79. The business relating to the technology has the potential to rapidly expand its customer base across the Australian market and globally. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

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

80. The technology is strongly backed by intellectual property laws, the technology itself is expected to be the best available technology in a field that has high barriers to entry.

81. The technology offers a cheaper, more accurate alternative for major laboratories. On site units offer flexibility and faster analysis turnaround than currently available assay methods.

82. Company A has provided a map of the various competing technologies.

83. Company A's technology is well protected with regards to the IP, there are no real competitors that Company A is aware of that can offer the same improvements over existing technology as Company A. Based on the revenue and costs Company A provided, there is room to reduce charge-out rates while maintaining profitability if it becomes necessary to compete economically. Company A also plans to continue to develop the science and the units themselves, potentially offering higher throughput, lower cost and analysis of additional elements, all of which will improve Company A's competitive position.

84. Therefore, Company A has demonstrated the potential for the technology to have competitive advantages for customers, satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

85. Company A satisfies the principles based test as it meets the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 201X until 30 June 201X or the date when the technology has been fully developed, whichever occurs earlier.

Conclusion

86.Company A meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 201X until the earlier of 30 June 201X or the date when the technology has been fully developed, whichever occurs earlier.

Other references (non ATO view)

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

¹