Edited version of your written advice

Authorisation Number: 1051444030867

Date of advice: 19 October 2018

Ruling

Subject: Early stage innovation company qualification

Question

For the year ended 30 June 20XX 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

No.

This ruling applies for the following periods:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

1. The Company was registered on the Australian Business Register in the 20XX income year.

2. The Company has two wholly owned subsidiaries.

3. The Company’s equity interests and that of its subsidiaries are not listed for quotation in the official list of any stock exchange.

4. The Company had expenses of less than $X million in the 20XX income year, and no assessable income.

5. Profit and Loss statements for the Company’s subsidiaries for the 3 months ended 30 June 20XX and the year ended 31 March 20XX show combined expenses of less than $X million and income below $XX.

6. The purpose of establishing the Company was to acquire newly developed but existing ‘know how’ that had not been fully developed and develop it, modify it and enhance it so as to make it commercially viable in a large range of primary production situations. To achieve this the Company acquired 100% of the shares in one of its subsidiary companies (SubCo) in 20XX. SubCo was originally registered by the individual who had originated the product concept.

7. SubCo is the registered owner of all patents, trade secrets, knowhow and trademarks. SubCo holds the intellectual property (IP) for asset protection purposes.

8. The Commissioner has not been advised that there is a licence agreement in place between KBL and RTS in respect of the IP.

9. Whilst SubCo is the holder of the IP and will not earn direct sales revenue it has been engaged by the Company to partner in its innovation agenda. In essence the Company and SubCo are responsible for the innovation agenda - SubCo for providing the historical knowledge and the Company for continuing to direct and fund the research, innovation and commercialisation.

10. The Company has stated the following in relation to its acquisition of SubCo:

SubCo had started down a path and had come up with a base concept and early stage product but was unable to complete the process of refining and improving the product and taking it to market on its own. The Company acquired 100% of the share capital of SubCo and all proprietary knowledge held by it and kept SubCo in play to simply hold and assist in development the IP and thereby provide some asset protection by holding the IP in a non-trading entity. The Chairman of SubCo became the Chairman of the Company. The Company then directed the innovation program and funded it through SubCo. The entire of SubCo’s energies and expenditure was directed by the Company and to meet the Company’s purposes.

All SubCo’s services are designed to improve the product through innovation, develop new products and all this is done for and on behalf of and in conjunction with the Company’s Board of Directors.

11. The products in question are a portfolio of supplements.

12. The Company’s products are transportable worldwide.

13. All revenue is to be generated by the Company either directly or via subsidiaries where required in other countries. This will be done via the Company holding the worldwide distribution rights to all products.

14. During 20XX the Company worked together with a third party Innovation Manager and staff to improve the science, improve and refine the product output. As a result of this work a number of improvements were made and plans developed for developing and trialling new products.

15. The Company also agreed to engage an outside capital raising firm to help them raise further capital to continue the innovation process and bring it to a commercial reality.

16. The Company’s initial strategy is to generate revenue to expand and further develop the IP to strengthen the position of the company. As part of this continuing effort, the Company is forming a global research consortium. This consortium will include at least one Australian partner, but will also include capability from overseas.

17. SubCo lodged an EU patent application in 20XX.

18. The Company has initially chosen to concentrate on the Australian market and several overseas markets.

19. The efficiency of the Company’s closest competitor’s product are for a benefit of around 30% of that experienced by users of the Company’s products in trials.

20. The Company has already identified over 100 established producers who have the capacity to manufacture the Company’s products and supply key markets.

21. Sales revenue forecasts are contained in the Information Memorandum, along with a description of revenue potential.

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 ITAA 1997 unless otherwise indicated.

Summary

22. The Company does not meet the eligibility requirements of an ESIC under subsection 360-40(1) for the year ended 30 June 20XX.

Detailed reasoning

Qualifying Early Stage Innovation Company

23. 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’

24. 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)

25. 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).

26. 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.

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

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

28. 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)

29. 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)

30. 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

31. 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. The Company has applied for this ruling on the basis that it meets the principles-based test.

‘Principles-based test’ – subparagraphs 360-40(1)(e)(i) to (iv)

32. 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.

33. 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.

34. 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

35. To satisfy this test the Commissioner considers that a company must own the innovation in order to be developing it. Otherwise it is merely doing work on contract, providing services, or providing funds to another entity that is developing the innovation.

36. The Commissioner considers that a potential ESIC must have more than an indirect interest in the innovation. It is not sufficient that a company has an indirect interest in IP by virtue of having a controlling interest in a subsidiary that owns the IP.

37. The Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (‘EM’) states at paragraph 1.79 that the innovation that is being developed by a qualifying ESIC must either be new or significantly improved for the applicable addressable market:

“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…”

38. Further, at paragraph 1.81 it states that:

In addition, the company must be focussed on developing its innovation for a commercial purpose, or in other words, for the purpose of generating economic value and revenue for the ESIC. This requirement draws the distinction between simply having an idea and generating economic value from that idea. Commercialisation encompasses a spectrum of activities including those leading to the sale of new or significantly improved product, process or service as well as activities involving the implementation of a new, or significantly improved, process or method, where the process or method directly leads to the generation of economic value for the company.

39. 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.

40. 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.

41. The EM does not define the meaning of the term “genuinely focussed” within the context of subparagraph 360-40(1)(e)(i). Genuine is defined in the online Macquarie Dictionary as “Being truly such; real; authentic.” Focus is defined as “3. a central point, as of attraction, attention, or activity. … 8. to concentrate; to focus one's attention.” In essence, the phrase “genuinely focussed” is looking to what the company is truly concentrating and focussing their attention on or, put another way, what is the real central point of the company’s activities.

42. 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.

43. The pre-commercialisation stage may involve a range of activities such as market research, developing a proof of concept, prototyping, user testing, setting up manufacturing and marketing processes, and other business development activities to prepare for the launch of a product or service.

44. To be developing an innovation for commercialisation, the company must be at a stage before the innovation has been successfully commercialised. If the company has achieved a number of commercial sales or it is otherwise generating significant revenue from the business relating to the innovation, it is likely that the innovation is no longer being developed for commercialisation.

High growth potential

45. 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

46. 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

47. 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

48. 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

49. For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC will be a particular date on or after 1 July 20XX, but before 30 June 20XX.

Current year

50. For the purposes of subsection 360-40(1), the current year will be the year ended 30 June 20XX (the 20XX income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years will include the years ended 30 June 20XX, 20XX and 20XX.

Early stage test

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

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

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

52. As the Company and its 100% owned subsidiaries had expenses less than $X million in the prior income year, paragraph 360-40(1)(b) is satisfied.

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

53. As the assessable income of the Company and its 100% owned subsidiaries for the prior income year is less than $XX and paragraphs 360-40(1)(c) is satisfied.

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

54. As the Company and its 100% owned subsidiaries are not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(a)(d) is satisfied.

Conclusion on early stage test

55. 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.

Principles based test

Genuinely focussed on developing for commercialisation one or more new or significantly improved innovations – subparagraph 360-40(1)(e)(i)

New or significantly improved innovation

56. The Company is seeking to develop a range of supplements.

57. The supplements are easy to store and substantially outperform all other similar supplements commercially available today. They are transportable worldwide.

58. Of the most widely advertised feed supplements, only one makes a claim to enhance efficiency, with their claim providing approximately 30% of the benefit provided by the Company’s product.

59. The supplements are considered to be innovative products for the purposes of subparagraph 360-40(1)(e)(i).

Developing an innovation for commercialisation

60. To satisfy the test at subparagraph 360-40(1)(e)(i) “the company” must be genuinely focussed on developing the product for commercialisation. The company must satisfy this test in its own right, not a related company or a subsidiary company.

61. In this case SubCo is the registered owner of all patents, trade secrets, knowhow and trademarks relating to the supplements. The Company acquired 100% of the shares in SubCo. The Company has worldwide distribution rights to the product.

62. SubCo owns the innovation by virtue of owning the IP. As stated in the submission for this ruling, the Company’s initial strategy is to generate revenue to expand and further develop the IP. However in the absence of any further innovations developed beyond what SubCo initially created at the time that it was acquired by the Company remain indirect interests in innovations belonging to SubCo.

63. Indeed, the statement that “SubCo’s services are designed to improve the product through innovation, develop new products and all this is done for and on behalf of and in conjunction with the Company’s Board of Directors” is indicative of SubCo developing the innovation, whilst acting under the direction of - and receiving funding from - the Company.

64. Since the Company does not own the IP it is not genuinely focussed on developing the supplements for commercialisation. Although it operates in conjunction with SubCo and provides funding, this is insufficient to be considered to be genuinely focussed on developing the innovation.

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

65. The supplements for which the Company has distribution rights are considered innovative products for the purposes of subparagraph 360-40(1)(e)(i). However the Company has merely an indirect interest in the innovation by virtue of owning 100% of the shares in the company that owns the IP (SubCo). This is insufficient to establish that the Company is genuinely focussed on developing its innovation, i.e. the supplements, for commercialisation.

66. Therefore, subparagraph 360-40(1)(e)(i) has not been be satisfied for the year ended 30 June 20XX.

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

67. The Company has initially chosen to concentrate on the Australian market, and several overseas markets.

68. Sales revenue projections are forecast to rise markedly by the year ending March 20XX. This will be based on two core income streams.

69. The Company has a growth strategy that involves international operations. The potential for high growth exists. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied.

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

70. Securing a large partner allows for scalability of the Company’s business model. Intended to be the first of several such joint ventures partnerships with global producers, partnering will allow the Company to scale quickly into the global territories it is targeting. Once revenue is achieved, there will be very low capital costs required to scale rapidly around the world. This is because the Company will be leveraging the manufacturing, administration and distribution capability of its joint venture partners.

71. The Company can demonstrate 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)

72. The Company has chosen to initially focus on the Australian market, and several overseas markets.

73. The Company will commence marketing product with a national sales campaign in an overseas market, product trials with new customers and referrals from existing satisfied customers. The growth target is to achieve 20% market penetration by year five. The Company also anticipates solid sales volumes from the Australian markets as part of this process.

74. Based on the above mentioned plans and likelihood of taking its product globally, the Company has demonstrated it has the potential to address a broader market than Australia. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

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

75. There are a number of similar supplements being marketed internationally. Of the most widely advertised feed supplements, only one makes a claim to enhance feed efficiency. Their claim is for approximately 30% of the benefit provided by the Company’s product and only lasts for a short time.

76. A further point of difference is that the Company provides high-end product support, focused on each partner’s customer needs. This will be done through the Company’s partners and their distributors by maintaining a continuing flow of product refinements and ongoing global product trial results.

77. Along with its first mover advantage, creating significant barrier to entry for competitors, the Company can demonstrate the potential for its product to have competitive advantages within its market, satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles-based test

78. For the year ended 30 June 20XX the Company does not satisfy the principles-based test as it did not meet the requirements within subparagraph 360-40(1)(e)(i) for this period.

Conclusion

79. The Company does not meet the eligibility criteria of an ESIC under section 360-40 for the year ended 30 June 20XX.