Edited version of private advice

Authorisation Number: 1051590104669

Date of advice: 5 November 2019

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)?

Answer

Yes, provided that the Company is not listed on any stock exchange and that the Product continues to be developed for commercialisation.

This ruling applies for the following period

Year ended 30 June 20YY

Year ended 30 June 20ZZ

The scheme commences on

1 July 20XX

Relevant facts and circumstances

1.    The Company was incorporated in Australia on 22 June 20XX.

2.    The Company does not have any subsidiaries.

3.    For each the financial years ended 30 June 20XX and 20YY, the Company incurred less than $1 million of expenses and earned less than $200,000 in assessable income.

4.    The Company's equity interests were not, and will not be, listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.

5.    The Company is developing the Product for commercialisation.

6.    The Product is designed to be as automated as possible and have minimal human input.

7.    The Company will monetise the Product in a number of ways.

8.    There are no known products/systems in the Australian market that encompass all of the above in a single system on a commercial scale.

9.    By 30 June 20YY, the Company had completed a number of key steps. However, the Company is continuing to develop their product, which is expected to continue over the duration of the 20ZZ income year.

10.  The Product is tackling national and global issues.

11.  The Product the Company intends to build represents significant capital outlay. It is expected that expenses will significantly drop off as revenues are generated through the operation of the plant.

12.  The Product will allow the Company to service large areas in many different locations.

13.  The Product can be set up and used in any location.

14.  The Company is in the process of establishing patents as well as intellectual property agreements.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-15

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 section 360-45

Reasons for decision

All references are to the Income Tax Assessment Act 1997, unless otherwise indicated.

Summary

1.      The Company satisfies the criteria of an Early Stage Innovation Company (ESIC) pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provided that the Company is not listed on any stock exchange and that the Product continues to be developed for commercialisation.

Detailed reasoning

Qualifying Early Stage Innovation Company

2.      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'

3.      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)

4.      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).

5.      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.

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

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

7.      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)

8.      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)

9.      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

10.   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

11.   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 (IV)

12.   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.

13.   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.

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

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

          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

15.   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..."

16.   The innovation being developed by the company must either be new or significantly improved for an applicable addressable market.^[1] 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.

17.   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.

18.   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."

19.   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.

20.   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.

High growth potential

21.   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

22.   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

23.   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

24.   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

25.   For the purposes of this ruling, the 'test time' for determining if the Company is a qualifying ESIC, will be upon the issue of qualifying shares on a particular date or dates on or after 1 July 20XX, and on or before 30 June 20ZZ.

Current year

26.   Therefore, for the purposes of subsection 360-40(1), for a test time that occurred in the 20YY income year, the current year will be the 20YY income year, the prior income will be the 20XX income year and the last 3 income years comprise the 20WW, 20XX and 20YY income years up until the test time.

27.   For a test time that occurs in the 20ZZ income year, the current year will be the 20ZZ income year, the prior income year will be the 20YY income year, and the last 3 income years will comprise the 20XX, 20YY and 20ZZ income years up until the test time.

THE 'EARLY STAGE TEST' - PARAGRAPHS 360-40(1)(A) - (D)

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

28.   The Company was incorporated in Australia within the 3 income years of the 20YY and 20ZZ income years. Therefore, the Company satisfies subparagraph 360-40(1)(a)(i). Consequently, paragraph 360-40(1)(a) is satisfied.

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

29.   In applying the requirements of paragraph 360-40(1)(b), the Company and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the relevant prior income years, being the income year before the year in which the test time occurs.

30.   As total expenses in both years were less than $1 million, paragraph 360-40(1)(b) is satisfied for the 20YY and 20ZZ income years.

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

31.   In applying the requirements of paragraph 360-40(1)(c), the Company and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the relevant prior income year, being the income year before the current year.

32.   As the Company earned assessable income of less than $200,000 in each of the 20XX and 20YY income years, paragraph 360-40(1)(c) is satisfied for the 20YY and 20ZZ income years.

No Stock Exchange listing - paragraph 360-40(1)(d)

33.   In applying the requirements of paragraph 360-40(1)(d), the Company must not be listed on any Stock Exchange in Australia or a foreign country at the test time.

34.   The Company was not, and will not be, listed on any stock exchange in Australia or a foreign country at the test time, so paragraph 360-40(1)(d) is satisfied for the 20YY and 20ZZ income years.

CONCLUSION FOR EARLY STAGE TEST

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

36.   The Company will satisfy the early stage test for the 20ZZ income year, as each of the requirements within paragraphs 360-40(1)(a) to (c) have been satisfied and the requirements within paragraphs 360-40(1)(d) will be satisfied if the Company remains unlisted at any test time.

THE '100 POINT TEST' - paragraph 360-40(1)(E) AND SECTION 360-45

37.   The Company is electing to seek eligibility by satisfying the Principles-based Innovation test under section 360-40(1)(e)(i)-(v), in order to be issued with a Private Binding Ruling.

THE 'PRINCIPLES-BASED TEST' - paragraph 360-40(1)(E)

Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i)

38.   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.

39.   The Company is developing a unique system called 'the Product'. This is being developed initially for the Australian market, with the aim of it being more broadly globally marketed.

40.   The Product is a significant improvement over other similar systems on the market as it combines a number of elements that make it unique to the market.

41.   The product was being developed during the 20YY financial year and by 30 June 20YY, the Company had completed a number of aspects. As at 30 June 20YY, the Company were still developing their product.

42.   The Company anticipates that the current programme of development to continue for at least the next 12 months.

43.   The Company was, and is, genuinely focussed on developing their Product, a new or significantly improved innovation, so subparagraph 360-40(1)(e)(i) is satisfied for the years ended 30 June 20YY and 20ZZ.

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

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

45.   the Company expects to monetise the Product in a number of ways as described in paragraphs 7 and 8 of the 'Relevant facts and circumstances'. the Company aims to operate with the assistance of capital injections via investors and/or via joint venture arrangements.

46.   the Company is genuinely focused on developing the Product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the year ended 30 June 20YY and will be satisfied for a test time during the year ended 30 June 20ZZ while the Product continues to be developed for commercialisation.

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

47.   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.

48.   The issues addressed by the Product are poignant issues nationally and globally.

49.   The Product is designed to handle these issues, giving it broad appeal to the public, government agencies and environmentally friendly minded private organisations.

50.   As such, the Product, has the ability for broad adoption across the Australian and international markets

51.   Once the Company has built facilities, it will be able to service large areas that extend beyond local markets. The Company plans to build a number of facilities in a number of different locations which will allow it to service a larger area.

52.   The Company has demonstrated a high growth potential for their Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the years ended 30 June 20YY and 20ZZ.

Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997

53.   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.

54.   After the initial costs of development of the Product and construction of the facilities, expenses drastically drop, while revenues increase, thus offering the Company economies of scale.

55.   The construction of the Product also allows the Company to scale up its operations as the need arises.

56.   This leverage ensures that the Company has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the years ended 30 June 20YY and 20ZZ.

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

57.   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.

58.   Given that the Product addresses the international issues, it has appeal to national and international markets. The Product can be set up in any location. Thus, it can address global markets.

59.   The Company has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied for the years ended 30 June 20YY and 20ZZ.

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

60.   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 that business.

61.   Currently there are no known systems that offer the complete offering that the Product offers. The offering may make the Product very attractive to the public, government and private institutions.

62.   By being the first to offer such a unique process, the Company may gain a first mover advantage. It may be able to establish contracts before competitors enter the market. This may be particularly significant if contracting for extended periods of time or establishing joint ventures

63.   The Product addressing current global issues may make it more likely for private and public entities to contract with the Company for use of the Product.

64.   The significant initial capital outlay is also a barrier to entry for competitors.

65.   The Product generates income from a number of different sources. This offers it protection from threats to any one of its revenue sources and allows time for an appropriate response to be made.

66.   The management team of the Company have extensive experience in a range of relevant areas on a national and global scale. This gives it a specific skill set that is difficult for competitors to easily emulate. This may offer significant advantages in the development, promotion and adoption of the Product.

67.   The Company is in the process of patenting the product as well as developing intellectual property agreements, which will offer further protection for its design and will increase the difficulty for competitors to replicate the Product.

68.   The Company has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the years ended 30 June 20YY and 20ZZ.

CONCLUSION FOR PRINCIPLES BASED TEST

69.   The Company satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the years ended 30 June 20YY and will satisfy the requirements for the year ended 30 June 20ZZ while the Product continues to be developed for commercialisation.

CONCLUSION

70.   The Company will meet the eligibility criteria of an ESIC under section 360-40 for a test time during the years ended 30 June 20YY and 20ZZ while the Product continues to be developed for commercialisation.