Edited version of private advice

Authorisation Number: 1051596407567

Date of advice: 18 October 2019

Ruling

Subject: Early stage innovation company qualification

Question 1

For the income year ended 30 June 2019, did the Company meet the early stage test requirements at paragraphs 360-40(1)(a) to (d) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

For the income year ended 30 June 2019, did the Company qualify under the principles-based innovation test by meeting the five requirements at paragraph 360-40(1)(e)(i)-(v)?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 2019

The scheme commences on:

1 July 2018

Relevant facts and circumstances

The Company was incorporated in Australia. Its equity interests are not listed for quotation in the official list of any stock exchange. The Company has no subsidiaries. It had less than $1 million of expenses, and less than $200,000 of income, in the prior income year.

The Company is developing a Widget. The Company has undertaken market research which indicates there is no direct competitor for the product they are developing. The Company has filed an Australian provisional patent application for the Widget.

The Widget is able to address a global market. The Company is already in discussions with clients around the world who have expressed an interest in the Widget.

The Company has commenced building a prototype of the Widget and is anticipating a completion date in 2020. From there, the Company expects to manufacture the Widget at scale in 2021.

Relevant legislative provisions

Income Tax Assessment Act 1997, subsection 360-40(1)

Income Tax Assessment Act 1997, paragraph 360-40(1)(a)

Income Tax Assessment Act 1997, paragraph 360-40(1)(b)

Income Tax Assessment Act 1997, paragraph 360-40(1)(c)

Income Tax Assessment Act 1997, paragraph 360-40(1)(d)

Income Tax Assessment Act 1997, paragraph 360-40(1)(e)

Income Tax Assessment Act 1997, subparagraph 360-40(1)(e)(i)

Income Tax Assessment Act 1997, subparagraph 360-40(1)(e)(ii)

Income Tax Assessment Act 1997, subparagraph 360-40(1)(e)(iii)

Income Tax Assessment Act 1997, subparagraph 360-40(1)(e)(iv)

Income Tax Assessment Act 1997, subparagraph 360-40(1)(e)(v)

Income Tax Assessment Act 1997, section 360-45

Reasons for decision

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

Issue 1

Question 1

Summary

For the income year ended 30 June 2019, the Company met the early stage test requirements at paragraphs 360-40(1)(a) to (d).

Detailed reasoning

Qualifying Early Stage Innovation Company

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 if it is developing new or significantly improved innovations to generate an economic return.

'The early stage test'

The early stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d).

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

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

To meet the requirement in paragraph 360-40(1)(a), at the test time in an income year (the current year being the income year in which the company issues shares to the investor), 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 within the last three income years (the latest being the current year).

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

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)

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)

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.

Application to your circumstances

Test time

For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC will be during the income year ended 30 June 2019.

Current year

For the purposes of subsection 360-40(1), the current year will be the year ended 30 June 2019.

Conclusion on 'the early stage test'

For the year ended 30 June 2019, the Company satisfies the requirements in paragraphs 360-40(1)(a) to (d) because:

1. It was incorporated in 2018, which is within the last 3 income years;
2. It had expenses of less than $1 million in the prior income year (year ended 30 June 2018);
3. It's income for the prior income year was less than $200,000; and
4. It is privately owned and is not listed on any stock exchange in Australia or a foreign country.

Question 2

Summary

For the income year ended 30 June 2019, the Company qualified under the principles-based innovation test by meeting the five requirements in subparagraphs 360-40(1)(e)(i)-(v).

Detailed reasoning

Innovation tests

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

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)

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.

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.

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

For the purposes of Subdivision 360-A, the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (the EM) states 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...'

Paragraph 1.79 of the EM explains that the innovation being developed by the company must either be new or significantly improved for the 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.

Paragraph 1.80 of the EM states that improvements must be significant in nature to be considered to be 'significantly improved'. 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.

Paragraph 1.81 of the EM explains that 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. 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

Paragraph 1.82 of the EM states that the company must be able to demonstrate that it has the potential for high growth within a broad addressable market. Companies that service a single local market are unlikely to demonstrate high growth potential.

Scalability

Paragraph 1.83 of the EM states that the company must be able to demonstrate that it has the potential to successfully scale its business. The company must have operating leverage, where existing revenues can be multiplied through incurring a reduced or minimal increase in operating costs.

Broader than local market

Paragraph 1.84 of the EM explains that 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 national, multinational or global scale in the future.

Competitive advantages

Paragraph 1.85 of the EM states that 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. Competitive advantage can be evaluated through the measures of the level of value for customers, rarity, imitability and substitutability of the advantage.

Application to your circumstances

100 point test

For the year ended 30 June 2019, the Company has determined they will not satisfy the 100 point test under paragraph 360-40(1)(e), through obtaining at least 100 points by meeting the innovation criteria in the table within section 360-45. 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)

The Company is developing the Widget which has no direct competitor according to market research undertaken. The Widget can address a global market.

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

The Company has undertaken market research which indicates there is no direct competitor for the product they are developing. The Company is already in discussions with clients around the world who have expressed an interest in the Widget.

The Company has commenced building a prototype of the Widget and is anticipating a completion date in 2020. From there, the Company expects to manufacture the Widget at scale in 2021.

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

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

Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 2018 until 30 June 2019 or the date when the Widget has been fully developed, whichever occurs earliest. Once the Widget 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)

The Company will be a first mover with their Widget.

The Company is already in discussions with clients around the world who have expressed an interest in the Widget. The Company can address the global market.

The Company has demonstrated its potential to significantly increase its economic value therefore subparagraph 360-40(1)(e)(ii) will be satisfied.

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

Once the Widget is in production, the Company can simply manufacture more units anytime it needs to.

Operating costs are not expected to increase significantly after the Widget is in production. 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)

The Company is already in discussions with clients around the world who have expressed an interest in the Widget.

The Company's Widget allows it to access the global market therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

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

The Company has the following differentiating features which may give it a competitive advantage:

·         The Company is the only company in the world that is developing this type of product.

·         The Company is seeking to disrupt the industry by developing a unique product.

The Company is unique in its ability to offer a product that is not currently available. The Company has demonstrated the potential to have competitive advantages within its industry, thereby satisfying subparagraph 360-40(1)(e)(v).

Conclusion on 'principles-based test'

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 2018 until 30 June 2019, or the date when the Widget has been fully developed and is ready for sale, whichever occurs earlier.