Edited version of private advice

Authorisation Number: 1051704372286

Date of advice: 23 June 2020

Ruling

Subject: Early stage innovation company qualification

Question

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

Yes.

This ruling applies for the following periods:

Year ending 30 June 20XX

The scheme commences on:

1 XX 20XX

Relevant facts and circumstances

'The Company' was incorporated in Australia recently. Its equity interests are not listed for quotation in the official list of any stock exchange.

'The Company' has full ownership of a subsidiary which was also incorporated recently.

Neither company incurred expenses or earned income in the 20XX income year. Therefore both companies together have expenses of less than $1 million in the previous income year, i.e. the year ended 30 June 20XX. They have not yet generated any revenue and assessable income is less than $200,000.

'The Company' is developing 'The Innovation'. 'The Company's' goal is to provide a licence to 'The Innovation' allowing customers to sell through their existing established networks. 'The Company' has identified its ultimate market as being the global market, with its initial target being Asian markets.

The Company has a novel product which it believes can both prevent and cure the disease. One of its competitors produces a vaccine which is expensive to administer, transport and produce and requires a pre-test for the disease before injection to be totally safe. Another vaccine has also been developed along the same lines and is also at clinical trial Phase III. As a consequence of the controversy over the first vaccine, both are undergoing rigorous testing and development is slow.

Other competitors are repurposed drugs and structure designed antivirals which have failed to achieve clinically trialled outcomes and will not be entering the market place any time soon. The Company predicts it can produce its pill for around the cost of Panadol and it is likely to have both a therapeutic and prophylactic effect. It also shows promise in treating other similar diseases.

Expertise of Founders and any Intellectual Property rights (i.e. ownership or licence) The General Manager is responsible for the program that identified the key compound in the Innovation. The Board itself is comprised of people with significant expertise in research, business development in the pharmaceutical industry and patent protection knowledge.

The Patent held by the inventor, was assigned to the Company on XX/XX/XX.

In addition to the above, you have highlighted the key differentiators as being:

a.    a novel first-in-class treatment for the disease.

b.    lead candidate shows high efficacy against the disease

c.     has both therapeutic and prophylactic potential

d.    is a simple, well characterised and easily synthesized small molecule

e.    presents a cost-effective pill as compared to high costs associated with a vaccine treatment delivered by injection.

f.      has also shown promise in treating other diseases.

The Company has identified its addressable market as the population of all countries affected the disease (mainly in Asia and Latin America) and international travellers. Some millions of people a year are symptomatic for the disease and its spread is increasing worldwide.

Commercialisation strategy

'The Company' has completed computer modelling on the research done thus far and is preparing for a Phase I trial in Australia by XX/XX with a version ready for general release within three to five years.

'The Company's' activities over the next 12 to 36 months will be to continue the development of the products to prove their efficacy, with the view of then engaging in the commercial licensing and/or sale of the products.

Specific tasks over the next 12 months include:

a.    Complete the initial murine models for safety & efficacy in the disease and follow-up another related disease.

b.    Initial ADME Tox in third-party providers

c.     Formulation & stability, manufacture

d.    Initiate a second species study

e.    Prepare phase I and be nearing initiation of the Phase 1 clinical trial

'The Company's commercialisation strategy starts from the development stage where

a.    Building a Board of Directors and Management Team with experience in developing and commercialising biotechnology products;

b.    Networking with the medical science community and government;

c.     Commercial collaboration and partnering with leading pharmaceutical companies that have an active interest in the disease and related diseases.

d.    Selectively expanding its program once 'The Company's' product hits key milestones for the disease.

e.    Entering into partnering and co-development arrangements with third party companies that have scale and commercial reach to market and sell 'The Company's' products;

f.      Out licensing of 'The Company's' products in global or regional territories.

'The Company' has engaged with large pharma who have expressed their interest in 'The Innovation'. It has entered a Co-operative Research Centres Project with one pharma and a Memorandum of Understanding in relation to Phase II clinical trials in Asia.

'The Company' is initially targeting the Australian and Asian markets. They will pursue product sales through entering into partnering and co-development arrangements with third parties that have the scale and commercial reach to market and sell the products when 'The Company' licences the product at the end of successful Phase II clinical trials.

The following market segments have been identified as initial targets:

a.    The disease

b.    Related diseases

c.     Other viruses.

Within each of the above segments, 'The Company' has identified specific potential customers such as Asia with a low-cost pill.

The product offering of a licence will be with made a major pharma at the completion of Phase II clinical trials.

Information provided

You have provided information in a number of documents and phone conversations in relation to 'The Innovation', including:

a.    your private ruling application.

b.    our phone conversation with 'The Contact'.

c.     supplementary information provided.

We have referred to the relevant information within these documents and conversations in applying the relevant tests to your circumstances.

You propose to issue new shares in 'The Company' to sophisticated investors to assist in funding the continued development and commercialisation of 'The Innovation'.

Assumption(s)

N/A

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-40

Further issues for you to consider

N/A

Reasons for decision

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

Question 1:

Summary

'The Company' meets the eligibility requirements of an ESIC under subsection 360-40(1).

Detailed reasoning

Qualifying Early Stage Innovation Company

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'

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)

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 its *100% subsidiaries (if any) 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).

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.

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

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.

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.

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

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 ('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]

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.

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.

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]

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."

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."

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

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

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 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

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

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)

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

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

For the purposes of this ruling, the test time for determining if 'The Company' is a qualifying ESIC will be a particular date during the income year ending 30 June 20XX.

Current year

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

Early stage test

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

As 'The Company' was incorporated on XX/XX/XX, which is within the current income year, subparagraph 360-40(1)(a)(i) is satisfied.

For the income year ended 30 June 20XX, 'The Company's' expenditure totalled $0 which is $1 million or less and subparagraph 360-40(1)(a)(ii) is satisfied.

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

As 'The Company' had no expenses in the prior income year (the 20XX income year) paragraph 360-40(1)(b) is satisfied.

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

As 'The Company's' assessable income in the prior income year (the 20XX income year) is $200,000 or less paragraph 360-40(1)(c) is satisfied.

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

As 'The Company' is privately owned and is not listed on any stock exchange in Australia or a foreign country paragraph 360-40(1)(d) is satisfied.

Conclusion on early stage test

'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.

100 point test

'The Company' has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20XX. 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)

According to 'The Company' 'The Innovation' is the first therapeutic and prophylactic treatment the disease. Although it will initially be targeted at the Australian and Asian markets, 'The Innovation' has been identified as having a wider global addressable market.

''The Innovation' will be the first to offer such a product for licence.

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

'The Company' has taken the following steps in developing 'The Innovation':

a.    Building a Board of Directors and Management Team with experience in developing and commercialising biotechnology products;

b.    Networking through the Board personnel within the medical science community;

c.     Commercial collaboration and partnering with leading pharmaceutical companies that have an active interest in the disease.

d.    Have further programs for other related diseases ready to process once 'The Company's' product hits key milestones for the disease and the process is de-risked;

e.    Entering into partnering and co-development arrangements with third party companies that have scale and commercial reach to market and sell 'The Company's' products;

This has led to 'The Company' developing potential pharma clients.

The timeline provides that 'The Company' expects Phase I clinical testing in XXX 20XX, with a version ready for general release within three to five years.

'The Company' will develop contracts / potential customers to increase direct sales of its licences.

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

'The Company' is genuinely focussed on developing 'The Innovation' for a commercial purpose. 'The Innovation' will be a significantly improved product compared to existing products.

Therefore subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XX until 30 June 20XX or the date when 'The Innovation' has been fully developed, whichever occurs earliest. Once 'The Innovation' 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' expects 'The Innovation' to appeal to many pharmaceutical companies and countries. This aids decision making and is particularly useful when assessing product viability in particular markets.

Through its commercialisation strategy, 'The Company' hopes to foster widespread use of its product by licencing to major pharmaceuticals who have the existing networks to market the product globally.

'The Company' is developing 'The Innovation' themselves and contracting stages of the development to another entity to perform Phase II clinical trials more broadly in other regions. They will make their revenue through licencing the product and further developing similar products to treat other related diseases.

If the commercialisation strategy is successful, this may give 'The Company' the ability to increase sales through the development of further similar products to address major unmet market needs.

Therefore subparagraph 360-40(1)(e)(ii) will be satisfied.

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

'The Innovation' projections provided illustrate the increase in projected sales.

Given that 'The Innovation' will be available globally, it is expected that 'The Innovation' has the potential to successfully scale up its business.

'The Company's strategy for the use of 'The Innovation' will be able to generate increased revenue with its licencing to major pharmaceutical companies. 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's' 'The Innovation' will initially be targeted at the Australian and Asian markets (but is intended for worldwide use. It will be released globally once it gains traction in the initial targeted markets.)

'The Innovation' can be used worldwide by any pharmaceutical company. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region.

'The Company' has demonstrated 'The Innovation' has the 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)

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

a.    a novel first-in-class treatment for the disease

b.    lead candidate shows high efficacy

c.     has both therapeutic and prophylactic potential

d.    is simple, well characterised and easily synthesized

e.    presents a cost-effective pill as compared to high costs associated with a vaccine treatment delivered by injection.

f.      has also shown promise in treating other diseases

Being the first of such 'The Innovation' 'The Company' has the first mover advantage. 'The Company' has demonstrated the potential for 'The Innovation' to have competitive advantages within the 'addressable market' satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles 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 20XX until 30 June 20XX or the date when 'The Innovation' has been fully developed and is ready for sale, whichever occurs earlier.

Foreign Company Test

As 'The Company' was incorporated in Australia it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied.

Conclusion

'The Company' meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until the earlier of 30 June 20XX or the date when 'The Innovation' has been fully developed and is ready for sale, whichever occurs earlier.

[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.