Edited version of private advice

Authorisation Number: 1051707723390

Date of advice: 30 June 2020

Ruling

Subject: Early stage innovation company eligibility

Question

Does the Company satisfy the criteria of an Early Stage Innovation Company (ESIC) pursuant to section 360-40 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following period

1 July 20XX to 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

The Company is a proprietary limited company incorporated and registered in the Australian Business Register.

The Company has no subsidiaries and is not listed on any stock exchange.

The Company has prior year expenses of less than $XXX.

The Company has prior year income of less than $XX.

The Company has researched, designed and developed a unique product (treatment).

The product introduces new innovations that improve the product user experience.

The Company received a grant to assist in the development of the product.

The product is registered as a Trademark.

The product has several patents in Australia and overseas.

The Company has undertaken research and development activities to develop the product.

The Company considers the global market to be vast and to present opportunities for patients to be treated. It has a global application.

There is currently no competition in the local Australian market for development of a similar product and minimal competition overseas.

The Company is seeking approval of the product in Australia initially.

The Company will then seek approval of the product overseas.

Information Provided

You have provided the following documents:

·         copy of the Company's Extract

·         the Company's Financial Statements

·         detailed explanation of the product and its application

·         approval sought from Australian and overseas Authorities

·         Registered Trademarks

·         Australian Patent, and

·         registered with AusIndustry.

·         size of Australian market.

·         milestones and expected timeframes for relevant approvals.

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

Income Tax Assessment Act 1997 section 360-40(1)(e)(i-v)

Reasons for decision

Qualifying Early Stage Innovation Company

All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

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 six income years (the latest being the current year), and across the last three of those income years before the current year 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).

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.

'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 ('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..."

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.

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.

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 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.

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

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

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, whereby it increases its market share or enters into new markets and its existing revenues can be multiplied with a reduced or minimal increase in operating costs.

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 can address 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.

Application to your circumstances

Test time

For the purposes of this ruling, the test time for determining if your 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). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending 30 June 20XX, 20XX and 20XX.

Early Stage Test

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

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

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

In applying the requirements of paragraph 360-40(1)(b), the Company and any of its 100% subsidiaries must have incurred total expenses of $XXX or less in the 20XX income year which is the income year before the current year.

The Company incurred expenses of less than $XXX in the 20XX income year. Therefore, paragraph 360-40(1)(b) is satisfied.

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

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 income year before the current year.

The Company earned assessable income of less than $XX in the 20XX income year. Therefore, paragraph 360-40(1)(c) is satisfied.

No stock exchange listing - 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.

As the Company is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(d) is satisfied.

Conclusion on Early Stage Test

The Company satisfies the Early Stage Test for the 20XX income year as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

The 100-Point Test

The Company has not provided sufficient 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)

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.

The Company has designed and developed a unique product. The product is an alternative to current treatments.

The Company's product has virtually minimal side effects to contemporary treatments.

The Company's product provides for a more cost-effective user experience.

The Company is genuinely focused on developing its product for a commercial purpose. The product is new to the marketplace and allows for further innovations to leverage off. The Company has:

·         undertaken significant R&D activities to develop the product and spent considerably for the past two years on R&D activities

·         the Company has received a grant to assist in the costs of obtaining relevant approvals, and

·         applied for registration of Patents in Australia and overseas.

The Company has shown its product is new or significantly improves what is currently in the marketplace. Therefore, subparagraph 360-40(1)(e)(i) is satisfied.

High Growth Potential - subparagraph 360-40(1)(e)(ii)

The product is expected to have high growth potential in the Australian and overseas markets.

The Company will also strategically expand across Australia and in other overseas markets where the potential for growth is exponential.

Expected patents and first mover advantage globally should ensure a further ability to expand internationally. You are in the process of seeking strategic partnerships overseas.

The Company has demonstrated that it has high growth potential for its product both in Australia and overseas. Therefore, subparagraph 360-40(1)(e)(ii) is satisfied.

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

The Company's Australian facility has the capacity to service the Australian demand and all initial international demand.

Your business model supports easier scalability as demand over time will peak.

Your strategic partnership with an international company will ensure scalability as well as having the potential to close out any later competitors.

The Company has demonstrated that it has the potential to scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) is satisfied.

Broader than Local Market - subparagraph 360-40(1)(e)(iv)

The Company is a first mover in both Australia and overseas. It will be making moves to expand overseas as soon as patents are approved and received.

The partnerships that are created overseas will open doors to more clientele. Centres around Australia. As there is no product of this type available in the world, this product is eagerly anticipated among your community. You expect all Australian States to offer this product once approval has been obtained. The Company has close relationships with overseas countries and will shortly commence trials with commercial interests.

The Company has demonstrated the potential to address a broader than local market. Therefore, subparagraph 360-40(1)(e)(iv) is satisfied.

Competitive Advantages - subparagraph 360-40(1)(e)(iv)

The Company has no direct competition in the Australian market and minimal competition overseas.

A patent is pending in Australia and patents are pending in foreign jurisdictions.

The Company has a first mover advantage which it will be able to maintain once a patent is granted in Australia and patents follow in foreign jurisdictions.

The Company has demonstrated that its product has competitive advantages within its markets. Therefore, subparagraph 360-40(1)(e)(v) is satisfied.

Conclusion on Principles-Based Test

The Company satisfies the Principles Based Test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20XX till 30 June 20XX.

Conclusion

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

[1] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.79.