Edited version of private advice

Authorisation Number: 1051778743711

Date of advice: 10 November 2020

Ruling

Subject: Early stage innovation company

Question 1

For the purpose of applying the early stage test requirements, please describe what value is to be used for "incurred expenses" in paragraph 360-40(1)(b) of the Income Tax Assessment Act 1997 ("ITAA 1997"). Specifically, please outline what the value of the incurred expenses is for settling a liability that was initially intended to be settled by direct deposit but was ultimately settled through the issuing of shares and options.

Answer

Refer to 'Application to your circumstances' section below.

Question 2

Does the Company satisfy the criteria of an Early Stage Innovation Company (ESIC) pursuant to subsection 360-40(1) of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods

1 July 20XX to 30 June 20XX

1 July 20XX to 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts and circumstances

The Company is an unlisted public Australian based company, incorporated in 20XX.

The Company directors are Mr A, Mr B and Mr C.

The Company is the parent company of a group of entities based in numerous countries.

The Company formed a tax consolidated group with Company X in 20XX.

For the financial year ending 30 June 20XX, the Company incurred and earned the following:

a)     Total expenses of $XX

b)     Total income of $XX

For the financial year ending 30 June 20XX, The Company incurred and earned the following:

c)      Total expenses of $XX

d)     Total income of $XX

The Company is an unlisted public company and its equity interests are not listed for quotation in the official list of any stock exchange in Australia or a foreign country.

The Company is developing a new product ("Product"). The product will have superior efficacy compared to other items.

The purpose of developing the product is to provide consumers with another option.

While other alternatives can currently be consumed in several forms, these alternatives have various drawbacks.

The Company currently has the formulation and is now progressing through a program to develop the first prototypes of products.

It is anticipated that the Products will be ready for a technology transfer to a manufacturer within 12 months. Following this, a test will be performed to determine if the levels have remained consistent since the date of manufacture.

Upon completion of the tests the Product can be sold in Australia and in international markets.

The Company's product has been identified as having an international addressable market.

The Company issued shares to investors at various dates in the relevant financial years.

The Company has taken steps to protect its IP rights.

20XX Invoice

The Company was provided services by Trust X during 20XX.

Trust X issued The Company with an invoice in the amount of $XX (incl GST) ($XX (excl GST).

The fee was agreed to be paid through a direct deposit to the Trust X's bank account.

Due to the Company's cash restrictions at the time, the fee was not able to be paid in a timely manner, and the parties subsequently agreed to settle the invoice through the issuance of shares and options in the Company, evidenced by meeting notes.

These shares and options were issued on XX January 20XX.

The issue price used per share when compensating Trust X for the outstanding liability was lower than the share price per the Company's most recent share issuing on XX 20XX.

As a result of the differences in share issue prices, the Company's auditor recommended that the expense be revalued in the company's 20XX financial statements. This was adopted by the company using the last issue price to value the shares, and a valuer to value the options.

These expense revaluations increased the expense amount within the financial statements by $XX, to an amount of $XX.

In completing its 20XX income tax return, the Company claimed the amount of $XX as a deduction, not the expensed amount of $XX. This was on the basis that at the time services were provided, and the invoice issued, it was agreed that the liability would be settled for $XX through a direct deposit. The subsequent settling of this liability at a later date through the issuing of shares and options does not change the fact that the value was $XX (excl GST) at the time the expense was incurred.

Information provided

You have provided a number of documents containing detailed information in relation to the Company's product, including:

e)    Private Binding Ruling ('PBR') Application; and

f)     Responses to further questions provided.

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

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

QUESTION 1

SUMMARY

For the purpose of applying the early stage test requirements, the value of the invoice in the amount of $XX (incl GST) is to be used for "incurred expenses" in paragraph 360-40(1)(b) of the ITAA 1997.

DETAILED REASONING

Under the expense tests in subparagraph 360-40(1)(a)(ii) and paragraph 360-40(1)(b), the company in which an investor is investing must only take into account 'expenses' which have been 'incurred' as at the test time.

In these provisions, 'expenses' are amounts recognised as expenses under general accounting concepts, 'incurred' has the same meaning as for the purposes of the general deduction provisions in section 8-1, and 'test time' means the time immediately after the company has issued shares.

The early stage test includes a requirement that the company issuing the shares, and any of its 100% subsidiaries, incurred total expenses of $1 million or less in the income year preceding the issue of the shares, pursuant to paragraph 360-40(1)(b).

Expenses

The word 'expenses' in the expense tests is not a defined term and so has its ordinary meaning in the context in which it appears. In the context of the early stage investor incentive, a meaning consistent with the general accounting concept of expense is the most appropriate.

Expense ordinarily refers to a 'cost or charge; a cause or occasion of spending'.[1] Spending conveys the notion of using up or consuming resources. In a business or commercial context, expense would not ordinarily be used to describe the purchase price of a capital asset. An interpretation which adopts the commercial meaning of the word is appropriate in the context of legislation concerned with business activities. This is supported by the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, which states:

The ATO's company tax return requires companies to report 'total expenses' at item six as part of the total profit or loss calculation. A Company that has submitted a company tax return in the previous income year must rely on the amount reported in item six for the purposes of this test. Alternatively, if the company was not required to submit a company tax return, it may use the amount corresponding to this item.

The expenses reported at item six of a company tax return are the expense amounts taken from the company's financial statements. The Australian Accounting Standards Board (AASB) Framework for the Preparation and Presentation of Financial Statements defines expenses as:

Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Accordingly, an amount will be an expense where it results in a decrease in the equity of the potential ESIC, otherwise than by way of a distribution to its member.

An implication of this interpretation is that an outgoing that has been properly capitalised, and results in the recognition of an asset under general accounting concepts, is not an expense for the ESIC expense tests. In such a case any outgoing of cash or increase in liabilities will be offset by the recognition of a new asset.

Incurred

The early stage test is only concerned with expenses which have been 'incurred' at the test time. The general law meaning of incurred is the most appropriate.

There is nothing in the ESIC provisions to suggest that incurred in the expense tests means anything other than the usual interpretation of section 8-1, which has already been extensively considered and established by the courts.

An expense for accounting purposes is not necessarily incurred for the purposes of the expense tests. In each case it is necessary to consider whether there is a presently existing liability, having regard to the legal nature of the arrangements in question.

Application to your circumstances

It is evident from the information provided that the Company had the initial intention to settle the invoice by way of direct deposit, and that the issue of shares and options at a later date was a wholly independent event, completely separate from the initial transaction.

This view is supported by the invoice dated, which provides direct deposit details for Trust X for settlement.

Further, meeting notes detail that the parties subsequently agreed to settle the invoice through the issue of shares and options in the Company, given financial restrictions of the company.

We accept the view that the expense is for the invoiced amount which was discharged by way of a later agreement to accept it in the form of shares and options. This does not change the value of the expense liability that the Company was subjected to.

In the circumstances, we accept that for the purpose of applying the early stage test requirements, the value of the invoice in the amount of $XX (incl GST) is to be used for "incurred expenses" in paragraph 360-40(1)(b).

QUESTION 2

SUMMARY

The Company meets the eligibility requirements of an ESIC pursuant to 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 (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 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

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.[2] 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, whereas 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

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.

APPLICATION TO YOUR CIRCUMSTANCES

TEST TIME

20XX financial year

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 20XX. The Company issued shares on various dates in the 20XX financial year. Each date is a 'test time' for the purposes of the tests in section 360-40(1) of the ITAA 1997.

20XX financial year

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 20XX. The Company issued shares on various dates in the 2020 financial year. Each date is a 'test time' for the purposes of the tests in section 360-40(1) of the ITAA 1997.

Current year

20XX financial year

Therefore, for the purposes of subsection 360-40(1) ITAA 1997, 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, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year).

20XX financial year

Therefore, for the purposes of subsection 360-40(1) ITAA 1997, 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, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year).

THE 'EARLY STAGE TEST' - PARAGRAPHS 360-40(1)(A) - (D) ITAA 1997

Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997

20XX financial year

The Company was incorporated in 20XX, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) are satisfied.

20XX financial year

The Company was incorporated in 20XX, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) are satisfied.

Total expenses - paragraph 360-40(1)(b) ITAA 1997

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 income year before the current year.

20XX financial year

The Company has incurred total expenses of less than $1 million in the 20XX financial year. Consequently, paragraph 360-40(1)(b) is satisfied.

20XX financial year

As established in Question 1, the Company has incurred total expenses of less than $1 million in the 20XX financial year. Consequently, paragraph 360-40(1)(b) is satisfied.

Assessable income - paragraph 360-40(1)(c) ITAA 1997

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.

20XX financial year

The Company had total income of $XX in the 20XX financial year. Consequently, paragraph 360-40(1)(c) is satisfied.

20XX financial year

The Company had less than $200,000 assessable income for the 20XX financial year. Consequently, paragraph 360-40(1)(c) is satisfied.

No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997

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.

20XX financial year

As the Company is an unlisted public Australian based company and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(d) is satisfied.

20XX financial year

As the Company is an unlisted public Australian based company and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(d) is satisfied.

Conclusion for Early stage test

20XX financial year

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.

20XX financial year

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' - PARAGRAPH 360-40(1)(E) AND SECTION 360-45

The Company has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the financial years ending 30 June 20XX and 30 June 20XX. The Company are 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) ITAA 1997

Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i) ITAA 1997

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 is developing a new product. The product will have superior efficacy compared to other forms.

The purpose of developing the product is to provide consumers with another method to address the market.

While alternatives can currently be provided in several forms, these alternatives have various drawbacks.

The Company is genuinely focused on developing their Product for an applicable addressable market, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 20XX to 30 June 20XX and 1 July 20XX to 30 June 20XX.

Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997

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

Work already undertaken to develop the Company's Product is as follows:

•         The Company has the formulation

•         The Company is progressing through a program to develop the first prototypes of products

The Company anticipates that the Products will be ready for a technology transfer to a manufacturer within 12 months of the date of this Ruling.

There are a number of steps which are required to be completed into the future, before the Product is considered to be fully developed for commercialisation:

•         Following a technology transfer to a manufacturer, a test will be performed to determine if the levels of ingredients have remained consistent since the date of manufacture

•         Upon completion of the tests, the Product can be sold in Australia and in international markets

The Company is genuinely focussed on developing their Product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 20XX to 30 June 20XX and 1 July 20XX to 30 June 20XX.

High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997

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.

The products have the potential to be high growth products.

The Company has engaged an external firm to develop the its products. This firm has successfully achieved this for another company treating a specific condition.

Total market value forecasts anticipate that this industry will generate significant growth globally.

There is genuine intention to launch the Product beyond Australia, as the Company is focussed on larger, international markets. The Company has a supply agreement with a foreign country. This is then expected to be a steppingstone for providing its future products into other regions.

The Company has demonstrated a high growth potential for their Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period 1 July 20XX to 30 June 20XX and 1 July 20XX to 30 June 20XX.

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

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.

To advance the product with the market, a tangible prototype must first be developed. The Company has engaged an external firm to develop the products. This firm has successfully achieved this for company treating a specific condition.

The Company is unable to provide revenue projections and estimated operating costs for the Product until the prototype is developed and the tech transfer to a manufacturer is complete.

While the product is anticipated to be significantly more advanced than existing products, the Product will need to consider a competitive sale price per item. The determined price will need to reflect the market conditions at the time that the products are available for sale.

The Company has detailed operating costs. It is projected that the production cost will be approximately $XX.

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 periods 1 July 20XX to 30 June 20XX and 1 July 20XX to 30 June 20XX.

Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997

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.

The Company has the mindset of thinking globally.

While Australia will be one addressable market, the Company is focussed on larger, international markets.

The Company already has a supply agreement into a foreign country. This is expected to be a steppingstone for providing its future products into the region, and then into other regions once a trusted brand has been built.

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 period 1 July 20XX to 30 June 20XX and 1 July 20XX to 30 June 20XX.

Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997

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.

The majority of readily available alternatives are supplied in other forms.

Another company in Australia has developed a similar item, however, this is for a specific matter that the Company is not intending to impact with its products.

The Product has various benefits over alternatives.

The Company has taken steps to protect its IP rights.

The Company believes that the unique form and the anticipated competitive price per product will provide it with a superior competitive advantage in the market.

The Company has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period 1 July 20XX to 30 June 20XX and 1 July 20XX to 30 June 20XX.

Comclusion for 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 periods 1 July 20XX to 30 June 20XX and 1 July 20XX to 30 June 20XX.

Conclusion

The Company meets the eligibility criteria of an ESIC under section 360-40 for the periods 1 July 20XX to 30 June 20XX and 1 July 20XX to 30 June 20XX.

[1] Macmillan Publishers Australia, The Macquarie Dictionary Online, www.macquariedictionary.com.au; viewed 30 May 2019.

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