Edited version of private advice

Authorisation Number: 1051785163669

Date of advice: 1 December 2020

Ruling

Subject: Early stage innovation company

Question 1

Does Company A 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

This ruling applies for the following periods

1 July 20XX to 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

Company A is a proprietary company incorporated and registered in the Australian Business Register in State C on z ZZ 20ZZ.

Company A's directors are Taxpayer A and Taxpayer B.

Company A has no ultimate holding company and no subsidiaries.

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

a.    Total expenses of $xyz

b.    Total income of $xyz

Company A's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.

Company A has engaged with Company B under an Intellectual Property Licence Agreement which grants Company A an exclusive licence for the purpose of commercialising the relevant Intellectual Property('IP').

Company A is developing IP based on, and in addition to, the licenced IP.

Company A is developing and commercialising a number of technologies (the 'Products').

Company A's Products currently being developed are called the ABC Products. The ABC Products are a small product that meets customer demand for access to these products today, to prepare customers for the market tomorrow. The ABC Products are an internationally unique product.

Company A's aim is to develop products that are able to be operated simply and effectively, with simple hardware, to provide capability that outperforms classical products with similar capabilities.

Company A has issued a number of ordinary shares in the 20ZZ/XX financial year and 20XX/YY financial year and there are currently no plans to issue any further shares in the 20XXYY1 financial year.

Company A's Products have been identified as having an international addressable market and Company A is continuing to develop their Products.

Information provided

You have provided documents containing detailed information in relation to Company A's Products, including:

a.    Private Binding Ruling ('PBR') Application, dated x XX 20xx

b.    Additional information - Company background, financials

c.     Responses to various emails seeking further information

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

You propose to issue new shares in Company A to various investors to assist in funding the continued development and commercialisation of the Product.

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:

Summary

Company A 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.[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, 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

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

For the purposes of this ruling, the 'test time' for determining if Company A 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 20YY, that is, within the 20XX/YY financial year.

Current year

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

Company A was registered in the Australian Business Register (ABR) on z ZZ 20ZZ, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(iii) are satisfied.

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

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

Company A incurred a total of $xyz in expenses in the 20XX income 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), Company A and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20XX income year, being the income year before the current year.

Company A earned a total of $xyz in assessable income in the 20XX income 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), Company A must not be listed on any Stock Exchange in Australia or a foreign country at the test time.

Company A is not listed on any Stock Exchange in Australia or a foreign country at the test time, so paragraph 360-40(1)(d) is satisfied.

CONCLUSION FOR EARLY STAGE TEST

Company A satisfies 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.

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

Company A has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20YY. Company A 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), Company A must be developing an innovation which is either new or significantly improved for an applicable addressable market.

Company A is developing and commercialising a number of technologies (the 'Products').

Company A's Products currently being developed are called the ABC Products. The ABC Products are a small product that meets customer demand for access to these products today, to prepare customers for the market tomorrow. The ABC Products are an internationally unique product.

Company A's aim is to develop products that are able to be operated simply and effectively, with simple hardware, to provide capability that outperforms classical products with similar capabilities.

Company A's secret competitive advantage lies in their particular technology which is based on particular properties preserved at a particular temperature.

Company A has undertaken work to develop a functional prototype of their ABC Products. This prototype has been built over the past x years. Ther prototype is deeply interesting to leaders in this field, leading to a research collaboration with an overseas company.

Further development work is continuing on their Product, and Company A anticipates that their Product will be fully developed within the next xy months.

Company A is genuinely focussed 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 20YY.

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), Company A must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company.

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. It is anticipated that the following steps will be completed in the next xx months:

•         Design components and combine this design with off-the-shelf hardware

•         Test & design specification

•         Develop control systems

•         Prepare components & designs for manufacturing and testing

It is anticipated that the following steps will be commenced within xx months, and completed within yy months:

•         Build the Products

•         Prepare detailed documentation for the product manufacturing procedure

•         Commercial Development through technical collaboration with early customers as Company A refines its Product

Globally, Company A is the only company commercialising these particular products. Their ability to do so is protected by a patent on product design, and IP on the long-term scalability.

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

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

In applying the requirements of subparagraph 360-40(1)(e)(ii), Company A must be able to demonstrate that it has the potential for high growth within a broad addressable market.

Company A has extremely high growth potential as the Product is easily and infinitely scalable to a global audience.

Company A has completed extensive research and has concluded that their product is projected to be a $xy market by 20AA, and $yz by 20BB.

The particular market is experiencing unprecedented demand in the global market, having grown from $zy in 19CC. Current figures show an explosive growth in a very short timeframe.

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

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

In applying the requirements of subparagraph 360-40(1)(e)(iii), Company A must be able to demonstrate that it has the potential to successfully scale up the business.

The Executive team, consisting of Taxpayer A, Taxpayer B and Taxpayer C, has international expertise and proven experience with successfully scaling up companies. They are considered experts in their field.

Company A will exhibit operating leverage as it enters new global markets. Based on current projections, upon commercialisation of the products, revenues will be multiplied year on year with a relatively lower rate of increase of operating costs.

This operating leverage ensures that Company A has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period 1 July 20XX to 30 June 20YY.

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

In applying the requirements of subparagraph 360-40(1)(e)(iv), Company A must be able to demonstrate that it has the potential to address a broader than local market, including global markets.

Company A is preparing an immediate 'Go to Market' strategy, with strategic customers based in a number of countries around the world. There is a growing customer pipeline in these markets.

The product market is proven to improve economic success and innovation, and this is why investments in these products have accelerated globally.

Company A will aim to increase its market share and to enter into new markets globally, and its existing revenues will be multiplied.

Since commencing development, Company A has had the mindset of thinking globally.

Globally, Company A are the only company commercialising these particular products. Their ability to do so is protected by a patent on the ABC Products, and IP on the long-term scalability of these products.

Company A is looking at global markets projected for 20ZY.

Company A 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 20YY.

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

In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must demonstrate that it has the potential to be able to have competitive advantage for that business.

Company A has provided information which identifies that its Products have a competitive advantage by outlining the competitive landscape, illustrating where their Products lie in relation to their competitors' products:

Company A's product supremacy solves useful problems which are generally unsolvable by any classical means.

Company A 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 20YY.

CONCLUSION FOR PRINCIPLES BASED TEST

Company A satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period 1 July 20XX to 30 June 20YY.

Conclusion

Company A meets the eligibility criteria of an ESIC under section 360-40 for the period 1 July 20XX to 30 June 20YY.

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