Edited version of private advice

Authorisation Number: 1051804000929

Date of advice: 1 March 2021

Ruling

Subject: Early stage innovation company

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 period:

Year ending 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

Company X was incorporated in Australia and registered in the Australian Business Register on xx October 20xx.

Company Y is a wholly owned subsidiary of Company X.

Company X and Company Y formed a tax consolidated group on xx October 20xx, with Company X as the head company and Company Y as the sole subsidiary member.

In the previous year, year ended 30 June 20xx, Company X and Company Y had total expenditure of less than $1,000,000.

In the previous year, year ended 30 June 20xx, Company X and Company Y had total income of less than $200,000.

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

The company that intends to issue equity to investors is Company X. No equity will be issued in Company Y.

IP Assignment and Licence Deed

An IP Assignment and Licence Deed (Deed) was executed on xx xxx 20xx between Company X and Company Y.

The Deed includes that Company Y agrees to assign all of its rights, title and interest in and to the IP to Company X on the terms and conditions of the deed. Company X agrees to licence the IP to Company Y on the terms and conditions of the deed.

Product

Company Y, on behalf of Company X, has built an innovative product in its targeted market. The product's ultimate market will be the global market, with its initial target being Australian markets as well as some other foreign markets.

Company X, through Company Y, has identified its addressable market

Information provided

We have referred to the relevant information within the following documents in applying the relevant tests:

•         Private Ruling Application dated xx

•         Product Overview

•         A Commercial Offer from a partner xx

•         Product Program dated xx

•         A technical infrastructure document

•         IP Assignment and Licence Deed executed xx.

We have also referred to information provided via email and phone conversations in applying the relevant tests.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 section 360-45

Reasons for decision

Summary

Company X 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 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.

In determining the company's assessable income, any amount of Accelerating Commercialisation Grant that the company received in that year can be disregarded.

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 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 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.

The Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 ('EM') does not define the meaning of the term 'genuinely focussed' within the context of subparagraph 360-40(1)(e)(i). Genuine is defined in the online Macquarie Dictionary as "Being truly such; real; authentic." Focus is defined as "3. a central point, as of attraction, attention, or activity. ... 8. to concentrate; to focus one's attention." In essence, the phrase "genuinely focussed" is looking to what the company is truly concentrating and focussing their attention on or, put another way, what is the real central point of the company's activities.

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 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, 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 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.

Application to your circumstances

Test time

For the purposes of this ruling, the test time for determining if Company X is a qualifying ESIC will be a particular date during the income year ending 30 June 20xx. Company X will be the company in the Company structure from which equity is issued. Company X has entered into an IP Assignment and Licence Deed to allow Company Y to develop the Application of its behalf. Under the Deed Company X retains all current and future rights, title and interest in and to the IP.

Current year

For the purposes of subsection 360-40(1), the current income 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 three income years will include the years ending 30 June 20xx, 20xx and 20xx, and the income year before the current year (the prior income 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 Company X was incorporated on xx October 20xx, which is within the last three income years, paragraph 360-40(1)(a) is satisfied.

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

As Company X and Company Y had expenses of $1 million or less in the prior income year, paragraph 360-40(1)(b) is satisfied.

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

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

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

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

Conclusion on early stage test

Company X will satisfy the early stage test for the 20xx income year, as each of the requirements within subparagraph 360-40(1)(a) to (d) have been satisfied.

100 point test

Company X has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 2021. For Company X to be a qualifying ESIC it will need to satisfy the principles-based test.

Principles based test

Developing new or significantly improve innovations for commercialisation - subparagraph 360-40(1)(e)(i)

Company X states that it is pioneering a significant change in a specific industry. Company Y, on behalf of Company X, has created a product that is bespoke in its targeted market.

New, or significantly improved, products, processes, services or marketing or organisational methods - subparagraph 360-40(1)(e)(i)

The product combines common products of a specific industry into one. Part of a product is a mobile application with certain features. It is explained that technology behind the product that allows the combined products to run smoothly as one is the bespoke feature of the product.

Company X, through Company Y, has planned that its initial product roll-out will be in Australia, and a number of other foreign countries. However, with the exclusive commercial deal with a global partner, the product is planned to be launched in markets around the world.

Conclusion

Based on the facts presented, we consider that the product will be a new, or significantly improved product compared to other products of the specified industry currently commonly used within the initial target markets.

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

A working version of the product is in test mode and the product is being tested and refined. The product's core technology is already built. Successive Features are currently planned to be added.

1.     The Product launch will have two key stages:

•         launch of up to 100 participants.

•         a public launch.

We recognise that at the time of the period under consideration, Company X through the IP Assignment and Licence Deed, are allowing Company Y to undertake a number of actions and activities evidencing or indicating its intention to develop the product for commercialisation, including having:

•         undertaken market research

•         developed full marketing plans and prepared documents including Product Guide

•         engaged engineers and undertaken development up to the stage of a test version

•         executed IP Assignment and Licence Deed between Company X and Company Y

•         entered a commercial deal with a global partner.

Conclusion

Based on the facts presented, we consider that Company X has satisfied the 'genuinely focussed on developing for commercialisation' requirement under subparagraph 360-40(1)(e)(i).

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

Based on the facts presented, we consider that the product will be a new, or significantly improved product compared to other products within the specified industry currently commonly used within the initial target markets.

Based on the facts presented, we consider that Company X has satisfied the 'genuinely focussed on developing for commercialisation' requirement under subparagraph 360-40(1)(e)(i).

Therefore, Company X satisfies subparagraph 360-40(1)(e)(i) for the period during the test time.

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

Company X, through Company Y, has developed a product that has wide applications and appeals as a genuine alternative solution to the products offered by the mainstream well established stakeholders within a specific industry.

Company Y's growth forecast has been agreed with their partners such as the aforementioned partner, and the commercial deal entered between Company Y, on behalf of Company X, and the partner have been agreed based on the high growth forecast.

Company X has demonstrated that its product has high growth potential and evidenced it through the commercial deal entered by Company Y on behalf of Company X with its partners. Therefore, subparagraph 360-40(1)(e)(ii) is satisfied.

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

With its growth forecasts and trajectory, Company Y, on behalf of Company X, has built the business model that caters and deals with this scale. It includes the product structure and economics, the operations supporting the product and the technology that is in place to deliver certain solutions.

Company X, through Company Y, has built full marketing plan that has been developed to cover multinational rollouts for the product, starting with Australia and a number of other foreign countries.

Therefore, Company X has demonstrated that subparagraph 360-40(1)(e)(iii) is satisfied.

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

Company X stated that its product will be rolled out in Australia, and several other foreign countries.

Company X's product aims to be a genuine alternative of common products within a specific industry worldwide. Company Y's global partnership with a partner, on behalf of Company X, also demonstrates Company X's intentions on global markets.

Company X has demonstrated that the product has the potential to address a broader market than just the Australian market, including global markets. Therefore, Company X has demonstrated that subparagraph 360-40(1)(e)(iv) is satisfied.

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

Company X states competitive advantage for its business includes:

•         core intellectual property on the structuring and operations of the product;

•         key partnerships identified to deliver product and customer experience;

•         economic advantage in offering the product (relative to incumbents who are protecting their product based profitability);

•         rollout plan; and

•         partnership with a significant stakeholder which will assist in driving localisation across multiple markets.

Further, Company X's product will also have competitive advantage of first mover advantage, unique product insight, proprietary technology and bespoke technology.

Company Y's commercial deal, on behalf of Company X, is an exclusive deal which in turn there will be no deal with a similar product.

Company X has demonstrated that it has the potential to have competitive advantages within the product's relevant market. Therefore, Company X has demonstrated that subparagraph 360-40(1)(e)(v) is satisfied.

Conclusion on principles based test

Company X, through Company Y, satisfy the principles based test as all requirement within subparagraph 360-40(1)(e) has been satisfied for the period within the Test time.

Conclusion

Company X meets the eligibility criteria of an ESIC under section 360-40(1) for the period of income year ending 30 June 20XX.

[1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76.