Edited version of private advice

Authorisation Number: 1051811366594

Date of advice: 3 March 2021

Ruling

Subject: Early stage innovation company

Question

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 period:

Income year ending 30 June 20X3

The scheme commences on:

1 July 20X2

Relevant facts and circumstances

Company A is an Australian proprietary company that was incorporated during the income year ending 30 June 20X3.

Company A's shares are on issue to individual shareholders. Company A therefore has no ultimate holding company.

Company A has no subsidiaries.

Company A is not listed for quotation on any stock exchange.

Company A commenced its business activities during the 20X3 income year. Its business consists of developing a product.

Company A has incurred expenses in undertaking its business activities.

Company A has not derived any income in the 20X3 income year.

Company A's product is a significantly improved product from other products offered by competitors.

Company A's product has high growth potential.

Company A has an established leadership team that are resourced to scale Company A's business.

Company A's product is transferable to other markets.

Company A intends to engage an in-house sales team to market its product.

Company A expects its activities will become profitable in the 20X5 income year.

Company A does not currently satisfy the 100 point innovation test contained in paragraph 360-40(1)(e) and section 360-45 of the ITAA 1997.

Company A is intending to seek further capital from investors.

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 ITAA 1997 unless otherwise specified.

Qualifying ESIC

Subsection 360-40(1) of the ITAA 1997 outlines the criteria for a company to qualify as an 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) of the ITAA 1997.

Paragraph 360-40(1)(a) Incorporation or registration

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:

•         incorporated in Australia within the last three income years (the latest being the current year); or

•         incorporated in Australia within the last six income years (the latest being the current year), and across the last three income years the company and its 100% subsidiaries incurred total expenses of $1 million or less; or

•         registered in the Australian Business Register (ABR) within the last three income years (the latest being the current income 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.

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

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.

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

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.

Paragraph 360-40(1)(d) Stock exchange listing

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.

Paragraph 360-40(1)(e) 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

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 of the ITAA 1997. 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

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) of the ITAA 1997 are:

•         the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation,

•         the business relating to that innovation must have high growth potential,

•         the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation,

•         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

•         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. 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, 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 a particular date during the income year ending 30 June 20X3.

Current year

For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20X3. For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years will include the years ending 30 June 20X3, 20X2 and 20X1.

Early stage test

Paragraph 360-40(1)(a) Incorporation or registration

Company A was incorporated during the income year ended 30 June 20X3, which is within the last three income years. Therefore, subparagraph 360-40(1)(a)(i) is satisfied.

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

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 20X2 income year which is the income year before the current year.

Company A has no subsidiary companies and incurred total expenses of less than $1 million in the 20X2 income year as its business operations did not commence until the 20X3 income year. Therefore, paragraph 360-40(1)(b) is satisfied.

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

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 income year before the current year.

Company A had no assessable income in the 20X2 income year. Therefore, paragraph 360-40(1)(c) is satisfied.

Paragraph 360-40(1)(d) Stock exchange listing

Company A must not be listed on any stock exchange in Australia or a foreign country at the test time.

As Company A 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

Company A satisfies the Early Stage Test for the 20X3 income year as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

100 point test

Company A does not currently satisfy the 100-point innovation test under section 360-45 for the income year ending 30 June 20X3. Accordingly, for Company A 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

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 market.

Company A is developing a new product that is a significant improvement on existing products in the market. Company A is genuinely focused on developing its product for commercialisation.

Company A 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

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

Scalability

Company A 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

Company A has demonstrated the potential that it can operate in an overseas market. Therefore, subparagraph 360-40(1)(e)(iv) is satisfied.

Competitive advantages

Company A 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

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 20X2 to 30 June 20X3.

Conclusion

Company A meets the eligibility criteria of an ESIC under section 360-40 of the ITAA 1997 for the period 1 July 20X2 to 30 June 20X3.