Edited version of private advice

Authorisation Number: 1051852957833

Date of advice: 16 June 2021

Ruling

Subject: Early stage innovation company - principle-based innovation test

Question

Does the Company qualify as an early stage innovation company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 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

1.            A certain medical condition affects humans within a certain age-group, and requires treatment Y. When attempting to treat patients, clinicians can easily make errors, which can cause the patient to die or suffer serious disability.

2.            The Company has developed a medical device ('the Company's device') that provides appropriate feedback to clinicians so they can optimise treatment Y attempts.

3.            The Company:

•                    was incorporated in Australia during the 20XX income year

•                    had no 100% subsidiaries in the 20XX income year

•                    had assessable income of less than $200,000 and total expenses of less than $1 million in the 20XX income year

•                    was not, and will not be, listed on any stock exchange, either in Australia or in a foreign country, at any time during the 20XX income year.

4.            The facts and circumstances for this private ruling are taken from the Company Business Plan ('Business Plan').

5.            The Company's vision and mission statement is to prevent deaths and disabilities from ineffective treatment Y, through making the Company's device available to clinicians throughout the world.

6.            The Company has established relationships with X medical institutions. These medical institutions have experienced clinicians in medical fields X and Z. It is in talks with schools in medical field Z to test the Company's device.

7.            The Company intends to use large medical device manufacturers. The Company has talked to a large medical device company specialising in medical field W devices, who has indicated it would be willing to act as a distributor. The Company is in talks with two local moulders to fabricate the case, and an electronic manufacturer and assembler to assemble the Company's device. The Company will use firms to identify and screen potential medical distributors.

8.            The Business Plan identifies the following customer groups:

•                    medical institution procurement

•                    clinician unit managers

•                    medical institution department heads

•                    independent clinicians

•                    educational institutions (universities and medical schools).

9.            According to the Company's analysis of the market:

•                    there are no medical devices suitable for treatment Y which are currently being widely used for either training clinicians or in actual treatment

•                    there are two current medical field X devices suitable for treatment Y manufactured exclusively for use in research: competitor product A, and competitor product B

•                    there are three medical field X medical devices suitable for treatment Y manufactured for clinical use:

-   competitor product C, which cannot be used to provide feedback to clinicians

-   competitor product D, which is aimed at specialised research groups or clinicians with access to expensive equipment and advanced training, and requires external equipment

-   competitor product E, which requires external equipment.

10.         The Company's device offers points of difference from competitor product C, competitor product D, and competitor product E, because:

•                    it can be used to provide feedback to clinicians

•                    it is designed for all skill levels and does not require specialist training

•                    it does not require expensive external equipment, which also means the clinician is not distracted by having to look away from the patient

•                    it is less bulky and can be deployed quickly

•                    it will be substantially cheaper, and will be priced at less than a Xth of the cheapest competitor (currently the competitor product E).

11.         The Company considers that there is a significant opportunity for 'first mover advantage' (which would make it difficult for competitors to enter the market) because no medical devices are currently used in clinical practice for treatment Y. However, even if competitors introduce alternative products into the market before the Company, it believes that its product has advantages over the competition, and would be effective as a 'fast follower'.

12.         The Company intends to develop low-cost equipment to bring the bill-of-materials and manufacturing costs down, so that the Company's device can be sold to markets in developing/low and middle income countries. The low-cost flow sensor will be applied to updates to the clinical and educational devices to lower the cost of goods sold. The Company may be able to modify the technology, with minimal alterations, to apply it to medical treatment Y for patients in other age groups.

13.         Intellectual Property ('IP') for the Company's device has been developed under contracts with educational institution F (who owns XX% of the IP) and medical institution G (who owns XX% of the IP). The Company has first right to commercialisation of the IP. The Company plans to file a patent application over its ZZZ interface in Australia, Region H and Region I, and has obtained a patentability assessment. The Company will not patent some of its software as competitors may be able to develop a similar product without infringing the patent, or through IP theft. The Business Plan says it will instead rely on maintaining confidentiality, and seeking continual improvement, to protect a competitive edge.

14.         The Company has designed a two-stage market strategy. First, it will develop a device for educational use, and distribute this to educational and medical institutions. Second, it will develop a clinical product, and market this gradually to department heads and clinical unit managers, before potentially expanding to procurement departments if necessary. The goal is to establish a base of users who have been trained on the Company's device, which will generate demand. The Company believes its connections with educational and medical institutions will allow it to develop a reputation for quality, which will lead to early adoption by practitioners, and recognition as the 'standard of care'.

15.         The Company will sell the Company's device both through direct sales, and indirect/channel sales through distributors in regions where it doesn't have a direct presence. While sales for the Company's device will be 'once off', it will have a disposable component which will allow for repeat sales. It is considering offering a 'Software as a Service' offering to complement its educational and clinical devices, which will allow for recurring revenue through a subscription model. The Business Plan says that using indirect distribution channels will allow its core staff to focus on product development.

16.         In the next X to X years, the Company intends to:

•                    develop a clinical medical device and launch it in Australia, Region H, and Region I

•                    develop and implement a software platform for treatment Y data collection and clinical certification

•                    develop a developing/low and middle income country version of the clinical medical device, and introduce it to markets in relevant regions.

17.         The Company's sales projections are consistent with this approach. Sales of educational medical devices will begin to the Australian market in the 20XX and 20XX calendar years, with clinical medical device sales beginning in the 20XX calendar year. The Company will begin selling educational medical devices in the Region H and Region I in the 20XX calendar year, and will begin selling clinical medical devices to these markets in the 20XX calendar years.

18.         The Company is currently both the holding entity and trading entity. However, the Company envisages that it will establish an operating entity to engage in business activities, with the Company holding the business assets.

19.         The Company's personnel include:

•                    Dr J, a consultant and academic in medical field X at educational institution F

•                    Dr K, a clinical engineer and specialist in the performance of medical field X equipment

•                    Dr L, an academic in medical field Z research at educational institution F

•                    Dr M, a consultant neonatologist at medical institution P

•                    N and O, who are PhD candidates at educational institution F, researching in medical field X.

20.         The Company estimates that the market size is:

•                    $X in Australia

•                    $X in Region H

•                    $X worldwide.

21.         The Company's cash flow forecast and sales projections predict that the Company will:

•                    be cash flow negative in the 20XX, 20XX and 20XX calendar years

•                    become cash flow positive in the 20XX calendar year, by generating $X in sales to about $X in expenses

•                    generate almost $X in sales to about $X in expenses in the 20XX calendar year

•                    have sales increase at a faster rate than costs across the 20XX to 20XX calendar years.

22.         By the 20XX calendar year, the Company estimates that it will be making sales of the following amounts to these markets:

•                    over $X for the Australian market

•                    over $X for the Region H market

•                    over $X for the Region I market.

Relevant legislative provisions

Section 360-40 of the Income Tax Assessment Act 1997

Section 6 of the Corporations Act 2001

Reasons for decision

Legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated.

Question

Does the Company qualify as an ESIC under subsection 360-40(1)?

Summary

23.         The Company will qualify as an ESIC in the 2021 income year. It meets the principles-based innovation test in paragraph 360-40(1)(e), and all other necessary requirements in subsection 360-40(1).

Detailed reasoning

Background

24.         Broadly, Division 360 provides a tax offset to entities which make qualifying investments in 'early stage innovation companies' ('ESICs'). One of the relevant requirements is that subsection 360-40(1) applies to the company: see paragraph 360-15(1)(c).

25.         Subsection 360-40(1) will apply to a company if it meets requirements in that provision:

•                    at the test time, it meets at least one of two alternative tests in paragraph 360-40(1)(e): ('collectively, the ESIC tests')

-   it has at least 100 points under section 360-45 ('the 100 points innovation test'), or

-   meets all the requirements in subparagraphs 360-40(1)(e)(i) through 360-40(1)(e)(v) ('the principles-based innovation test')

•                    at least one of three alternative incorporation/business registration requirements ('the incorporation requirements') in paragraph 360-40(1)(a), to the effect that the company was

-   incorporated in Australia within the last 3 income years, the latest being the current year: subparagraph 360-40(1)(a)(i)

-   incorporated in Australia within the last 6 income years, the latest being the current year, and across the last 3 of those income years it, and its 100% subsidiaries (if any) incurred total expenses of $1 million or less: subparagraph 360-40(1)(a)(ii)

-   registered in the Australian Business Register within the last 3 income years, the latest being the current year: subparagraph 360-40(1)(a)(iii)

•                    in the previous income year, the company, and its 100% subsidiaries:

-   incurred total expenses of $1 million or less: paragraph 360-40(1)(b) ('the total expenses requirement')

-   had total assessable income of $200,000 or less: paragraph 360-40(1)(c) ('the assessable income requirement')

•                    at the test time, its equity interests are not listed on a stock exchange: paragraph 360-40(1)(d) ('the non-listing requirement')

•                    at the test time, the company is not a foreign company within the meaning of the Corporations Act 2001: paragraph 360-40(1)(f) ('the domestic company requirement').

26.         The Company has asked whether it meets the principles-based innovation test, so we will consider this test first.

The principles-based innovation test

27.         The principles-based innovation test requirements in paragraph 360-40(1)(e) are that at the test time:

•                    the company is genuinely focussed on developing for commercialisation one or more new, or significantly improved, products, processes, services or marketing or organisational methods: subparagraph 360-40(1)(e)(i) ('the new or significantly improved requirement')

•                    the business relating to those products, processes, services or methods has a high growth potential: subparagraph 360-40(1)(e)(ii) ('the high growth potential requirement')

•                    the company can demonstrate that it has the potential to be able to successfully scale that business: subparagraph 360-40(1)(e)(iii) ('the scalability requirement')

•                    the company can demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business: subparagraph 360-40(1)(e)(iv) ('the broader than local market requirement')

•                    the company can demonstrate that it has the potential to be able to have competitive advantages for that business: subparagraph 360-40(1)(e)(v) ('the competitive advantages requirement').

28.         We discuss and apply each requirement to the Company at paragraphs 29 through 50.

The new or significantly improved requirement: subparagraph 360-40(1)(e)(i)

29.         The Macquarie Dictionary says that meanings of 'new' include:

•                    'of recent origin or production, or having only lately come or been brought into being'

•                    'of a kind now existing or appearing for the first time'

•                    'having only come lately or only now come into knowledge'

•                    'recently arrived or established'.[1]

30.         Meanings of 'improve' include:

•                    'to bring into a more desirable or excellent condition'

•                    'to increase in value, excellence etc.; become better'.[2]

31.         Paragraphs 1.79 to 1.81 of the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 ('the EM'), which introduced Division 360, when explaining the new or significantly improved requirement, say that:

•                    the relevant innovation must be new or significantly improved for the applicable 'addressable market'

•                    the 'addressable market' means the available revenue opportunity or market demand arising from the innovation

•                    the addressable market must be objective and realistic

•                    improvements from customisation, minor extensions or updates to existing products, where these changes are similar to the approach of competitors, are unlikely to satisfy the 'significantly improved' threshold

•                    the 'commercialisation' requirement means the innovation must be developed for the purpose of generating economic value and revenue for the ESIC.

32.         The Company is developing a product: the Company's device. The Business Plan suggests that the goal of developing and selling the Company's device is the Company's primary (if not exclusive) activity. This is clearly a 'genuine focus'. The sales projections within the Business Plan shows a commercial objective to generate revenue from that activity. Therefore, we need to determine if the product is 'new or improved' for the relevant market.

33.         The addressable market is medical and educational institutions and private clinicians, in Australia, Region H, Region I and developing/low and middle income countries.

34.         The Company's device may not be the first treatment Y device, because some similar devices are already used in research. But the Company's addressable market is medical and educational institutions, and private clinicians, rather than medical research centres. Treatment Y devices are not widely used in clinical practice, so the Company's device has the potential to be a 'new' product for the addressable market.

35.         Some competitors are also developing treatment Y devices for clinical use, so it is possible that other devices may establish themselves in the market before the Company. In that event, the Company's device may not be 'new.' However, based on the information provided by the Company, the Company's device will have advantages over the known competitors. For example, the Company's device:

•                    can be used to provide feedback to clinicians about the effectiveness of treatment Y attempts (unlike competitor product C)

•                    does not rely on expensive external equipment

•                    has an intuitive and easy to use system (compared to competitors) so it can be used by clinicians without extensive technical knowledge or training

•                    does not require an external medical device (unlike competitor product D and competitor product E)

•                    is smaller and easy to deploy than all its competitors

•                    is cheaper than all its competitors, and will be priced at one Xth of the cheapest competitor.

36.         The Company can establish clear points of difference over alternative products in affordability and useability, which will allow the Company's device to be used by many more clinicians. We consider those differences go well beyond 'customisation' or 'minor updates', and would be a significant improvement on any existing products.

37.         Therefore, the Company is genuinely focussed on developing a significantly improved product for commercialisation. The Company meets the new or significantly improved requirement.

The high growth potential requirement: subparagraph 360-40(1)(e)(ii)

38.         The EM (at paragraph 1.82) says the high growth potential requirement requires an ESIC to show that it has the potential for high growth within a broad addressable market, and that ESICs should be distinct from typical small to medium enterprises which service a 'single local market.'

39.         The Business Plan suggests that the Company's medical device could potentially be made available throughout the world, for use in treatment Y by medical institutions and clinicians. The Company estimates that the potential market is $X globally. Therefore, we accept that the Company has the potential for high growth within a broad addressable market. It meets the high growth potential requirement.

The scalability requirement: subparagraph 360-40(1)(e)(iii)

40.         The scalability requirement is about demonstrating the potential to successfully scale the business. The EM (at paragraph 1.83) suggests this means the expanding business must be able to have 'operating leverage' as it increases its market share or enters new markets, through multiplying existing revenues while incurring reduced or minimal increases in operating costs. In other words, it is not enough to 'scale up': an ESIC must also have the potential to achieve economies of scale as it scales up.

41.         The Business Plan shows several possible ways in which the Company may achieve economies of scale. For example:

•                    the Company plans to use distributors to reach geographic areas it doesn't have a direct presence in. This suggests it may be able to save costs that would be incurred if it made all of its sales 'direct' (such as hiring more sales staff, or establishing permanent branches in other regions).

•                    the Company intends to use established medical device manufacturers. This suggests it may be able to save costs that would be incurred if it had to develop large scale manufacturing capability itself.

•                    the Company intends to develop a lower-cost version of the Company's device to lower the cost of goods sold, to allow it to be marketed to developing/low and middle income countries. This, together with the distribution strategy, suggests it will be able to access a larger market, making more sales without incurring costs at a greater rate.

•                    the Company may be able to:

-   modify the Company's device to allow it to be used to treat humans in different age groups requiring similar treatment without making substantial changes

-   make repeat sales of disposable components to existing customers

-   develop a 'Software as a Service' subscription service, which will provide an ongoing revenue stream.

These suggest the possibility of an increased revenue stream without incurring substantial extra costs.

42.         Further, the Company's cash flow projections from the 20XX to 20XX calendar years predict that revenue will increase more rapidly than costs over the period. We accept that the Company has the potential to successfully scale the business, so the scalability requirement is met.

The broader than local market requirement: subparagraph 360-40(1)(e)(iv)

43.         The EM (at paragraph 1.84) says that says that the broader than local market requirement doesn't require the entity to have a national, multinational or global market at the test time, simply that it has the capability to be adapted to a national, multinational or global scale in the future.

44.         The Company's device appears to fill a global market gap, because it offers clinicians worldwide with a treatment Y device with significant advantages over competitors. The Company plans to introduce the Company's device to Region H and Region I markets, and developing/low and middle income countries.

45.         We accept that the Company has the potential to address a broader than local market, including global markets, so this requirement is also met.

The competitive advantages requirement: subparagraph 360-40(1)(e)(v)

46.         The EM (at paragraph 1.85) when explaining the competitive advantages requirement says that:

•                    examples of competitive advantage include 'cost' or 'differential' advantage

•                    the competitive advantages must be sustainable

•                    possible measures to evaluate competitive advantage include the level of value for customers, rarity, imitability and substitutability.

47.         The Company's device can be deployed more easily, can be used by a wider range of clinicians lacking specialist training and equipment, and is cheaper than its competitors. Therefore, it has the potential to achieve both cost and differential advantages over its competitors.

48.         Competitive advantages must be sustainable. Arguably, this requirement would not be met if competitors could eliminate competitive advantages by producing a comparable product.

49.         The Business Plan provides some indications that these cost and differential advantages will be sustainable. For example:

•                    the Company has plans in place to protect its IP, by acquiring patents over one component, and strategically not patenting software which might be easily copied. This may allow the Company to maintain technical design advantages over its competitors for a significant period.

•                    the Company has a strategy of targeting educational institutions, to develop demand from clinicians who have been trained on the existing system. This strategy, if successful, may lead to sustainable competitive advantages. For example, even if competitors develop products with similar cost or technical attributes to the Company's device, it seems unlikely that clinicians would switch to a comparable but unfamiliar product.

•                    the Company has personnel with professional and academic experience in relevant fields including medical field X, clinical engineering, and medical field Z, and has established relationships with several educational and medical institutions. This expertise may allow it to improve its product and create new differential advantages over the longer-term. Further, this expertise may help it to establish a reputation or trusted status with clinicians which might prove difficult for competitors to displace, even if competitors produce products which replicate the cost, or technical capabilities, of the Company's device.

50.         We consider that the Company has the potential to establish sustainable competitive advantages, so the competitive advantages requirement is met.

Conclusion on the principles-based innovation test

51.         The Company meets all the requirements set out in subparagraphs 360-40(1)(e)(i) through 360-40(1)(e)(v), so it passes the principles-based innovation test.

52.         Since we consider that the Company passes the principles-based innovation test, we will not address the 100 points innovation test.

Other requirements in subsection 360-40(1)

53.         While the Company passes one of the ESIC tests in paragraph 360-40(1)(e), it still must meet the remaining conditions in subsection 360-40(1): the incorporation/registration, total expenses, assessable income, non-listing and domestic company requirements. We apply these requirements to the Company in the Table.

Table: requirements in subsection 360-40(1), apart from the ESIC tests

54.         Therefore, all the remaining requirements in subsection 360-40(1) are met.

Conclusion

55.         The Company meets all the requirements in paragraphs 360-40(1), including one of the ESIC tests in subparagraph 360-40(1)(e), namely, the principles-based innovation test.

56.         Therefore, the Company qualifies as an ESIC under subsection 360-40(1) for the 2021 income year.

[1] Macmillan Publishers Australia, The Macquarie Dictionary online, www.macquariedictionary.com.au, accessed 9 June 2021.

[2] Macmillan Publishers Australia, The Macquarie Dictionary online, www.macquariedictionary.com.au, accessed 9 June 2021.

[3] Note that broadly, section 6 of the Corporations Act 2001 defines 'foreign company' as a body corporate that is formed or incorporated in an external territory or outside Australia.