Edited version of private advice

Authorisation Number: 1051929777225

Date of advice: 2 December 2021

Ruling

Subject: Early stage investors in innovation companies

Question

Is Company X Pty Ltd ('Company X') an Early Stage Innovation Company ('ESIC') under subsection 360-40(1) of the Income Tax Assessment Act 1997, for the 20XX and 20XX income years?

Answer

No, for the 20XX income year.

Yes, for the 20XX income year.

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

Company X is a private company which was incorporated in Australia and registered in the Australian Business Register during the 20XX income year.

Company X has a wholly owned subsidiary, Subsidiary Y Pty Ltd ('Subsidiary Y').

Company X and Subsidiary Y formed a tax consolidated group on XX July 20XX.

Company X and Subsidiary Y incurred total expenses of about $x (item 6 of 20XX ITR) in the income year before the current year. This included $y of accounting expenditure which was claimed as notional deductions under section 355-205 (R&D expenditure).

Company X and Subsidiary Y had a total assessable income of $z (item 6 of 20XX ITR) in the income year before the current year

We extract information from Company X's company tax return for the 20XX income year in Table 1.

Table 1. Company X's company tax return for the 20XX income year

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

Company X issued shares on 3 dates in the 20XX income year: Date A, Date B and Date C. Details in Table 2. Date B was roughly 6 months after Date A. Date C was roughly 3 months after Date B.

Table 2. Company X shares issued in the 20XX income year

Details about each shareholder, their relationship to Company X, and percentage shareholding are in Table 3.

Table 3: shareholder details at Date A, Date B and Date C

Company X issued more shares to other entities during the 20XX income year.

Company X correctly reported its tax obligations in its income tax return for the 20XX income year. This includes notional deductions under Division 355 (for R&D expenditure).

Company X did not have associates during 20XX income year.

All shares Company X issued during the 20XX income year were ordinary shares, carrying equal rights to votes, dividends and capital.

During the 20XX income year dividend rights were contingent on the directors declaring dividends.

Relevant legislative provisions

Section 360-40 of the Income Tax Assessment Act 1997

Section 360-45 of the Income Tax Assessment Act 1997

Reasons for decision

Question

Is Company X Pty Ltd ('Company X') an Early Stage Innovation Company ('ESIC') under subsection 360-40(1) for the 20XX and 20XX income years?

Summary

Company X qualifies as an ESIC for the 20XX income year, but not for the 20XX income year. Broadly:

•         for the 20XX income year, Company X didn't have points under Item 3 (about R&D expenditure in the previous year), because it didn't incur R&D expenditure in 20XX. It only had XX points under Item 5 (about investments from non-associates), for two out of the three issue dates.

•         for the 20XX income year, Company X qualifies under the XXX points innovation test in paragraph 360-40(1)(e), because it will have XX points each under Item 3 and Item 5.

Detailed reasoning

Overview of the eligibility requirements for the ESIC tax offset

Broadly, Division 360 provides a tax offset to entities which make qualifying investments in ESICs. Some of the requirements are that:

•         a company issues the investor with shares that are classified as equity interests at a particular time in the income year: paragraph 360-15(1)(b)

•         subsection 360-40(1) applies to the company immediately after that time: paragraph 360-15(1)(c).

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):

­  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 in paragraph 360-40(1)(a), 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)

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

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

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

Company X submits that it meets the 100 points innovation test. We will address this test first.

The 100 points innovation test

Section 360-45 allocates points to a company for meeting requirements (listed in a table in that section). A company will have points if it meets those requirements at a particular test time. We summarise the items in section 360-45 in Table 3.

Table 3 - items in section 360-45 (summarised)

Many items aren't relevant to Company X. There is no evidence that Company X:

•         entered any accelerator program for entrepreneurs (Items 2 or 4)

•         has standard patent, innovation patent, registered design or similar rights (Items 6 and 7)

•         has an agreement with a research body (Item 8).

We apply the remaining Items (1, 3 and 5) to Company X for both the 20XX and 20XX income year.

Items 1 and 3: did Company X have qualifying R&D expenditure in the previous year?

Items 1 and 3 may apply where a company incurred R&D expenditure in the previous income year. The relevant innovation criteria:

•         Item 1: At least 50% of the company's total expenses for the previous income year is expenditure that the company can notionally deduct for that income year under section 355-205 (about R&D expenditure).

•         Item 3: At least 15%, but less than 50%, of the company's total expenses for the previous income year is expenditure that the company can notionally deduct for that income year under section 355-205 (about R&D expenditure).

To meet either Item, the company must have expenses which qualified as notional deductions for the R&D tax incentive in section 355-205, in the previous income year.

Company X has correctly reported all items in its 20XX income year, including R&D expenditure. We have accepted as facts, without determining, that:

•         Company X registered R&D activities with Ausindustry for the 20XX income year

•         the activities Company X registered with Ausindustry qualified as core R&D activities or supporting R&D activities under Division 355

•         the $z Company X recorded as R&D expenditure were correctly claimed as notional deductions under Division 355.

For the 20XX income year:

Company X cannot meet either Item 1 or 3 in 20XX, because it was registered in the same income year. For 20XX, the previous income year would be the 20XX income year. Company X didn't incur any expenses in the 20XX year because it didn't exist. Therefore, it couldn't have had R&D notional deductions either. Company X couldn't meet either threshold. It couldn't have spent at least 15% (or 50%) of its total expenses on R&D expenditure.

For the 20XX income year:

Company X will meet Item 3 in the 20XX income year. For 20XX, the previous income year would be the 20XX income year. According to its 20XX company tax return, Company X had $x in total expenses, which included $z in R&D expenditure. $z is roughly 20% of $x. More than 15%, but less than 50%, of Company X's total expenses for the 20XX income year were notional deductions under section 355-205. Company X meets Item 3 for the 20XX income year.

Item 5: has more than $50,000 had been paid by non-associates at the relevant test times?

The requirements in Item 5 need to be met at the time when the shares are issued to the relevant ESIC claimant:

•         one of the requirements for the ESIC offset is that the company qualifies as an ESIC 'immediately after' the time it issues the shares: see paragraphs 360-15(b) and 360-15(c)

•         the ESIC qualification rules apply to a company 'at a particular time', known as the 'test time': see subsection 360-40(1)

•         the 100 points innovation test also applies at the 'test time': see subsection 360-45(1).

We need to apply the 100 points innovation test to Company X for all relevant issue dates. For the 20XX income year, this will be Date A, Date B, and Date C. (As discussed in Table 4, Company X will meet Item 5 at all times in the 20XX income year.).

Company X met the criteria in Item 5 on two out of the three share issues in the 20XX income year:

•         Broadly, Item 5 applies where at least $XXX has been paid for shares, and those shares were issued to non-associates, at least one day before the relevant test time.

•         Company X couldn't meet this test on the first issue date (Date A) because no shares had been issued before that time.

•         However, it did meet this test on the second and third issue dates, because $XXX worth of Company X's shares had already been issued.

•         The share recipients on the first issue date weren't Company X's associates at or around that point.

We describe and apply the relevant innovation criteria in Item 5 in more detail in Table 4.

Table 4: Innovation criteria in Item 5

Shares in Company X are equity interests

Division 974 contains rules for classifying interests as 'equity' or 'debt'. Very broadly:

•         A scheme gives rise to an equity interest if it passes the equity test, but isn't also classified as a debt interest: subsection 974-70(1).

•         A share in a company will pass the equity test: see Item 1 in subsection 974-75(1).

•         An interest will be classified as debt if it creates an 'effectively non-contingent' obligation for an entity to provide a financial benefit at least equal to the value it receives: see subsection 974-20(1).

•         An obligation is non-contingent if it is not contingent on an event, condition, or situation other than the entity's willingness to meet an obligation: subsection 974-135(3).

•         The mere issue of an equity interest is not a financial benefit: subsection 974-30(1).

The relevant shares will be classified as equity interests for tax purposes. All Company X's shares issued in the 20XX income year were ordinary shares, carrying equal rights to votes, capital and dividends. They pass the equity test because they are shares in a company. They aren't classified as debt interests. Ordinary shares entitle a shareholder to receive dividends and capital distributions. However, that will only happen if Company X has assets available for distribution, and those payments are authorised by the company's directors. In other words, the financial benefits are contingent on Company X's economic performance, and the director's dividend decision. There is no non-contingent obligation for Company X to pay dividends or make distributions before the directors declare them.

Company X had no associates immediately before the relevant issue time

Company X won't pass Item 5 to the extent shares were issued to its associates.

Associates of a company include 'controlling entities' which have a sufficient influence over it. 'Associate' has the meaning given by section 318 of the Income Tax Assessment Act 1936 (ITAA 1936). Subsection 318(2) lists entities which are associates of a company (known as the primary entity). Relevant paragraphs are 318(2)(d) and 318(2)(e), which broadly cover:

•         another entity or another company (a controlling entity)[1], where the primary entity is 'sufficiently influenced' by that controlling entity

•         a controlling entity holding a majority voting interest in the primary entity.

Broadly, paragraph 318(6)(b) of the ITAA 1936 says that a company will be sufficiently influenced by another entity if it:

•         acts

•         is accustomed or under an obligation to act

•         might reasonably be expected to act

in accordance with the other entity's directions, instructions or wishes.

Under corporate law, a company is created, together with its members and officeholders, on registration. Relevant provisions in the Corporations Act 2001:

•         a company comes into existence at the beginning of the day on which it is registered: section 119

•         people become members or directors on registration if they are specified in the application: subsection 120(1)

•         shares to be taken up by members as specified in the application are taken to be issued on registration: subsection 120(2).

Company X did issue more than $XXX in shares to recipients who weren't its associates immediately before the issue for two reasons. First, the relevant time is arguably immediately before Company X existed, or had shareholders. Second, Company X's original shareholders weren't associates, even considering their future influence after the share issue.

To elaborate on the first reason, Company X can't have had associates at the relevant time because it didn't exist.

•         In determining whether Company X has associates, we need to consider whether any entities have majority control or sufficient influence, immediately before those shares were issued. As a company, Company X is controlled by its directors. Its directors are appointed by shareholders. Absent special circumstances (such as third parties exercising de facto control), we expect that its shareholders would be potential entities who could exercise either majority control or sufficient influence.

•         The combined effect of sections 119 and 120 of the Corporations Act 2001 is that a company will come into existence, appoint its first directors, and issue shares to its first members, on registration.

•         Company X was registered and issued its first shares on Date A. Immediately before that time, Company X didn't exist.

•         Company X couldn't have had majority controllers, or any entities capable of exercising sufficient influence, at a time when it didn't exist or have shares.

Even if the reasoning in paragraph 37 isn't correct,[2] Company X would meet subparagraph (b)(i) in Item 5 regardless. It had no associates during the 20XX income year. Therefore, it still wouldn't have had associates even it was possible for a company to have associates at the relevant time.[3]

We don't need to determine whether Company X had associates at later times. Item 5 only requires that at least $XXX in shares were issued to entities who weren't associates immediately before that share issue. Once Company X has met that test, it is irrelevant if those, or other entities, became its associates later. Company X met Item 5 by the second and third test times in the 20XX income year. It would have also met Item 5 at any test time in the 20XX income year.

Company X will have XX points under Item 5 from XX January 20XX onwards. That applies to the second and third issue dates in the 20XX income year, and the entire 20XX income year.

Conclusion on the 100 points innovation test

Company X won't meet the XXX points innovation test in the 20XX income year. It will have XX points under Item 5 for the second and third issue dates. However, it won't have points under any other Item. It won't meet Item 3 because it had no R&D expenditure in the previous (20XX) income year.

Company X will meet the XXX points innovation test in the 20XX income year. It will have XX points each under Items 3 and 5 for the entire year.

Principles-based innovation test

The principles-based innovation test requirements in paragraph 360-40(1)(e) are that at the test time, the company meets five requirements:

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

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

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

We don't have enough information to determine whether Company X met the principles-based innovation test during either the 20XX or 20XX income years. Company X didn't make any submissions on the principles-based innovation test.

Other requirements in subsection 360-40(1)

Company X must also 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 Company X in Table 5.

Table 5: requirements in subsection 360-40(1), apart from the ESIC tests

Therefore, all the remaining requirements in subsection 360-40(1) are met for the 20XX income year.

Conclusion: Company X is an ESIC

Company X meets the criteria of an ESIC under subsection 360-40(1) for the 20XX income year, but not the 20XX income year:

•         Company X didn't qualify for the 20XX income year, because it didn't incur qualifying R&D expenditure during the 20XX income year. It didn't meet Item 3.

•         For the 20XX income year, Company X meets all the requirements in paragraphs 360-40(1), including one of the ESIC tests in subparagraph 360-40(1)(e), namely, the 100 points innovation test. It had 50 points each under Item 3 (R&D expenditure in the previous year), and Item 5 (investment by non-associates).

[1] The provisions are more broadly drafted, with the general effect that they extend to cover some cases where the controlling entity, together with other entities (such as its own associates) controls or sufficiently influences the primary entity.

[2] We can think of two possible arguments why a company could still have associates for Item 5 purposes on an initial share issue. First, perhaps for an initial share issue, the time 'immediately before they were issued' should be understood (by implication) to apply to the first time at which the company existed and had issued shares. Second, the 'associate' test, even if applied before the shares were issued, might be broad enough to consider the potential influence that the proposed shareholders and directors would be expected to hold after that time. We don't need to determine these arguments.

[3] If adopting the first argument in footnote 3, immediately after the share issue, or if adopting the second argument, immediately before the share issue.

[4] 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.