Edited version of private advice

Authorisation Number: 1051932209967

Date of advice: 10 December 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') for the period x XX 20XX to y YY 20YY?

Answer

Yes.

This ruling applies for the following periods

x XX 20XX to y YY 20YY

The Scheme commences on

x XX 20XX

Relevant Facts and Circumstances

Company A is an Australian proprietary company incorporated in XYZ on x XX 20XX.

Company A's directors are Taxpayer A, taxpayer B and Taxpayer C.

Company A's registered office and principal place of business is situated at XYZ.

Company A has no wholly or partly owned subsidiaries. Company A is not part of an income tax consolidated group.

For the financial year ending y YY 20XX, Company A incurred and earned the following:

•         Total expenses of $xyz

•         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 is developing a food product, which will be the first entirely Australian sourced and produced product of its type in the industry (the 'Product').

Currently, 100% of this food type to support the food category in Australia is imported. The growing industry presents a significant opportunity for an Australian manufacturing ecosystem and strong export capability.

Company A has based its first system on an ingredient, due to the availability of raw materials in Australia, as well as the ingredient's ability to have a superior texture compared to other popular products. However, as Company A expand to other food products in the near future, they will develop partnerships back to the field to further strengthen the domestic supply chain.

Company A has undertaken significant product development, resulting in a product far superior to competitors in the existing market.

Company A has developed an IP strategy that includes both patenting its innovative Product and the use of trade secrets as and when they are developed.

Company A has entered a collaboration with another company to share R&D resources and provide manufacturing facilities to the company until the pilot facility is ready for use in late 20YY.

Company A has also successfully secured an investment commitment from the corporate venture arm of a major retailer and is to be an ingredients supplier into the retailer's private label product range as well as distributing Company A's products globally through their ingredients trading business.

Company A's immediate target customers are food brands and ingredient manufacturers in the domestic market. Company A has secured three food brands interested in their products. These customers will continue to use Company A long term as a key component of their products.

An investment platform has also committed to Company A's seed round, with a venture capital fund contributing a significant investment. Company A have also selected a small number of angel investors with backgrounds in high growth technology, believed to bring industry knowledge and expertise that will further assist them.

Over the next decade, Company A believe the global market for this food product will be $XYZ and domestically in Australia $XX. In the past few years, these food products have shifted from a niche category to mainstream and have begun to operate in the large and global food product industry.

Company A is currently developing a pilot manufacturing plant that will be operational by ZZ 20ZZ. Due to its small production capacity and immediate focus being on product development, Company A will initially focus on delivering its products to just the domestic market.

Between 20YY and 20ZZ, Company A aims to identify high priority export markets. By 20TT the company aims to expand to the international market through direct expansion or through the licensing of its IP. The initial areas of focus include but are not limited to the Country A, Country B, and Country C.

Company A's Product has been identified as having an international addressable market.

Information provided

You have provided a number of documents containing detailed information in relation to Company A's Product, including:

•           Private Binding Ruling ('PBR') Application, dated y YY 20YY

•           Response to further questions provided

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

Company A have issued a number of shares in YY 20YY and are currently raising a small additional capital round via a convertible note and expect a larger round to be raised in late 20ZZ.

Assumption(s)

Not applicable.

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

Further issues for you to consider

Not applicable.

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) for the period x XX 20XX to y YY 20YY.

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 (v)

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 - subparagraph 360-40(1)(e)(i) ITAA 1997

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 - subparagraph 360-40(1)(e)(ii) ITAA 1997

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

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, 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.

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

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

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.

Foreign Company test - paragraph 360-40(1)(f)

At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001 (Cth).

The dictionary in section 9 of the Corporations Act 2001 (Cth) defines a foreign company to mean:

(a) a body corporate that is incorporated in an external Territory, or outside Australia and the external Territories, and is not:

(i) a corporation sole; or

(ii) an exempt public authority; or

(b) an unincorporated body that:

(i) is formed in an external Territory or outside Australia and the external Territories; and

(ii) under the law of its place of formation, may sue or be sued, or may hold property in the name of its secretary or of an officer of the body duly appointed for that purpose; and

(iii) does not have its head office or principal place of business in Australia.

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 x XX 20XX, and on or before y YY 20YY.

Current year

Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending y YY 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 y YY 20YY, 20XX and 20VV, and the income year before the current year will be the year ending x XX 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 incorporated in XYZ on x XX 20XX, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) 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 2020 income year, being the income year before the current year.

Company A incurred $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 $xyz in 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 y YY 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 a food product, which will be the first entirely Australian sourced and produced product of its type in the industry (the 'Product').

Currently, 100% of this product type to support this food category in Australia is imported. The growing industry presents a significant opportunity for an Australian manufacturing ecosystem and strong export capability.

Company A has based its first protein system on an ingredient, due to the availability of raw materials in Australia, as well as the ingredient's ability to have a superior texture compared to other popular products. However, as Company A expand to other food products in the near future, they will develop partnerships back to the field to further strengthen the domestic supply chain.

Company A has undertaken significant product development, resulting in a product far superior to competitors in the existing market.

Company A's Product outperforms its competitors in the market and is uniquely positioned as the only Australian grown and made food product of its type. The Product, made from xyz, has a superior texture and taste to the current products used in the market by Australian food brands.

Company A's Product is differentiated across three key aspects - texture, taste and local chain supply.

Work already undertaken by Company A to develop their Product includes the following:

•           Stage 1: Prototype (XX 20XX - YY 20YY). Company A's team developed the recipe and process for a food product which was produced through low moisture extrusion at Company B. In YY 20YY, Company B's machine was relocated to the Company A site where work was continued on improving the texture and appearance of the prototype to achieve target success protocols.

•           Stage 2: Commercial Trials (YY 20YY - ZZ 20YY). Prototype development aided in the preparation of recipes and process settings to test in the commercial trials stage. The commercial trials were conducted on the same machine that was ordered for the pilot scale manufacturing facility.

•           Stage 3: Downstream Validation (ZZ 20YY - VV 20YY). To validate the commercial viability of the food product developed in the commercial trials, a set of sensory protocols and recipes were developed to evaluate the food products in their relevant applications.

Company A has developed an IP strategy that includes both patenting its innovative Product and the use of trade secrets as and when they are developed.

Company A is developing their food product to address a number of discrete markets and is continuing to develop their Product.

Company A is genuinely focussed on developing their Product, a food product, for an applicable addressable market, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 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.

Company A is currently developing their product for commercialisation by using a particular system. Following the staged process outlined above, work is being performed to develop the prototypes to test the hypotheses against the success protocols and inform the commercial trial design.

Following the commercial trials, the products are evaluated against sensory test protocols and texture analysis. If the products meet the success protocols, they will be progressed to downstream validation where they will be further tested.

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, as follows: Company A now has three fully developed commercial products which make up one third of the projected product portfolio over the next x months. Over the next x to y months, it is expected that new product stock-keeping units (SKUs) will be added to the product range and further improvement will be conducted on the products already fully developed.

Company A anticipate that the current programme of development will be completed by the end of the 20ZZ financial year.

Company A's strategy and tangible steps taken over the past x months demonstrate a genuine focus on the commercialisation of a significantly improved and new product.

Company A is genuinely focussed on developing their Product, a food product, for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 20YY. Once the Product has been fully developed, Company A will no longer be 'developing' the product for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied.

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.

Australian food brands of this type are increasingly being invited to export their products globally due to their high quality and innovative design as the global category grows.

Additionally, a leading Australian grocery group has committed a significant investment into Company A's seed round via its venture capital arm. This investment from the retailer will accelerate and increase international distribution, supplier terms, category insight, property expertise and overall customer sales.

Company A's diverse production process will also enable localised manufacturing, which can be achieved through direct expansion or licensing of IP. Through this strategy, Company A aims to expand into the international market in 20TT and subsequent years.

Company A has demonstrated a high growth potential for their Product, a food product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period x XX 20XX to y YY 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.

Since launching, Company A has devised an extensive strategy for rapid growth to be observed in both operations and revenue in the future. Company A's expansion strategy is split into three phases, as follows:

•           Phase 1: Phase 1 will occur between 20YY and 20ZZ and focus on advancing the product portfolio and establishing a pilot facility.

•           Phase 2: Phase 2 will commence between 20VV and 20SS. This phase will involve further expansion of the product portfolio and R&D capabilities.

•           Phase 3: Phase 3 will commence in 20TT, whereby forecasts assume that full capacity will be achieved within the 20RR financial year with potential annual turnover reaching $xy.

Company A validates these sales projections through the $xyz investment from three companies and the significant investment commitment from the corporate venture arm of a major retailer as discussed above.

Additionally, potential accounts in XYZ have been identified as target customers for Company A's food product. Through the above expansion strategies and its scalable platform, Company A has the operating leverage to successfully scale up its business.

This 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 x XX 20XX to y YY 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 be able to address a broader than local market, including global markets.

Company A's diverse production system and extensive expansion plans, focusing on its product development and quality, make it clear that foreign expansion is imminent once Phase 3 of their commercialisation strategy has taken place.

In addition to shifting consumer trends, global population and wealth growth across Region A, in particular, is driving a significant increase in forecasted consumption.

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 x XX 20XX to y YY 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 potential to be able to have competitive advantage for that business.

The manufacturers currently supplying downstream customers are typically only offering one food type that is often tied to their upstream operations. As the industry and supply chain matures, customer demand is likely to require a variety of food types and blends that meet the varied nutrition and taste preferences in markets around the world.

Company A will sustain its competitive advantage by continuing to develop products consisting of different food products.

Additionally, Company A will be the first Australian origin, premium food product supplier designed for this particular food type market. Currently, all Australian food brands must import their food products of this type and this supply chain is severely strained due to a global shortage.

In addition to helping to build and secure a local supply chain in Australia, Company A will be offering an opportunity for food brands to be 100% Australian made. Company A's food product will be manufactured locally for true sustainability.

Company A has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period x XX 20XX to y YY 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 x XX 20XX to y YY 20YY.

Foreign Company Test - subparagraph 360-40(1)(f) ITAA 1997

As Company A was incorporated in XYZ, it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied.

CONCLUSION

Company A meets the eligibility criteria of an ESIC under section 360-40 for the period x XX 20XX to y YY 20YY.

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