Edited version of private advice

Authorisation Number: 1051955366945

Date of advice: 4 March 2022

Ruling

Subject: Early stage innovation company

Question 1

As part of the requirements for entitlement to the tax offset under section 360-15 of the Income Tax Assessment Act 1997 (ITAA 1997), did The Company satisfy the requirements of subparagraphs 360-40(1)(e)(i) to (v) immediately after it issued shares to The Taxpayer?

Answer

Yes.

Question 2

Is the Company an affiliate of the Investor for the purposes of section 328-130 and section 360-15(1)(d) of ITAA 1997 for the relevant period?

Answer

No.

This ruling applies for the following period

Year ended 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

Background

The Company is an Australian resident proprietary limited company.

The Company is a specialised developer of technology.

The Investor is a trust.

The Investor has subscribed for ordinary shares in The Company during the Relevant Period.

The Investor does not carry on any business activities. Any income is primarily from passive investment.

The Investor has access to information regarding innovation features of products and processes of the Company. For the relevant period, the investor provided information outlining:

•         The Company is developing a product and details of its development.

•         The Company is developing their products to address a number of discrete markets and is continuing to develop their products.

•         The Company products have been identified as having an international addressable market.

•         The Company has identified that it has the ability to rapidly expand its business.

•         The Company has identified its product has competitive advantage over similar product.

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 360-30

Income Tax Assessment Act 1997 section 360-35

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 section 360-45

Income Tax Assessment Act 1997 section 328-130

Reasons for decision

Question 1

Summary

As part of the requirements for entitlement to the tax offset under section 360-15 of the Income Tax Assessment Act 1997, the Company satisfies the requirements of subparagraphs 360-40(1)(e)(i) to (v) immediately after each time it issued shares (the Subject Shares) to the Investor.

Detailed reasoning

Entitlement to Early Stage Innovation Company tax offset

Section 360-15 sets out the requirements for entitlement to the early stage investor tax incentives for various entities. Subsection 360-15(1) provides that an entity may be entitled to a tax offset for an income year if certain requirements are satisfied. In particular, paragraph 360-15(1)(c) requires that subsection 360-40(1), regarding early stage innovation companies, applies to the company immediately after the time an entity is issued shares in that company.

If the investor is a trust, special rules in subsections 360-15(2) and 360-15(3) apply so that entitlement to the tax offset flows through to the member of the trust, or to a trustee of a trust, able to apply the early stage investor tax offset to a tax liability.

Subsection 360-15(2) applies as if the trust was an individual that would be entitled to the tax offset available under subsection 360-15(1). Section 360-30 determines the amount of the tax offset members of the trust are entitled to for the income year.

Subsection 360-15(3) applies as if the trustee of a trust was an individual that would be entitled to the tax offset available under subsection 360-15(1) and the trustee is liable to be assessed or has been assessed for tax on some or all of the trust's net income. The trustee's liability must be assessed under section 98, 99 or 99A of the Income Tax Assessment Act 1936. Section 360-35 determines the amount of the tax offset the trustee of the trust is entitled to for the income year.

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.

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:

           iv.        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

            v.        the business relating to that innovation must have a high growth potential

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

          vii.       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

         viii.       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.

Application to your circumstances

Test time

For the purposes of this ruling, the test time for determining whether the Company satisfies the criteria under paragraphs 360-40(1)(e) (i) to (v) is each time shares were issued by the Company to the Investor.

You have only asked whether the criteria within paragraphs 360-40(1)(e) (i) to (v) were met at the time shares were issued.

To qualify as an ESIC, the early stage test and the innovation test must be satisfied. However, this ruling only considers whether the principle based innovation test has been met and does not consider whether The Company meets all the necessary criteria of an ESIC or whether you meet the other investor requirements.

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), the Company must be developing an innovation which is either new or significantly improved for an applicable addressable market.

It is reasonable to conclude that the Company was genuinely focussed on developing products and processes for an applicable addressable market.

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), the Company must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company.

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

It is reasonable to conclude that the Company was genuinely focussed on developing their Products for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the Relevant Period.

High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997

In applying the requirements of subparagraph 360-40(1)(e)(ii), the Company must be able to demonstrate that it has the potential for high growth within a broad addressable market.

It is reasonable to conclude that the Company demonstrated a high growth potential for their Products so subparagraph 360-40(1)(e)(ii) is satisfied for the Relevant Period.

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

In applying the requirements of subparagraph 360-40(1)(e)(iii), the Company must be able to demonstrate that it has the potential to successfully scale up the business.

It is reasonable to conclude that the Company had the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the Relevant Period.

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

In applying the requirements of subparagraph 360-40(1)(e)(iv), the Company must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets.

It is reasonable to conclude that the Company demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied for the Relevant Period.

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

In applying the requirements of subparagraph 360-40(1)(e)(v), the Company must demonstrate that it has potential to be able to have competitive advantages for that business.

It is reasonable to conclude that the Company demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the Relevant Period.

CONCLUSION FOR PRINCIPLES BASED TEST

The Company satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the relevant period.

Question 2

Summary

The Company is not an affiliate of the Investor for the purposes of section 328-130 and section 360-15(1)(d) of ITAA 1997 for relevant periods.

Detailed reasoning

Background section 360-15

Members of partnership or trust -entitlement to offset

Subsection 360-15(2) states that a member of a trust is entitled to a tax offset for an income year if the trust would be entitled to a tax offset, under subsection (1), for the income year if the trust were an individual.

Trustees- entitlement to offset

Subsection 360-15(3) applies in situations where the trustee is liable to be assessed or has been assessed, and is liable to pay tax, on a share of, or all or a part of, the trust's net income under section 98, 99 or 99A of the Income Tax Assessment Act 1936 for the income year.

If the trustee is liable to pay tax under one of the above provisions then the trustee is entitled to a tax offset for an income year if the trust would be entitled to a tax offset, under subsection 360-15 (1), for the income year, if the trust were an individual.

Individual's entitlement to offset -section 360-15(1)

An individual is entitled to the offset if:

•         at a particular time during the income year, a company issues the individual with equity interests that are shares in the company;

•         the company was an ESIC immediately after the shares were issued;

•         neither the company or the individual is an affiliate of each other when the shares were issued;

•         the issue of those shares is not acquired under an employee share scheme; and

•         immediately after the shares were issued, the individual didn't hold more than 30% of the equity interests in the company or in an entity connected with the company.

Affiliate

The meaning of affiliate is set out in section 328-130. An individual or company is an affiliate of an entity where that individual or company acts, or could reasonably be expected to act:

•         in accordance with the entity's directions or wishes in relation to the affairs of that individual or company's business; or

•         in concert with the entity in relation to the affairs of the individual or company's business.

Subsection 328-130(2) states that an individual or company is not your affiliate merely because of the nature of the business relationship you and the individual or company share.

The following factors may have a bearing on whether an individual or company is an affiliate of an entity to the extent that they show that two or more entities are acting in concert:

•         family or close personal relationships;

•         financial relationships or dependencies;

•         relationships created through links such as common directors, partners, or shareholders;

•         the degree to which the entities consult with each other on business matters; or

•         whether one of the entities is under a formal or informal obligation to purchase goods or services or conduct aspects of their business with the other entity.

In normal circumstance a trust cannot be an affiliate of a company. However, in examining 360-15(1) we are treating the trust as if it was an individual.

The Investor does not carry on any business activities. Any income that the Trust does derive is primarily from passive investments such as dividends and interest income.

Therefore, there is no evidence that leads to a conclusion that the Investor is acting or could reasonably be expected to act in accordance with the direction and wishes of the Company. Similarly, there is no evidence that leads to a conclusion that the Company is acting or could reasonably be expected to act in accordance with the direction and wishes of the Investor.

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