Edited version of private advice

Authorisation Number: 1051960916842

Date of advice: 20 April 2022

Ruling

Subject: Early stage innovation company

Question

Does Company A meet the criteria of an Early Stage Innovation Company (ESIC) under 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 a proprietary company incorporated in XYZ on z ZZ 20ZZ.

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

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

Company A has a wholly owned subsidiary named Company B. Company A holds the Intellectual Property ('IP') and Company B eventually becomes the trading company. Company A is not part of an income tax consolidated group.

For the financial year ending x XX 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 process to produce a particular product for domestic and export markets (the 'Process').

Company A is commercialising Company C's XXX Process, which is a process for extraction of this particular product.

Around x% of this particular product is made via the YYY Process, which is a particular process, producing an estimated y tonnes of CO₂ per tonne of the particular product produced.

The remaining y% of global production is produced via an alternative process, which produces an estimated y tonnes of CO₂ per tonne of the particular product produced.

The XXX Process is entirely different from both the YYY Process and the alternative process. The XXX Process consumes x% less energy than current processes, with a path to zero emissions, which neither of the other two processes have.

XXX is a completely different chemical path to produce the particular product as compared to YYY and the alternative process.

Company A is significantly improving the process to be continuous, and ready to be commercially scalable.

Company A has the objective to be the cornerstone of an advanced manufacturing industry and to help power growth and to on-share the product processing.

Currently, Australia does not produce any of this particular product, but relies on another country for supply.

Company A has already secured reserves of this particular product. The essential product produced by Company A will be produced using the only independently validated scalable alternate processing method to the YYY process, which today accounts for over x% of the world's production of this particular product.

The new and innovative process by Company A is aimed to create this particular product's production process by 20ZZ.

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

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

Company A has issued a number of shares to various investors between XX 20XX and YY 20YY. Company A hopes to issue new shares soon to raise further funds to build the continuous scale plant.

Information provided

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

•           Private Binding Ruling ('PBR') Application, dated x 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.

You propose to issue new shares in Company A to various investors to assist in funding the continued development and commercialisation of the Process.

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.

SUMMARY

Company A meets the eligibility requirements of an ESIC under 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 any 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 any 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 any 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 20ZZ 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 z ZZ 20ZZ, 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 20XX income year, being the income year before the current year.

Company A incurred expenses of $xyz 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 assessable income of $xyz 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 process to produce a particular product for domestic and export markets (the 'Process').

Company A is commercialising Company C's XXX Process, which is a process for primary extraction of a particular product using a particular nozzle.

Around x% of this particular product is made via the YYY Process, producing an estimated x tonnes of CO₂ per tonne of particular product produced.

The remaining x% of global production is produced via the alternative process, which produces an estimated x tonnes of CO₂ per tonne of particular product produced.

The XXX Process is entirely different from both the YYY Process and the alternative process.

Company A is significantly improving the process to be continuous, and ready to be commercially scalable.

Company A has the objective to be the cornerstone of an advanced manufacturing industry and to help power growth and to on-share this particular product's processing.

Currently, Australia does not produce any of this particular product, but relies on another country for supply.

Company A has already secured reserves of this particular product. The essential product produced by Company A will be produced using the only independently validated scalable alternate processing method to the YYY process, which today accounts for over x% of the world's production of this particular product.

The new and innovative process by Company A is aimed to create this particular product's production process by 20ZZ.

Company A is genuinely focussed on developing their Process 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), 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 has undertaken the following work to develop their Process for a commercial purpose:

•           Prior to 20ZZ - Company B developed the prior version of the Process

•           20ZZ - XX 20XX - Company A commenced conceptual work on the demand response aspect of production

•           YY 20XX - Company A commenced preliminary design of the continuous version, which will be a significant improvement of the batch version.

Presently, Company A is building the continuous plant, and developing the Process into a continuous process that can be scaled to commercial production scales.

There are a number of steps which are required to be completed into the future, before the Process is considered to be fully developed for commercialisation:

•           The Process will need to be proven to be continuous

•           The Process will then be scaled to a commercial scale

•           Q4 20YY - Proof of commerciality with continuous process pilot plant

•           Q1 20TT - Construction of first commercial scale module.

Company A anticipate that the current programme of development will be completed in the 20TT financial year.

Company A's Process is protected by a global patent that covers all major markets.

Company A is genuinely focussed on developing their Process for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 20YY, or the date when their Process has been fully developed and is ready for client use, whichever occurs earlier. Once the Process has been fully developed, Company A will no longer be 'developing' the Process for commercialisation.

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 high growth potential as their Process is easily and infinitely scalable to a global audience.

Company A's technology in a commercial plant will be the first of its kind, which is currently the only independently validated scalable alternate processing method to the YYY process.

Company A has already been contacted by major brands elsewhere in the world for their technology, indicating its growth potential.

A large corporation has reached out and Company A have an executed NDA with discussions ongoing. Another company has also signed an NDA and detailed a willingness to debt fund to expand production.

The fact that Australia relies on another country for supply of this particular product also confirms that there is domestic growth potential. The particular product produced by Company A has potential to be used in various products.

Company A has demonstrated a high growth potential for their Process, 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.

Company A currently has a small scale plant in XX. Company C support, international interest, and independent reviews validate the technology. The technology is not yet proven at large scale, however there are no technology barriers to scale which confirms Company A has potential to successfully scale up the business successfully, without incurring any additional costs per unit of production.

Company A is in a position that they anticipate over xxx tonnes of this particular product will be produced per year by 20SS. As a result, any increase in production required will not affect any fixed costs associated with production, and the company has indicated that costs of production will not fluctuate as a result of any increases in production per unit.

Company A is anticipating that an uptake in demand and are fully prepared to manage this and all costs associated with this. They have support from other companies and the facilitation office.

Company A's technology is a global step-change processing technology in the production of this particular product and has a global competitive advantage in price, supporting that they will be able to up scale the business.

Company A have retained the right staff, who successfully built a similar business in XYZ.

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.

The production of the of this particular product has massive potential globally, with interest already shown by companies from across the world.

Government Department A have indicated that a number of countries wish to purchase all of this particular product from non-belt road countries.

As a result, Company A has the potential to service a broader than local market and to adapt its business to access global markets. Company A has had inquires for over zzz tonnes per annum in production.

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 technology and plants being created will provide a competitive advantage, as it has potential to produce this particular product's production, separating them from other competitors in this market.

The technology is exclusively patented globally to expire in 20TT. Demand is unquenchable at present for a different geographic source of this particular product produced by Company A.

The other processes are using variants of the YYY process. The product produced by Company A is essential for clean technology applications. They have also required inputs for advanced manufacturing supply chains, including defence and security technologies, consumer electronics, agriculture, medical applications, and critical infrastructure.

Company A's technology is a global step-change processing technology in the production of this particular product which has a global competitive advantage in price and emissions.

Company A has demonstrated that it has competitive advantages for its business, 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, or the date when their Process has been fully developed and is ready for client use, whichever occurs earlier.

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

As Company A was incorporated in Australia, 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 20XXto y YY 20YY, or the date when their Process has been fully developed and is ready for client use, whichever occurs earlier.

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