Edited version of private advice

Authorisation Number: 1051981255817

Date of advice: 10 May 2022

Ruling

Subject: Early stage innovation company qualification

Question

Does the Company 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 capital raisings that occur in the income year ended 30 June 20XX while the Innovation is in development?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Company was incorporated in Australia and has no subsidiaries.

The Company is an Australian technology company.

The Company's equity interests are not listed for quotation in the official list of any stock exchange (and will not be listed on any stock exchange before 1 July 20XX).

The Company had incurred expenses of less than $1 million in the three previous income years to the 20XX income year.

The Company's assessable income was less than $200,000 in the income year prior to the 20XX income year.

The Innovation

The Company is designing and developing the Innovation.

There is currently no solution in the market that provides all of the functionality that is proposed by the Innovation.

Intellectual Property

As part of the development of the Innovation, the Company has engaged with a patent attorney to assist with applying for an innovation patent for the Intellectual Property that the Company will hold.

Market & growth potential

The Company has identified its ultimate market as being the global market, with its targeting of both Australian and International markets.

The Company has provided statistics for the industry market showing the forecast compound growth rate for the sector.

Product progress

The Company has a working Minimum Viable Product and prototype.

Commercialisation strategy

The Company is initially targeting the domestic market.

The Company has identified several industries for its product. The main sectors identified will be targeted first.

Once traction has been gained, the Company expects the global market will also be an area of high growth potential.

The marketing and sales team will complete marketing campaigns targeting early adopters that are predicted to bring the most value.

The Company has already engaged with local business.

After engaging with early adopters, the Company has a number of marketing pathways it will utilise. This includes providing incentives for users to market the Innovation to others.

Pricing model

The Company has prepared budgets and forecast pricing models for the Innovation and its revenue streams.

Following the initial design and development of the Innovation, the cost of production of the Company's offerings will reduce. As market demand increases, revenues will multiply with reduced operating costs per service.

The Company has developed a partnership model to assist in significantly scaling the business.

Competitive advantages

The key differentiators of the Innovation to current solutions in the market have been provided.

The Company's board and management team are highly experienced and have extensive expertise across the industry.

Seeking Investment

The Company will seek investment to design and develop its Innovation.

The Company is seeking assurance that it will qualify as an ESIC under the ITAA 1997 for the issue of new shares in the Company during the year ended 30 June 20XX.

Information Provided

Documents in respect of the Innovation being developed by the Company were provided and the relevant information within these documents was used in applying the relevant tests to the Company's circumstances, including:

• Business Model
• Concept documents
• Information Memorandum
• Prototype Scope Report
• Development rights to IP

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 Section 360-40

Reasons for decision

Question

Does the Company 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 capital raisings that occur in the income year ended 30 June 20XX while the Innovation is in development?

Summary

Yes. The Company meets the eligibility requirements of an ESIC under subsection 360-40(1) of the ITAA 1997.

Detailed reasoning

Qualifying Early Stage Innovation Company

Subdivision 360-A of the ITAA 1997 outlines the tax incentives that are available to investors in Early Stage Innovation Companies (ESICs) where they satisfy the relevant conditions.

Investors who purchase shares in an ESIC may be eligible for the following tax incentives:

• A tax offset for their investment in the company
• Concessional CGT treatment that may reduce any capital gain on the disposal of their shares in future

Critical to determining whether the ESIC tax incentives are available to investors is confirming whether the company qualifies as an Early Stage Innovation Company (ESIC).

Section 360-40 of the ITAA 1997 outlines the criteria required for a company to qualify as an ESIC. 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.

Test time

The criteria required for a company to qualify as an ESIC are measured at a particular time in an income year. This time is referred to as the "test time". The test time is determined by virtue of section 360-15 of the ITAA 1997 which outlines the eligibility criteria for investors seeking to obtain the ESIC tax offset. Specifically, the "test time" is determined by paragraphs 360-15(b) and (c) to be the point in time immediately after the relevant new shares are issued by the company to the investor.

The Company is looking to raise capital to commercialise the Innovation in the income year ended 30 June 20XX. Accordingly, for the purposes of this ruling, the "test time" for determining if the Company is a qualifying ESIC will be a particular date during the income year ending 30 June 20XX.

Qualifying tests

To qualify as an ESIC, the Company must satisfy the following tests:

1. The Early Stage Test, and
2. One of the following two tests:
   1. The Objective (100 point) Test, or
   2. The Principles-Based Test.

The Company has approached the Commissioner to confirm that the Company is a qualifying ESIC on the basis of satisfying the Early Stage Test and the Principles-Based Test.

The Early Stage Test

The Early Stage Test requirements are outlined by subsection 360-40(1) of the ITAA 1997, within paragraphs (a), (b), (c), (d) and (f). These requirements are considered below.

Incorporation or Registration - paragraph 360-40(1)(a)

To meet the requirement in paragraph 360-40(1)(a) of the ITAA 1997, at a particular time (the test time) in an income year (the current year) the company must have been either:

1. Incorporated in Australia within the last three income years (the latest being the current year); or
2. 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
3. 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) of the ITAA 1997 with reference to the "test time". The "current year" is the income year in which the Company issues shares to the investor, being the income year ended 30 June 20XX.

The Company was incorporated on Date X, which is within the last 6 income years for test times that occur within the 30 June 20XX income year.

The Company had expenses of less than $1 million in the three previous income years to the 20XX income year.

Subparagraph 360-40(1)(a)(ii) of the ITAA 1997 will be satisfied for capital raisings that occur in the 30 June 20XX income year.

Total expenses - paragraph 360-40(1)(b)

To meet the requirement in paragraph 360-40(1)(b) of the ITAA 1997, the company and its 100% subsidiaries must have incurred total expenses of $1 million or less in the income year before the current year.

The Company had expenses of less than $1 million in the 30 June 20XX income year. Accordingly, paragraph 360-40(1)(b) of the ITAA 1997 will be satisfied for capital raisings that occur in the 30 June 20XX income year.

Assessable income - paragraph 360-40(1)(c)

To meet the requirement in paragraph 360-40(1)(c) of the ITAA 1997, 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.

For the purposes of this paragraph, subsection 360-40(2) of the ITAA 1997 disregards any of the following:

(a)  An Accelerating Commercialisation Grant under the program administered by the Commonwealth known as the Entrepreneurs' Programme.

(b)  An amountrequired to be included in the company's assessable income undersubsection 355-450(1).

The Company's assessable income for the income year ended 30 June 20XX was less than $200,000.

Paragraph 360-40(1)(c) of the ITAA 1997 will be satisfied for capital raisings that occur in the 30 June 20XX income year.

No stock exchange listing - paragraph 360-40(1)(d)

To meet the requirement in paragraph 360-40(1)(d) of the ITAA 1997, at the test time the company must not be listed on any stock exchange in Australia or a foreign country.

The Company is privately owned and at the test time is not listed on any stock exchange in Australia or a foreign country. It will not be listed on any stock exchange before 1 July 20XX. Accordingly, paragraph 360-40(1)(d) of the ITAA 1997 is satisfied.

Not a foreign company - paragraph 360-40(1)(f)

To meet the requirement in paragraph 360-40(1)(f) of the ITAA 1997, the company must not be a foreign company within the meaning of the Corporations Act 2001.

The dictionary in section 9 of the Corporations Act 2001 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.

The Company was incorporated in Australia. Accordingly it is not a foreign company and therefore paragraph 360-40(1)(f) of the ITAA 1997 is satisfied.

Conclusion Early Stage Test

The Company will satisfy the Early Stage Test for the income year ended 30 June 20XX as each of the requirements within paragraphs 360-40(1)(a), (b), (c), (d) and (f) of the ITAA 1997 will be satisfied.

Principles-Based Test

To satisfy the Principles-Based Test, the company must meet the five requirements outlined in paragraph 360-40(1)(e) of the ITAA 1997.

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) of the ITAA 1997, are outlined below. For simplification, the phrase "one or more products, processes, services or marketing or organisational methods" will be referred to as "the innovation".

1. The company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation
2. The business relating to that innovation must have a high growth potential
3. The company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation
4. 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
5. The company must demonstrate that it has the potential to be able to have competitive advantages for that business.

The requirements are tested at the "test time", being the point in time immediately after shares are issued by the company to the investor. As outlined above, the test time could be at any time during the income year ended 30 June 20XX.

For completeness we note that there is a specific exclusion in subsection 360-40(3) of the ITAA 1997 which says that the Principles-Based Test criteria in paragraph 360-40(1)(e) of the ITAA 1997 cannot be satisfied for an innovation that is of a kind prescribed by regulations made for the purposes of this subsection. Paragraph 1.75 of the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (EM) explains that this subsection provides ongoing flexibility should the Government wish to more tightly target the ESIC tax incentives in the future or if the incentive is being used for inappropriate purposes. There are currently no regulations made for the purposes of subsection 360-40(3) of the ITAA 1997 and accordingly no exclusions will apply to the Innovation developed by the Company.

i.              Developing new or significantly improved innovations for commercialisation

The first requirement of the Principles-Based Test, as outlined in subparagraph 360-40(1)(e)(i) of the ITAA 1997, is that the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation.

The Innovation being developed by the Company is a product innovation.

New or significantly improved

The innovation must be new or significantly improved. In order to determine whether a potential innovation is something new, or is a significant improvement to something that already exists, the EM clarifies that it must be compared to the products, services, processes or methods that may or may not exist in the intended market for the innovation. This requires identification of the market (referred to as the addressable market) and the products already in existence.

"New" means novel to or introduced to the addressable market for the first time, whereas "significantly improved" means having a significant degree of improvement in relation to the addressable market but excludes minor changes or improvements. Customising existing products or minor changes resulting from software updates, pricing strategies or seasonal changes are all examples of improvements that would not be considered significant.

The EM references the Oslo Manual (published by the Organisation for Economic Co-operation and Development (OECD)) in paragraph 1.76 under the Principles-Based Test. It references the Oslo Manual as providing a description of the different types of innovations that are new or significantly improved.

In regards to "new" innovations, the Oslo Manual states at paragraphs 136 and 137:

A technologically new product is a product whose technological characteristics or intended uses differ significantly from those of previously produced products. Such innovations can involve radically new technologies, can be based on combining existing technologies in new uses, or can be derived from the use of new knowledge.

The first microprocessors and video cassette recorders were examples of technologically new products of the first kind, using radically new technologies. The first portable cassette player, which combined existing tape and mini-headphone techniques, was a technologically new product of the second type, combining existing technologies in a new use. In each case the overall product had not existed before.

In regards to "significantly improved" innovations, the Oslo Manual states at paragraph 138:

A technologically improved product is an existing product whose performance has been significantly enhanced or upgraded. A simple product may be improved (in terms of better performance or lower cost) through use of higher-performance components or materials, or a complex product which consists of a number of integrated technical sub-systems may be improved by partial changes to one of the sub-systems.

The Company has identified its addressable market as being the global market, with its targeting of both Australian and International markets. There is currently no product already in existence, within the global market, that provides all of the functionality that is proposed by the Innovation.

Key differences and enhancements between the Innovation and current solutions have been provided.

The Innovation will combine existing technologies, and also create new software, to produce an Innovation that is new to the market. This is a significant improvement that goes beyond minor changes such as minor software updates. The software design and its functionality and features are significant. The Innovation will be a significant product innovation that is new to the global market.

Genuinely focused on developing for commercialisation

The Company must be able to demonstrate that it is genuinely focused on developing its innovation for commercialisation. 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.

The EM explains the requirement to be developing the innovation for commercialisation at paragraph 1.81 as follows:

In addition, the company must be focussed on developing its innovation for a commercial purpose, or in other words, for the purpose of generating economic value and revenue for the ESIC. This requirement draws the distinction between simply having an idea and generating economic value from that idea. Commercialisation encompasses a spectrum of activities including those leading to the sale of new or significantly improved product, process or service as well as activities involving the implementation of a new, or significantly improved, process or method, where the process, or method directly leads to the generation of economic value for the company.

Developing for commercialisation does not include activities in the innovation's addressable market where the company has already made its first sales and is no longer developing the innovation (i.e. the innovation is commercially accepted and any development activity undertaken is for minor changes or improvements). 'First sales' does not include prior activities such as user-testing, trials or pilots with potential customers. The primary consideration is whether the innovation is still being developed, even if sales have started.

The Company is actively designing and developing the Innovation for the purpose of generating economic value once the product is introduced to the market.

The Company has developed the idea sufficiently beyond the pre-concept stage, undertaking activities and taking tangible steps with the intention of commercially exploiting the Innovation.

The Company has actively taken steps to develop the Innovation with the aim of generating economic value for the Company and supported by the documentation provided.

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

The Innovation will result in the creation of a new innovation compared to existing products in its addressable market. The Company has demonstrated that it is genuinely focussed on developing the Innovation to generate economic value for its business.

Accordingly, subparagraph 360-40(1)(e)(i) of the ITAA 1997 will be satisfied for the time period from 1 July 20XX until 30 June 20XX, or until the date when the Innovation has been fully developed, whichever occurs earliest. Once the Innovation has been fully developed, the Company will no longer be 'developing' the product for commercialisation and subparagraph 360-40((1)(e)(i) of the ITAA 1997 will no longer be satisfied.

ii.     The business relating to the innovation must have a high growth potential

The company must be able to demonstrate that it has the potential for high growth 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.

The Company has identified its ultimate market as being the global market, with its targeting of both Australian and International markets. The industry statistics provided suggest there is high growth potential in relation to the business that the Company is operating.

Through its marketing strategy, the Company hopes to foster widespread use of its product by strategically targeting early adopters. Incentives will be provided for marketing the Innovation to others. The Company has already generated interest from local business.

The Company can demonstrate that its business has a high growth potential in the global market once the Innovation is released. Accordingly, subparagraph 360-40(1)(e)(ii) of the ITAA 1997 will be satisfied.

iii.    Demonstrated potential to successfully scale up the business relating to the innovation

The company must be able to demonstrate that it has the potential to successfully scale up the business. The company must have operating leverage where, as 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 per unit.

The Company has prepared forecast pricing models for its offerings and revenue streams.

Once the Innovation has been designed and developed, the cost to provide services will reduce. As market demand increases, revenues will multiply with reduced operating costs per service.

The partnership model aims to assist in successfully scaling the business.

The Company has demonstrated that the Innovation will be able to generate increased revenue with reduced costs. This operating leverage affords the Company the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) of the ITAA 1997 will be satisfied.

iv.   Demonstrated potential to address a broader than local market through the business

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.

The Company's Innovation will initially be targeted at the domestic market, but is intended for worldwide use. It will be released globally once it gains traction in the initial targeted markets.

The Innovation can be used worldwide, thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region.

The Company has demonstrated that its business has the potential to address a broader market than just the local market, including international markets. Therefore, subparagraph 360-40(1)(e)(iv) of the ITAA 1997 will be satisfied.

v.     Demonstrated potential to have competitive advantages for the business

The company must be able to demonstrate that it has the potential to have competitive advantages for that business. For example, 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.

The Innovation will be the first of its kind. The Innovation has key differences and enhancements to other products that are currently in the market.

The Company has a significant competitive advantage with a working prototype. Being the first, the Company has the first mover advantage.

The Company's board and management team are highly experienced in the industry.

The Company has demonstrated the potential for its business to have competitive advantages satisfying subparagraph 360-40(1)(e)(v) of the ITAA 1997.

Conclusion Principles-Based Test

The Company satisfies the Principles-Based Test requirements within subparagraphs 360-40(1)(e)(i)to (v) of the ITAA 1997 for the period commencing 1 July 20XX until 30 June 20XX, or the date when the Innovation has been fully developed for release, whichever occurs earlier.

General exclusion

For completeness we note that there is a specific exclusion in subsection 360-40(4) of the ITAA 1997 which says that subsection 360-40(1) of the ITAA 1997 cannot be satisfied, if before the test time, the company engaged in an activity of a kind prescribed by regulations made for the purposes of this subsection. Subsection 360-40(1) of the ITAA 1997 incorporates all three of the ESIC qualification tests: the Early Stage Test, the Objective (100 point) Test and the Principles-Based Test.

Same as the exclusion in subsection 360-40(3) of the ITAA 1997 for the Principles-Based Test outlined further above, paragraph 1.75 of the EM explains that this subsection provides ongoing flexibility should the Government wish to more tightly target the ESIC tax incentives in the future or if the incentive is being used for inappropriate purposes.

There are currently no regulations made for the purposes of subsection 360-40(3) of the ITAA 1997 and accordingly no exclusions will apply to the Innovation developed by the Company.

Conclusion

If the Company were to capital raise it will meet the eligibility criteria of an ESIC under section 360-40 of the ITAA 1997 for the period commencing 1 July 20XX until the earlier of 30 June 20XX or the date when the Innovation has been fully developed for release, whichever occurs earlier.