Edited version of private advice

Authorisation Number: 1052012313434

Date of advice: 11 October 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 DD MM YYYY to DD MM YYYY?

Answer:

Yes

This ruling applies for the following periods

DD MM YYYY to DD MM YYYY

The Scheme commences on

DD MM YYYY

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect, and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Background Facts

1.      Company A is an Australian proprietary company incorporated in XYZ on DD MM YYYY.

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

3.      Company A's registered office is situated at XYZ.

4.      Company A's principal place of business is situated at XYZ.

5.      Company A has had a wholly owned subsidiary company, Company B, incorporated in XYZ, since DD MM YYYY.

6.      For the financial year ending DD MM YYYY, Company A incurred and earned the following:

•           Total expenses of $xxx

•           Total income of $yyy

7.      For the financial year ending DD MM YYYY, Company A incurred and earned the following:

•           Total expenses of $zzz

8.      For the financial year ending DD MM YYYY, Company A incurred and earned the following:

•           Total expenses of $xyz

9.      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.

Development of innovation

10.   Company A is developing technology products and software.

11.   Company A's objective is to develop industry first patented technology that supports renewable energy businesses and communities.

Commercialisation strategy

12.   The development of the above products and technologies will directly lead to the generation of economic value for Company A.

13.   Company A has taken steps towards commercialisation by developing and patenting over xx inventions that support its products.

14.   A list of patents currently available for use by Company A and/or Company B are set out in documentation provided to us, noting that all Patents listed as being registered under the Patent Cooperation Treaty ('PCT') (ie. international patents) have been assigned to Company A; all Patents listed as being registered in XYZ have been, or are currently in the process of being, assigned to Company A; and all Patents listed as being registered in XXX are held by, or have been assigned to, Company B and are available for use by Company A (as the parent company of Company B).

15.   Company A's use and ownership of the Patents is also contemplated in their Subscription Agreement. For the avoidance of doubt, Company A's right to use and/or ownership of the Patents was a condition of the issuance of shares in the company under the Subscription Agreement.

16.   Company A is developing their technology products and software to address a number of discrete markets and is continuing to develop their Product.

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

Information provided

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

•           Private Binding Ruling ('PBR') Application, dated DD MM YYYY

•           Response to further questions provided

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

Company A has issued a number of ordinary shares, issued under the Subscription Agreement on DD MM YYYY to a number of investors, to assist in funding the continued development and commercialisation of the '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 360-40

Income Tax Assessment Act 1997 section 360-45

Reasons for Decision

All legislative references are to the Income Tax Assessment Act 1997 ('ITAA 1997') unless otherwise stated.

Summary

XXX meets the eligibility requirements of an ESIC under subsection 360-40(1) for the period DD MM YYYY to DD MM YYYY.

Detailed Reasoning

Qualifying Early Stage Innovation Company

20.   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'

21.   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)

22.   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).

23.   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.

24.   A company that does not meet any of these conditions will not qualify as an ESIC.

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

25.   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)

26.   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)

27.   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'

28.   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

29.   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)

30.   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.

31.   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.

32.   The 5 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)

33.   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..."

34.   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.

35.   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.

36.   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."

37.   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.

38.   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)

39.   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)

40.   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)

41.   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)

42.   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)

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

44.   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

45.   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 DD MM YYYY, and on or before DD MM YYYY.

Current year

46.   Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending DD MM YYYY (the YYYY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 6 income years will include the current year and previous 5 years and the income year before the current year will be the year ending DD MM YYYY (the YYYY income year).

The 'EARLY STAGE TEST' - paragraphs 360-40(1)(a) - (d)

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

47.   Company A was incorporated on DD MM YYYY, which is within the 6 income years outlined above, and across the last 3 of those years before the current year, it and its subsidiaries incurred total expenses of $1 million or less ($xxx for FY YYYY, $yyy for FY YYYY and $zzz for FY YYYY = Total of $xyz) therefore the requirements of subparagraph 360-40(1)(a)(ii) are satisfied.

48.   Company A did not have any 100% subsidiaries during the last three income years (before the current income year) notwithstanding Company B is currently a 100% subsidiary of Company A. Company B only became a 100% subsidiary of Company A in the current income year (DD MM YYYY). Accordingly, Company B's expenses (and assessable income) are irrelevant in determining whether Company A satisfies the Early Stage Test.

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

49.   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 YYYY income year, being the income year before the current year.

50.   Company A incurred expenses of $xyz in the YYYY income year. Consequently, paragraph 360-40(1)(b) is satisfied.

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

51.   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 YYYY income year, being the income year before the current year.

52.   Company A earned assessable income of $xyz in the YYYY income year. Consequently, paragraph 360-40(1)(c) is satisfied.

No Stock Exchange listing - paragraph 360-40(1)(d)

53.   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.

54.   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

55.   Company A satisfies the early stage test for the YYYY 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

56.   Company A may have sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending DD MM YYYY. However, 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)

Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i)

57.   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.

58.   Company A is developing technology products and software.

59.   Company A's objective is to develop industry first patented technology that supports renewable energy businesses and communities.

60.   A summary of two key innovative products being developed by Company A is set out below.

Product A

Product A is an Australian made, outdoor-rated, installation friendly system that meets the demands of specific operators.

The system integrates with real-time data, providing a framework for intelligent management.

Company A has designed Product A with software that is capable of being fully integrated with metering and asset management capabilities.

Product B

Product B is designed to support efficiency during voltage changes.

Product B also supports energy flow by using conventional methods.

Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i)

61.   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.

62.   Company A has taken tangible steps on development for commercialisation, including raising capital, entering into commercial agreements and constructing the necessary equipment to manufacture the device.

63.   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.

64.   Company A is genuinely focussed on developing their Product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period DD MM YYYY to DD MM YYYY. Once the Product has been fully developed, Company A will no longer be 'developing' the product for commercialisation.

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

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.

65.   The total addressable market for energy products is estimated to be worth approximately $xx AUD after accounting for replacements and new installations.

66.   Data published by an Australian Government Department indicates that Australia has the highest uptake of these products globally.

67.   These particular systems currently represent the largest such segment in Australia, whilst assets represent the fastest growing segment in Australia with a growth rate of approximately xx% per annum since YYYY.

68.   The products being developed by Company A, including Product A and Product B, cater to the abovementioned segments and will significantly benefit from the substantial growth expected across both segments.

69.   Company A forecasts its quarterly sale revenue to increase from approximately $xxx in MM YYYY to $zzz by MM YYYY. Company A also forecasts growth in total unit sales to increase from approximately xx units sold in MM YYYY to yyy units sold in MM YYYY. Company A anticipates that this growth will be achieved via the release of 8 new products to market and sustained increases in demand across this particular market.

70.   Company A has demonstrated a high growth potential for their Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period DD MM YYYY to DD MM YYYY.

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

71.   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.

72.   In order to scale its business, Company A has established domestic and international engineering and operational teams capable of expanding with the needs of the business. Company A's engineering team has demonstrated an ability to consistently develop and patent new innovations year after year as the business has continued to grow.

73.   Furthermore, the scalability of Company A's business is supported by several state government incentives, such as rebates and/or interest free loans, designed to encourage consumers to adopt these technologies by reducing upfront costs.

74.   Company A has incurred, and will continue to incur, significant research and development costs as it seeks to innovate, patent and commercialise market leading products. Once such products are fully introduced into the market, Company A will be in a position to expand its sales and generate increased revenue with a minimal increase in its operating costs as a result of its patent protections and demand-driven service offering.

75.   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 DD MM YYYY to DD MM YYYY.

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

76.   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.

77.   The utility of the products being developed by Company A is not limited to consumers in Australia. Company A 's products are capable of world-wide application and Company A intends to expand into the global market once its products have established a market presence in Australia.

78.   The international market for these particular products is expansive. Total global market revenue is forecasted to grow from approximately $xxxm in YYYY to $yyyb by YYYY. The products engineered by Company A, such as Product A in particular, stand to significantly benefit from this international growth.

79.   Although Company A 's initial target market is limited to the Australian market, the global demand for these particular products will benefit all of Company A's products. In anticipation of meeting such global demand, Company A has established engineering and operational teams outside of Australia that have the capability and capacity to supply international markets.

80.   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 DD MM YYYY to DD MM YYYY.

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

81.   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.

82.   Company A has identified the following features of its business that represent potential competitive advantages:

•           Company A has over xx patents registered in several countries to support its products and facilitate a superior market position;

•           Company A is one of a limited number of companies in the sector that provides both software and hardware as a total consumer solution;

•           Company A has its own overseas supply chain and production capabilities capable of handling the growth of the business and keeping its products competitively priced; and

•           Company A has a dedicated software team in XXX for the purpose of supporting its customers and providing market leading customer care.

83.   Despite a high concentration of competitors, the state and national market remains fragmented as a result of some competitors only producing single product components. Company A intends to capitalise on this fragmentation by providing its software and hardware as a total consumer solution.

84.   Furthermore, the growth in particular systems across Australia has resulted in demand to dwindle in certain parts of the day when particular output is high, and peak later in the day when output is low.

85.   In order to solve these issues, Company A's products provide greater storage capacity and control in order to smooth demand, decrease the risk of system faults during periods of peak demand and ride out system disturbances.

86.   Company A has demonstrated that it has competitive advantages for its business, so subparagraph 360-40(1)(e)(v) is satisfied for the period DD MM YYYY to DD MM YYYY.

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 DD MM YYYY to DD MM YYYY.

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

87.   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 DD MM YYYY to DD MM YYYY.

Other references (non ATO view)

Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016

Key words

Early Stage Innovation Company

Tax incentives for Early Stage Investors

Early Stage Test

Principles Based Innovation Test

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