Edited version of private advice

Authorisation Number: 1052025612191

Date of advice: 25 August 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)?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 2023

The scheme commences on:

1 July 2022

Relevant facts and circumstances

The Company was incorporated in Australia in 2020. Its equity interests are not listed for quotation in the official list of any stock exchange.

The Company has no subsidiaries and has expenses of less than $1 million in the previous income year, i.e., the year ended 30 June 2022. It has not yet generated any revenue and assessable income is less than $200,000.

The Company's goal is to provide a product to assist a specific group of patients within the health industry.

There are variations of the device that can be used. Two variations are built on the same core platform, enabling cost effective manufacturing for the device suite. The Innovation allows achievement of the specific Standard of Care.

The Innovation has been designed as a cost-effective, accessible and practical, clinical-research based solution to serve patients in different environments. We are advised that it contrasts strongly with the current suite of complex and expensive devices that have had limited success in clinical environments and research trials.

The Innovation will be the first of such a product.

There is an intellectual property license agreement.

The following key differentiators have been highlighted:

•                    Alternatives provide only partial solutions.

•                    The Innovation is the only device needed.

•                    The Innovation overcomes the need for support and will ultimately provide remote assistive care.

•                    The Innovation is cheaper than most currently available solutions.

The Company has been developing versions of its prototype for over 10 years. The prototypes have been tested through clinical trials conducted in the domestic markets. The Company has identified customer groups as part of its addressable market.

The Company has identified its ultimate market as being the global market.

The Company expects The Innovation to appeal to a niche sub-market within the health industry. This aids decision making and is particularly useful when assessing product or service viability in particular markets.

Through its commercialisation and marketing strategy, the Company hopes to foster widespread use of its product through the following:

•                    Testing The Innovation concept and refining of product features.

•                    Develop substantial clinical evidence of the efficacy of The Innovation.

•                    Treat a significant cohort of patients under controlled conditions.

To create a commercial product, currently further development work is required on the product, in particular:

•                    Refinement of the product based on feedback from current clinical users.

•                    Evolution of the design to support one platform that can be used in multiple environments.

•                    Improved design for manufacturability.

In addition, for the device to be approved for sale by regulators the manufacturer must be able to provide detailed documentary evidence that the device:

•                    Has been designed and tested under the auspices of a stringent quality system.

•                    Complies with all necessary standards and regulations.

•                    Is safe and fit for its intended use.

In assessing the current state of The Innovation and preparing a commercial go-to market strategy, the Company have engaged with a number of contract medical device design and manufacturing houses to obtain preliminary estimates and proposals on developing The Innovation to a commercially releasable product.

The Company has identified various key growth enablers:

•                    Successful current capital funding round

•                    Effective transition of the technology through the commercial device development process

•                    Complete development of the product line, set up manufacturing and quality systems

•                    Secure early adopters via direct sales channel

•                    Secure reimbursement and distribution mechanisms for market sector

•                    Engage medical professionals to provide support to market sector

•                    Connect with patients

•                    Continue the development of the technology and enhance the product line

The Company is developing The Innovation through contracting stages of the development to a third party company. They will make their revenue through direct sales. Product sales with be through capital purchases and rental hire.

The Company has taken the following steps in developing The Innovation:

•                    Engaged the services of an experienced set of medical device business professionals.

•                    Seeking investment to fund the design, development and launch of the commercial version of the product, drawing on the extensive experience and market knowledge built on the prototypes currently helping patients around Australia.

•                    Considerable clinical studies have been performed to demonstrate the impact that The Innovation training has on patients.

•                    The design will be finalised as the first part of the post-development activities but has already evolved through 4 prototypes with extensive clinical testing.

•                    The Innovation will be developed and released in a series of versions, based on the current conceptual design. All versions will be built on the same base platform, with different versions of the software and supporting stand.

This has led to The Company developing multiple prototypes and enhancing them via feedback from clinical trials and testing.

The Company has completed a commercial concept. The commercial product will require investment for a full hardware/software design and development programme to transform the existing prototype into a commercially acceptable product. Software is an integral part of the product which requires significant work. Ultimately this could be developed to enable remote care via a cloud interface. None of this work has been done as yet. The next steps involve both a product development and clinical strategy:

•                    Product Development: Develop a commercial product from the research device and clinical outcomes with segment-specific variants.

•                    Clinical: Building on the clinical evidence to date, undertake clinical validation to meet regulatory approval.

The timeline provides that the Company expects testing to continue with further development of its device.

The Company will develop contracts and seek potential customers to increase direct sales.

If the commercialisation strategy is successful, this may give the Company the ability to increase sales through referrals.

The Company will be engaging with local design and manufacturing companies, who have expressed their interest in The Innovation and that will assist with the commercialisation goals.

Of the competitors that the Company has identified, some already produce devices for the addressable market however, these traditional treatment approaches have proven uneconomic as they require 1-1 support. Alternative devices provide only partial solutions. The Innovation is the only device needed.

The Innovation's financial projections provided illustrate the increase in projected sales.

The Company's strategy for the use of The Innovation will be to have a direct sales channel for domestic markets. Business development activity in the initial 18 months post-financing will be the responsibility of the Project Leader. The financial model forecasts cash reserves based on Australia only sales. It is envisaged, subject to Board approval, that these cash reserves will be invested into the international expansion of the Company or the exit of current investors that have brought the company to this position or the payment of dividends to shareholders.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 Subdivision 360-40

Reasons for decision

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 6 income years (the latest being the current year), and across the last 3 of those income years before the current year it 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 is genuinely focused on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods; and

                     ii.        the business relating to those products, processes, services or methods has a high growth potential; and

                    iii.        the company can demonstrate that it has the potential to be able to successfully scale that business; and

                   iv.        the company can 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 can demonstrate that it has the potential to be able to have competitive advantages for that business.

Developing new or significantly improved innovations for commercialisation

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..."[1]

The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. 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. 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 defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. However, it is important to recognise that an innovation can also consist of a series of smaller incremental changes that together constitute a significant change.[2]

In discussing services innovation activity, paragraph 111 of the OECD Oslo Manual states,

"Innovation activity in services also tends to be a continuous process, consisting of a series of incremental changes in products and processes. This may occasionally complicate the identification of innovations in services in terms of single events, i.e. as the implementation of a significant change in products, processes or other methods."

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 focused 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.

'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

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.

Scalability

The company must be able to demonstrate that it has the potential to successfully scale up the business. 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 per unit.

Broader than local market

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

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.

The following key differentiators have been highlighted:

•                    Alternatives provide only partial solutions.

•                    The Innovation is the only device needed.

•                    The Innovation overcomes the need for additional support and will ultimately provide remote assistive care.

•                    The Innovation is cheaper than most currently available solutions.

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.

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.

Application to your circumstances

Test time

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 2023.

Current year

For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2023 (the 2023 income year). The income year before the current year will be the year ending 30 June 2022 (the 2022 income year).

Early stage test

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

As the Company was incorporated and registered in November 2020, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied.

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

As the Company had expenses of $1 million or less in the prior income year (the 2022 income year), paragraph 360-40(1)(b) is satisfied.

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

As the Company's assessable income in the prior income year (the 2022 income year) is $200,000 or less, paragraph 360-40(1)(c) is satisfied.

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

As the Company is privately owned and is not listed on any stock exchange in Australia or a foreign country, paragraph 360-40(1)(d) is satisfied.

Conclusion on early stage test

The Company will satisfy the early stage test for the entire 2023 income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

100 point innovation test

The Company has not provided any evidence of satisfying the 100-point test under section 360-45 for the year ending 30 June 2023. For the Company to be a qualifying ESIC it will need to satisfy the principles-based test.

Principles based test

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

The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. 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.

According to the Company, the Innovation is the first holistic product that assists these patients in this way. Although it will initially be targeted at the Australian and New Zealand markets, the Innovation has been identified as having a wider global addressable market.

The Innovation is accessible and allows achievement of the Standard of Care. The Innovation has been designed as a cost-effective, practical, clinical-research based solution for multiple environments. We are advised that it contrasts strongly with the current suite of complex and expensive devices that have had limited success in clinical environments and research trials.

The Innovation will be the first of such a product.

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

The Company has taken the following steps in developing The Innovation:

•                    Engaged the services of an experienced set of medical device business professionals.

•                    Sought investment to fund the design, development and launch of the commercial version of the product, drawing on the extensive experience and market knowledge built on the prototypes currently helping patients around Australia.

•                    Considerable clinical studies have been performed to demonstrate the impact that The Innovation has on the patients.

•                    The design will be finalised as the first part of the post-development activities but has already evolved through 4 prototypes with extensive clinical testing.

•                    The Innovation will be developed and released in a series of versions, based on the current conceptual design.

The timeline provided shows that the Company expects testing to continue and further development of their variations.

The Company will develop contracts and seek potential customers to increase direct sales.

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

The Company is genuinely focussed on developing The Innovation for a commercial purpose. The Innovation will be a significantly improved product compared to existing products.

Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 2022 until 30 June 2023 or 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) will no longer be satisfied.

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

The Company expects The Innovation to appeal to a niche sub-market within the health industry. This aids decision making and is particularly useful when assessing product or service viability in particular markets.

Through its commercialisation and marketing strategy, the Company hopes to foster widespread use of its product through the following:

•                    Testing the Innovation concept and refining of product features

•                    Develop a substantial clinical evidence of the efficacy of the Innovation product

•                    Treat a significant cohort of patients under controlled conditions

To create a commercial product, currently further development work is required on the product.

In assessing the current state of the Innovation and preparing a commercial go-to market strategy, the company have engaged with a number of contract medical device design and manufacturing houses to obtain preliminary estimates and proposals on developing the Innovation to a commercially releasable product.

The Company have identified various key growth enablers.

The Company is developing The Innovation through contracting stages of the development to a third party company. They will make their revenue through direct sales.

If the commercialisation strategy is successful, this may give the Company the ability to increase sales through referrals.

The Innovation offers a cost effective, accessible and effective product that is the first of its kind in this broad addressable market. Therefore, The Innovation has the potential for high growth within a broad addressable market. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied.

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

The Innovation's financial projections provided illustrate the increase in projected sales. The Company's strategy for the use of The Innovation will be to have a direct sales channel for domestic markets. Business development activity in the initial 18 months post-financing will be the responsibility of the Project Leader. The financial model forecasts cash reserves based on Australia only sales. It is envisaged, subject to Board approval, that these cash reserves will be invested into the international expansion of the Company or the exit of current investors that have brought the company to this position or the payment of dividends to shareholders.

The design will assist scaling as variations are produced i.e., existing revenues may be multiplied with a minimal increase in operating costs per unit. Further, given that the Innovation will be available globally, it is expected that the Company has the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied.

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

The Company is initially targeting the Australian and New Zealand markets.

The Company has identified customer groups as part of its addressable market.

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

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

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

Of the competitors that the Company has identified, some already produce devices for the addressable market. However, these traditional treatment approaches have proven uneconomic as they require 1-1 support. Alternative devices provide only partial solutions. The Innovation is the only device needed. A number of key competitive advantages have been identified.

Being the first of such innovation, the Company has the first mover advantage. The Company has demonstrated the potential for The Innovation to have competitive advantages within the 'addressable market'. Therefore, subparagraph 360-40(1)(e)(v) will be satisfied.

Conclusion on principles based test

The Company satisfies the principles based test, as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 2022 until 30 June 2023 or the date when The Innovation has been fully developed and is ready for sale, whichever occurs earlier.

Foreign Company Test

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

Conclusion

The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 2022 until the earlier of 30 June 2023 or the date when The Innovation has been fully developed and is ready for sale, whichever occurs earlier.

[1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76.

[2] OECD Oslo Manual, paragraph 124 and paragraph 151.