Edited version of private advice

Authorisation Number: 1052034831853

Date of advice: 23 September 2022

Ruling

Subject: Early stage innovation company

Question 1

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 the year ending 30 June 20XX?

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

1.      The Company was incorporated in Australia in 20XX.

2.      The equity interests in the Company (ordinary shares) are not listed for quotation on the official list of any stock exchange.

3.      The Company has wholly owned subsidiaries.

4.      Across the 20XX, 20XX and 20XX income years, the total expenses of the Company and its wholly owned subsidiaries was less than $X million.

5.      In the income year ended 30 June 20XX the total assessable income of the Company and its 100% subsidiaries was less than $XXX.

6.      The Company has been registered with the Australian Business Register from 20XX.

7.      The Company is not a foreign company within the meaning of the Corporations Act 2001.

8.      The Company will not meet the 100 Point Innovation Test in section 360-45 of the ITAA 1997.

9.      The Company has developed an innovative business model in an emerging market. The model provides end to end solutions for its target customers.

10.   The Company's business model provides its customers with a unique offering of services combined with delivery of its product.

11.   The Company will start production of its product in 20XX.

12.   The Company is not aware of a comparable innovation in the emerging market, and considers their offering represents a new method and product offering not yet available in Australia.

13.   The business model can be adapted, refined and developed across global markets. The Company expects that its approach will evolve in response to changes in the market.

14.   The emerging market has considerable growth potential.

15.   There are a number of market segments seeking to utilise the emerging market.

16.   The emerging market is being supported by state and commonwealth governments through a number of strategies and action plans. There has also been work on changing legislation, regulations and Australian standards.

17.   The Company will initially target the Australian market and then expand into export markets. The Company is taking a state based approach to its Australian operations. The Company consider that their state based approach will put them in a position to gain early market share in the major demand centres across Australia.

18.   The Company's primary facilities will be located at major logistical hubs which are near rail and major ports to access export markets. The Company expects that its operations will meet both domestic consumption and export requirements.

19.   The export market is expected to target Korea and Japan, the US China, and Europe.

20.   The Company's approach internalises margins and reduces the delivered cost to customers. The business model seeks to provide a lower cost product to customers, which will help remove cost as a barrier and lead to wider adoption.

21.   The Company currently has one project in development and is targeting completion of Phase 1 of the project towards the end of Q1 20XX and full completion of the facilities towards the end of 20XX.

22.   The Company also has seven prospective projects around Australia.

23.   The Company has undertaken the following activities to commercialise and develop its business model:

•         developed corporate and business strategies

•         set up a business development team

•         developed information packs that are shared with customers under non-disclosure agreements to protect IP

•         regular continuous improvement sessions targeting the evolution of the integrated strategy, its services and products

•         access to specialised consultants to provide insights into specific areas (e.g. technology, markets, software)

•         set up a knowledge management system to retain information and IP generated

•         membership of key groups

•         conducted various studies for identified customer segments to demonstrate how its approach can be of benefit

•         has executed Agreements with potential customers across a diverse range of sectors

24.   The Company projects annual growth in gross revenue up to 20XX. The Company also projects that it will move from a net loss position in 20XX and 20XX to net profit in 20XX, and projects growth in net profit until 20XX.

25.   Existing competitors and market participants focus on specific components of the supply chain, promoting their specific product or offering. the Company's approach will offer both product and services, seeking to deliver the lowest cost/risk outcome for customers.

26.   The Company's management team has relevant expertise and knowledge.

27.   The Company expects to grow its employee base significantly over the coming months and years to support the business growth.

28.   The Company has commenced negotiations with equipment manufacturers to import plant and equipment from offshore manufacturing facilities. The Company expects to be able to secure the necessary plant and equipment to meet its growth projections for the coming years and allow it to scale up.

29.   The Company is in advanced discussions to secure land and other resources to facilitate expansion of its facilities.

30.   The facilities are highly "modular". The Company's design specifications allow it to add capacity to existing facilities at low marginal cost, meaning it will benefit from economies of scale as market demand grows.

31.   The Company identified that it has the following competitive advantages:

•         It is a first mover in the emerging market and is seeking to take advantage of that status by establishing operations in favourable locations and being early to market with its preferred customers.

•         The business model is an end to end solution that offers both product and services. Existing competitors and market participants focus on specific components in the supply chain, promoting their specific products and offerings.

•         It is independent of any specific equipment manufacturers and can tailor processes on a project by project basis. Many competitors of the Company are tied to specific equipment manufacturers and suppliers.

•         It internalises margins, which reduces costs for consumers. The business model seeks to provide a lower cost product to customers, which will lead to adoption.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-40

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise indicated.

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 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, 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.

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.

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 20XX.

Current year

For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX (the 20XX income year). The income year before the current year will be the year ending 30 June 20XX (the 20XX income year).

Early stage test

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

The Company was incorporated in 20XX, which is within the last 6 income years, and across the 20XX-20XX income years (the last 3 income years before the current year) it and its wholly owned subsidiaries incurred total expenses of less than $X million. Subparagraph 360-40(1)(a)(ii) is satisfied.

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

The Company and its wholly owned subsidiaries incurred total expenses of less than $X million in the income year before the current year. Paragraph 360-40(1)(b) is satisfied.

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

The Company and its wholly owned subsidiaries had total assessable income of less than $XXX in the income year before the current year. Paragraph 360-40(1)(c) is satisfied.

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

The Company 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 satisfies the early stage test for the 20XX income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

100 point innovation test

The Company will not satisfy the 100-point test in section 360-45 in the year ending 30 June 20XX. 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 Company has created a business model in an emerging market. The business model involves an end to end solution for its target customers.

The Company will initially target the Australian market (the addressable market) and is taking a state based approach to its Australian operation.

The Company is not aware of a comparable innovation in the market, and considers that their approach represents a new method and product offering not currently available in Australia. Existing competitors and market participants focus on specific components of the supply chain, promoting their specific product or offering, whereas the Company's approach offers both product and services.

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

The Company has undertaken the following steps in developing its business model:

•        developed corporate and business strategies

•        set up a business development team

•        developed information packs that are shared with customers under non-disclosure agreements to protect IP

•        regular continuous improvement sessions targeting the evolution of the integrated strategy, its services and products

•         access to specialised consultants to provide insights into specific areas (e.g. technology, markets, software)

•        set up a knowledge management system to retain information and IP generated

•        conducted various studies for identified customer segments to demonstrate how their approach can be of benefit

•        commenced negotiations with equipment manufacturers to import plant and equipment

•        is in advanced discussions to secure land and other resources

The Company has one (1) project in development and expects full completion of the facility by the end of 20XX and will start production of its product in 20XX. The Company also has seven (7) prospective projects. The Company has executed Agreements with potential customers across a diverse range of sectors.

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

The Company's business model is a new organisational method in the emerging market, and the Company is genuinely focussed on developing its approach for a commercial purpose.

Therefore subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XX until 30 June 20XX or the date when the business model has been fully commercialised, whichever occurs earliest. Once the business model has been fully commercialised, the Company will no longer be developing the business model for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied.

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

The relevant market is an emerging market. The Company will initially target the Australian market. The Company expects to be producing its product by 20XX.

The Company has identified a number of customer segments for their product.

The Company is taking a state based approach to its Australian operations. The Company will locate its primary facilities in logistical hubs near rail and port facilities and will expand into export markets. The export markets will include Japan, Korea, the US, China and Europe. The Company considers that the business model can be adapted, refined and developed across global markets, and expects that its operations will meet both domestic consumption and export demand.

The Company's ultimate addressable market will be the Australian and overseas markets.

The Company demonstrates that its business model has the potential for high growth within a large addressable market. Therefore subparagraph 360-40(1)(e)(ii) will be satisfied.

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

Although the market is an emerging market, there is demand both nationally and internationally for the product in various markets. The emerging market is also being supported by state and commonwealth governments.

The Company will initially target the Australian market adopting a state based approach and then expand into export markets. The Company will position its primary facilities near major ports to access export markets including Japan, Korea, the US, China, and Europe.

The Company forecasts annual growth in gross revenue. The Company also projects that it will move from a net loss position in 20XX and 20XX to net profit in 20XX, and projects growth in net profit until 20XX.

Facilities are highly modular and the Company's design specifications allow it to add capacity to existing capacity at low costs. The Company expects to be able to secure the necessary plant and equipment to meet its growth projections for coming years and allow it to scale up.

The Company will expand into international markets and projects growth in its revenue and profits. The Company does have 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 will initially be targeted at the Australian market, and will then expand into foreign markets including Japan, Korea, the US, China, and Europe. The Company expects that its operations will meet both domestic consumption and export requirements.

The Company demonstrates that its ultimate addressable market is on a global scale and is not confined to a local city, area or region. The Company 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)

The Company is not aware of a comparable innovation in the market and considers the business model to be new in Australia. The Company is an early mover in the market and is seeking to take advantage of that status by establishing operations in favourable locations and being early to market with its preferred customers.

The Company's business model has the following differentiating features which may give it a competitive advantage:

• It is an end to end solution that offers both product and services. Existing competitors and market participants focus on specific components in the supply chain, promoting their specific products and offerings.
• It is independent of any specific equipment manufacturers and can tailor processes on a project by project basis. Many competitors of the Company are tied to specific equipment manufacturers and suppliers.
• It internalises margins, which reduces costs for consumers. The business model seeks to provide a lower cost product to customers, which will lead to adoption.

The Company has demonstrated the potential for its business model to have competitive advantages within the addressable market. Therefore subparagraph 360-40(1)(e)(v) will be satisfied.

Conclusion on principles test

The Company satisfies the requirements in subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20XX until 30 June 20XX or the date when the business model has been fully commercialised, whichever occurs earlier.

Foreign Company Test

The Company was incorporated in Australia and is not a Foreign Company. 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 20XX until 30 June 20XX or the date when the business model has been fully commercialised, 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.