Edited version of private advice

Authorisation Number: 1052046614957

Date of advice: 20 October 2022

Ruling

Subject: Early stage innovation company qualification

Question

Does Company X 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 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Background

Company X has been registered in the Australian Business Register since DD MM 20XX. Its equity interests are not listed for quotation in the official list of any stock exchange.

Company X has no subsidiaries and had less than $1 million in expenses and less than $200,000 in assessable income in the previous income year ended 30 June 20XX.

Company X has issued shares in the income year ended 30 June 20XX.

Product development

Company X is a creator and manufacturer of consumer brands across multiple products.

Company X's first brand developed multiple innovative products. These products contain a unique leading-edge ingredient.

The Innovation

Company X's innovative products are the first in the world to incorporate the unique leading-edge ingredient as a hero ingredient across the whole range.

Company X's product formulations ensures desirable intended outcomes.

Although this ingredient is used in some similar existing products, none of these existing products are mass produced or widely available, and none of these products are the products being offered by Company X.

Current products on the market undergo small batch production. Company X has innovated a new mass production process to incorporate the ingredient across its range of products. Company X utilises a specific process that significantly improves the process used by others in Company X's addressable market.

To develop Company X's product rage, Company X had to create unique processes to incorporate the ingredients to its products.

These processes allow Company X to have formulations that perform at the desired level as other products available on the market, but at the competitive price point.

Company X is in the process of finalising their R&D application. Company X provided the draft R&D application which includes information about their innovations

Commercialisation strategy

Company X conducted market research and discovered a consumer behaviour to target.

Company X's market research identified the largest generation globally as well as locally and discovered their traits.

Through market research Company X identified their target consumers for their brand and worth of their market. Company X anticipates the net revenue from their brand to generate $X in 20XX, $Y in 20YY and $Z in 20ZZ.

Company X plans to initially test and market the products in Australia. If the test is successful, it intends to sell the products internationally. Following the development of the intellectual property in Australia, Company X plans to license the numerous processes and innovations on a global scale.

Company X intends to lodge an R&D tax incentive application in relation to the new product innovations.

Company X has been taking tangible steps that are directed towards the sale of its products, such as:

•         Conducting market research and developing a business plan

•         Executing pilot programs

•         Taking steps to protect intellectual property rights existing in the innovation

•         Investing in world experts with significant experience

•         Setting up manufacturing processes. This involves a total capital requirement of $X, for the company, including costs such as formulation development, packaging development, cost of goods, implementation costs and marketing costs.

•         Executing on their marketing plan and other such processes to prepare for the launch of their new products, process, and marketing and organisational methods.

Within the business plan provided, it provides a timeline indicating the key steps Company X will take to commercialise the products.

Company X anticipates that within the first year of operations of its brand, it can capture X% of the total relevant Australian market and grow to capture Y% in 20YY and Z% in 20ZZ. The growth in sales and revenue of Company X will be further increased through their planned development and distribution of products into different categories.

Company X provided data to indicate that the supply of the unique ingredient can be met with the projected increase in revenue in future years.

Company X will be able to generate larger revenue, expand its workforce, increase production and broaden its market in the future.

The factors it has identified that will drive this growth include:

•         Increased demand of its products

•         Its unique leading-edge ingredient

•         Expertise of the company's leadership team

•         The ability of the organisational method, process, product and marketing method innovations to enter markets across the world

•         Planned development of products into different categories.

The products will form part of a dynamic range of premium products that Company X plans to sell. The growth potential for these products is high due to sales channels being used. The products will be sold through the mass market channels and online retailers, as well as direct to consumers. Company X's research has shown that these channels are the largest locally and globally for mass market products.

The business will initially develop the intellectual property in Australia, before then licensing the business model, processes and technology into the global market.

Its strategy to achieve a significant share of this market, first across Australia and then expand internationally, is detailed in its business plan.

Although Company X will incur significant costs to develop the products, as its customer base grows, the cost per unit will reduce. This means that it has operating leverage. It has the potential to successfully scale its' business to supply to broad markets. As it expands its sales, it will be able to generate increased revenue with only a minimal increase in its operating costs.

Furthermore, the nature of Company X's planned IP licensing across the world, will also ensure scalability in revenue.

Company X's new production process will enable mass production and in turn, economies of scale, so that they can scale their supply globally with minimal increase in operating costs.

Due to the nature its manufacturing investment, this can be easily adapted into other categories with minimal additional investment to develop other products.

Company X's marketing strategy targets its target consumer demands. The growing consumer demand for these offerings' positions Company X with strong potential to successfully address the global markets.

Marketing the product range online will allow it to easily enter new markets, and Company X already offers global shipping of its product to other countries. Company X is serious about its marketing and brand development strategy and has already allocated over $X to its initial marketing costs to ensure a successful product launch.

The business will initially develop the intellectual property in Australia, and once proven successful, Company X will then license the processes, technology and business model on a global scale.

Company X's products have competitive advantage due to its unique product formulation. These products have unique features that offer benefits which are not currently available to Australian and worldwide in the market.

The first of Company X's products have been developed to be unique and innovative in their category. Company X has competitive advantages that are sustainable, in that it offers a product that has a unique and striking design that appeals to the market.

It plans to sustain this competitive advantage by securing key relationships with distributors and formulators, and by rapidly building its brand recognition in the market once the products and technology is launched.

Furthermore, Company X has a cost advantage as it has the ability to produce at a lower cost than its competitors, thereby allowing it to offer its product at a lower price than its competitors. This is enabled by the company having gained efficiencies through its use of innovative production processes.

It plans to protect this advantage from imitation by registering a design right over the configuration of the product and ensuring IP protection for its technology and processes. If any IP is generated Company X will retain the IP that is generated.

As the creator and manufacturer of consumer brands, Company X has the potential to become a trusted business that is the go-to for purchases within the relevant different categories. The fact that other competitors do not have such a wide offering, give Company X unique advantages to protect its market position.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-40

Reasons for decision

Summary

Company X meets the eligibility requirements of an ESIC under subsection 360-40(1).

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 3 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 3 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 5 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 5 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.

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 Company X 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)

As Company X was registered on DD MM 20XX, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied.

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

As Company X had expenses of $1 million or less in the prior income year (the 20XX income year) paragraph 360-40(1)(b) is satisfied.

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

As Company X's assessable income in the prior income year (the 20XX income year) is $200,000 or less paragraph 360-40(1)(c) is satisfied.

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

As Company X 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

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

100 point innovation test

As an alternative to satisfying the principle-based test for a qualifying ESIC, a company may be a qualifying ESIC if it has at least 100 points for meeting certain objective innovation criteria. The 100 point test is provided as an alternative innovation test providing the company with a self-assessment test.

Principles based test

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

There are 3 interacting elements that needs to be addressed:

•         New, significantly improved, product, process, service or marketing method or organisational method - the Innovation;

•         Developing for commercialisation; and

•         Genuinely focussed.

Company X is a creator and manufacturer of consumer brands across multiple products.

Company X's first brand developed multiple innovative products. These products contain a unique leading-edge ingredient.

Company X's innovative products are the first in the world to incorporate the unique leading-edge ingredient as a hero ingredient across the whole range.

Company X's product formulations ensures desirable intended outcomes.

Although this ingredient is used in some similar existing products, none of these existing products are mass produced or widely available, and none of these products are the products being offered by Company X.

Current products on the market undergo small batch production. Company X has innovated a new mass production process to incorporate the ingredient across its range of products. Company X utilises a specific process that significantly improves the process used by others in Company X's addressable market.

To develop Company X's product rage, Company X had to create unique processes to incorporate the ingredients to its products.

These processes allow Company X to have formulations that perform at the desired level as other products available on the market, but at the competitive price point.

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

Company X conducted market research and discovered a consumer behaviour to target.

Company X's market research identified the largest generation globally as well as locally and discovered their traits.

Through market research Company X identified their target consumers for their brand and worth of their market. Company X anticipates the net revenue from their brand to generate $X in 20XX, $Y in 20YY and $Z in 20ZZ.

Company X plans to initially test and market the products in Australia. If the test is successful, it intends to sell the products internationally. Following the development of the intellectual property in Australia, Company X plans to license the numerous processes and innovations on a global scale.

Company X intends to lodge an R&D tax incentive application in relation to the new product innovations.

Company X has been taking tangible steps that are directed towards the sale of its products, such as:

•         Conducting market research and developing a business plan

•         Executing pilot programs

•         Taking steps to protect intellectual property rights existing in the innovation

•         Investing in world experts with significant experience

•         Setting up manufacturing processes. This involves a total capital requirement of $X, for the company including costs such as formulation development, packaging development, cost of goods, implementation costs and marketing costs

•         Executing on their marketing plan and other such processes to prepare for the launch of their new products, process, and marketing and organisational methods.

Within the business plan provided, it provides a timeline indicating the key steps Company X will take to commercialise the products.

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

Company X 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 20XX until 30 June 20XX or the date when the Innovation has been fully developed, whichever occurs earliest. Once the Innovation has been fully developed, Company X will no longer be developing the Innovation for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied.

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

Within the business plan provided, it provides a timeline indicating the key steps Company X will take to commercialise the products.

Company X anticipates that within the first year of operations of its brand, it can capture X% of the total relevant Australian market and grow to capture Y% in 20YY and Z% in 20ZZ. The growth in sales and revenue of Company X will be further increased through their planned development and distribution of products into different categories.

Company X provided data to indicate that the supply of the unique ingredient can be met with the projected increase in revenue in future years.

Company X will be able to generate larger revenue, expand its workforce, increase production and broaden its market in the future.

The factors it has identified that will drive this growth include:

•         Increased demand of its products

•         Its unique leading-edge ingredient

•         Expertise of the company's leadership team

•         The ability of the organisational method, process, product and marketing method innovations to enter markets across the world

•         Planned development of products into different categories.

The products will form part of a dynamic range of premium products that Company X plans to sell. The growth potential for these products is high due to sales channels being used. The products will be sold through the mass market channels and online retailers, as well as direct to consumers. Company X's research has shown that these channels are the largest locally and globally for mass market products.

The business will initially develop the intellectual property in Australia, before then licensing the business model, processes and technology into the global market.

Its strategy to achieve a significant share of this market, first across Australia and then expand internationally, is detailed in its business plan.

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

Therefore subparagraph 360-40(1)(e)(ii) will be satisfied.

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

The business model provided illustrates the increase in projected sales.

Given that the Innovation will be available domestically first and then potentially globally in the future, it is expected that the Innovation has the potential to successfully scale up its business.

Although Company X will incur significant costs to develop the products, as its customer base grows, the cost per unit will reduce. This means that it has operating leverage. It has the potential to successfully scale its' business to supply to broad markets. As it expands its sales, it will be able to generate increased revenue with only a minimal increase in its operating costs.

Furthermore, the nature of Company X's planned IP licensing across the world, will also ensure scalability in revenue.

Company X's new production process will enable mass production and in turn, economies of scale, so that they can scale their supply globally with minimal increase in operating costs.

Due to the nature its manufacturing investment, this can be easily adapted into other categories with minimal additional investment to develop other products.

These operating leverages affords Company X 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)

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

Company X's marketing strategy targets its target consumer demands. The growing consumer demand for these offerings' positions Company X with strong potential to successfully address the global markets.

Marketing the product range online will allow it to easily enter new markets, and Company X already offers global shipping of its product to other countries. Company X is serious about its marketing and brand development strategy and has already allocated over $X to its initial marketing costs to ensure a successful product launch.

The business will initially develop the intellectual property in Australia, and once proven successful, Company X will then license the processes, technology and business model on a global scale.

Company X's products can be sold worldwide through multiple avenues. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region.

Company X 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)

Company X's products have competitive advantage due to its unique product formulation. These products have unique features that offer benefits which are not currently available to Australian and worldwide in the market.

The first of Company X's products have been developed to be unique and innovative in their category. Company X has competitive advantages that are sustainable, in that it offers a product that has a unique and striking design that appeals to the market.

It plans to sustain this competitive advantage by securing key relationships with distributors and formulators, and by rapidly building its brand recognition in the market once the products and technology is launched.

Furthermore, Company X has a cost advantage as it has the ability to produce at a lower cost than its competitors, thereby allowing it to offer its product at a lower price than its competitors. This is enabled by the company having gained efficiencies through its use of innovative production processes.

It plans to protect this advantage from imitation by registering a design right over the configuration of the product and ensuring IP protection for its technology and processes. If any IP is generated Company X will retain the IP that is generated.

As the creator and manufacturer of consumer brands, Company X has the potential to become a trusted business that is the go-to for purchases within the relevant different categories. The fact that other competitors do not have such a wide offering, give Company X unique advantages to protect its market position.

Being the first of produce the innovative products at a mass scale, Company X has the first mover advantage. Company X 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 test

Company X 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 20XX until 30 June 20XX or the date when the Innovation has been fully developed and is ready for sale, whichever occurs earlier.

Foreign Company Test

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

•         Conclusion

Company X meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until the earlier of 30 June 20XX 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.