Edited version of private advice

Authorisation Number: 1052057363816

Date of advice: 18 November 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 yy YY 20YY to zz ZZ 20ZZ?

Answer

Yes.

This ruling applies for the following period:

yy YY 20YY to zz ZZ 20ZZ

The scheme commences on:

yy YY 20YY

Relevant facts and circumstances

1.    Company A is a proprietary company incorporated in XYZ on xx XX 20XY.

2.    Company A has no wholly or partly owned subsidiaries. Company A is not part of an income tax consolidated group.

3.      In the last 3 income years, being the years ending yy YY 20YY, 20XX and 20ZY, Company A had combined total expenses of $xyz.

4.      In the previous income year, being the year ending yy YY 20YY, Company A incurred and earned the following:

•           Total expenses of $xyz

•           Total income of $zyx

5.    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.

6.      Company A has previously received private binding rulings ('PBRs') for income years ending in zz ZZ 20ZZ, yy YY 20YY and zy ZY 20ZY confirming that Company A was an ESIC on the basis that they passed the principles-based test in respect of their Product being developed.

7.      Company A's goal is to invent a general medical Product.

8.      Since the issuing of the most recent PBR dated xy XY 20XY, Company A has continued to develop their Product for commercialisation and has undertaken the following activities:

•           Ongoing - Development of commercialisation and fundraising strategy in collaboration with Entity A and Entity B

•           Ongoing - Identifying and contacting potential investors

•           QY 20YY - Preparation of investment documents

•           QY 20YY - Conducting phase 1 of the entity's market validation by surveying the target market

•           QZ 20ZZ - Development of Go-to-Market Strategy document

•           QZ 20ZZ - Grant applications for Entity C

9.      The following steps need to be undertaken before the Product is fully developed and ready for commercialisation:

•           Continuing efforts to raise funds for further development of Product

•           Product design

•           Product development

•           Product manufacturing

10.   Company A holds the intellectual property rights for their Product. Currently, the entity has pending patents in multiple countries.

11.   Company A estimates that the development and commercialisation of their Product will be finalised in the 20AA income year.

12.   Company A has continued to develop their Product to address a number of discrete markets and is continuing to develop their Product.

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

Information provided

14.   You have provided a number of documents containing detailed information in relation to Company A's Product.

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

16.   You propose to issue new shares in Company A to various 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.

Qualifying Early Stage Innovation Company

17.  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'

18.  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)

19.  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).

20.  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.

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

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

22.  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)

23.  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)

24.  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'

25.  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

26.  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)

27.  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.

28.  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.

29.  The five 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) ITAA 1997

30.  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..."

31.  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.

32.  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.

33.  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."

34.  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.

35.  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) ITAA 1997

36.  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) ITAA 1997

37.  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) ITAA 1997

38.  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) ITAA 1997

39.  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 it has a differentiating advantage that would allow it to outperform these competitors.

Foreign Company test - paragraph 360-40(1)(f)

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

41.  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

42.  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 yy YY 20YY, and on or before zz ZZ 20ZZ.

Current year

43.  Therefore, for the purposes of subsection 360-40(1), the current year will be the year ending zz ZZ 20ZZ (the 20ZZ income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 6 income years will include the years ending zz ZZ 20ZZ, 20YY, 20XX, 20ZY, 20YX and 20ZX.

THE 'EARLY STAGE TEST' - PARAGRAPHS 360-40(1)(a) - (d) ITAA 1997

Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997

44.  Company A was incorporated in Australia on xx XX 20XY, which is within the last 6 income years outlined above.

45.  Company A incurred total expenses of $xyz across the last 3 income years, therefore the requirements of subparagraph 360-40(1)(a)(ii) are satisfied.

Total expenses - paragraph 360-40(1)(b) ITAA 1997

46.  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 20YY income year, being the income year before the current year.

47.  Company A incurred expenses of $xyz in the 20YY income year. Consequently, paragraph 360-40(1)(b) is satisfied.

Assessable income - paragraph 360-40(1)(c) ITAA 1997

48.  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 20YY income year, being the income year before the current year.

49.  Company A earned assessable income of $zyx in the 20YY income year. Consequently, paragraph 360-40(1)(c) is satisfied.

No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997

50.  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.

51.  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

52.  Company A satisfies the early stage test for the 20ZZ 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

53.  Company A has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending zz ZZ 20ZZ. 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) ITAA 1997

Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i) ITAA 1997

54.  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.

55.  Company A's Product includes a combination of technologies which are unique to the relevant market.

56.  Therefore, Company A is genuinely focussed on developing their Product for an applicable addressable market.

Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997

57.  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.

58.  Company A has undertaken the following work to develop their Product for commercial purposes:

•           Ongoing - Development of commercialisation and fundraising strategy in collaboration with Entity A and Entity B

•           Ongoing - Identifying and contacting potential investors

•           QY 20YY - Preparation of investment documents

•           QY 20YY - Conducting phase 1 of the entity's market validation by surveying the target market

•           QZ 20ZZ - Development of detailed Go-to-Market Strategy document

•           QZ 20ZZ - Grant applications for Entity C

59.  Presently, Company A is undertaking the following work to develop their Product for commercial purposes:

•           Continued efforts to raise funds for further development of Product

•           Ongoing refinement of fundraising strategy

•           Continued efforts on design and development plan of Product together with Entity D

•           Engagement with Entity E and a local innovation hub for continued prototyping

60.  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:

•           Ongoing - Continuing efforts to raise funds for further development of Product

•           QZ 20ZZ - Conclusion of design of Product

•           QZ 20ZZ - Commencement of manufacturing the Product

61.  Company A anticipate that their Product will be fully developed and commercialised by the 20AA income year.

62.  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 yy YY 20YY to zz ZZ 20ZZ, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier. 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) ITAA 1997

63.  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.

64.  Company A demonstrates a high growth potential for their Product and subparagraph 360-40(1)(e)(ii) is satisfied for the period yy YY 20YY to zz ZZ 20ZZ.

Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997

65.  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.

66.  Company A has developed a viable business strategy for expansion and growth of the commercialisation of their Product.

67.  Company A has continued to demonstrate their potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period yy YY 20YY to zz ZZ 20ZZ.

Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997

68.  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.

69.  Company A's Product is first being released in Australia and following that it will expand to a global market.

70.  Company A has pending patents in multiple countries, protecting the ownership and right to their Product's technology globally.

71.  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 yy YY 20YY to zz ZZ 20ZZ.

Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997

72.  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.

73.  Company A's Product has unique features which provide the entity with a competitive advantage.

74.  Company A holds pending patents in multiple countries, in order to protect their competitive advantage against competitors globally.

75.  Company A has continued to demonstrate that it has competitive advantages for its business, so subparagraph 360-40(1)(e)(v) is satisfied for the period yy YY 20YY to zz ZZ 20ZZ.

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 yy YY 20YY to zz ZZ 20ZZ, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier.

Foreign Company Test - subparagraph 360-40(1)(f) ITAA 1997

76.  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 yy YY 20YY to zz ZZ 20ZZ, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier.

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