Edited version of private advice

Authorisation Number: 1052103937762

Date of advice: 31 March 2023

Ruling

Subject: Early stage innovation company

Question

Does the Company satisfy 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, the Company is an ESIC for the year ended 30 June 20XX, having met the eligibility requirements under subsection 360-40(1) of the ITAA 1997.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commenced on:

1 September 20XX

Relevant facts and circumstances

The Company and its 100% owned subsidiary were both incorporated in Australia in the year ended 30 June 20XX.The Company and its wholly owned subsidiary elected to form an income tax consolidated group.

The Company's equity interests are not listed for quotation on the official list of any stock exchange in Australia or a foreign company.

The Company and its 100% owned subsidiary were incorporated in the 20XX income year and, therefore, incurred no expenses or assessable income in the prior income year (i.e., in the 20XX income year).

The Company issued ordinary shares in the 20XX financial year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 subsection 360-40(1)

Income Tax Assessment Act 1997 paragraph 360-40(1)(a)

Income Tax Assessment Act 1997 paragraph 360-40(1)(b)

Income Tax Assessment Act 1997 paragraph 360-40(1)(c)

Income Tax Assessment Act 1997 paragraph 360-40(1)(d)

Income Tax Assessment Act 1997 paragraph 360-40(1)(e)

Income Tax Assessment Act 1997 paragraph 360-40(1)(f)

Income Tax Assessment Act 1997 subparagraphs 360-40(1)(e)(i) to (v)

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise indicated.

Question 1

Summary

The Company is an ESIC for the year ended 30 June 20XX, having met the eligibility requirements under subsection 360-40(1).

Detailed reasoning

Subsection 360-40(1) outlines the criteria required for a company to qualify as an 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 if it is developing new or significantly improved innovations to generate an economic return.

A company qualifies as an ESIC if it satisfies the early stage test, is not a foreign company and satisfies one of two 'innovation' tests (which are the 100-point innovation test or the principles-based innovation test).

Early stage test

The early stage test requirements are specified in paragraphs 360-40(1)(a) to (d) and are outlined below.

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:

•         incorporated in Australia within the last three income years (the latest being the current year); or

•         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 its 100% subsidiaries incurred total expenses of $1 million or less; or

•         registered in the Australian Business Register 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 its 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 its 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.

Not a foreign company

Paragraph 360-40(1)(f) requires that at the test time, the company is not a foreign company (within the meaning of the Corporations Act 2001).

Innovation test

The company must also satisfy one of two innovation tests, the 100-point test or the principles-based test. The 100-point innovation test is an objective test and is self-assessed by the company at a time immediately after the relevant shares are issued. For the purposes of this ruling the principles-based test is considered.

Principles-based test

To satisfy the principles-based test, the company must meet the 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, are stated in paragraph 360-40(1)(e):

(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.

The requirements in sub-paragraphs 360-40(1)(e)(i) to (v) are outlined below.

(i) 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[1], published by the Organisation for Economic Co-operation and Development (OECD) provides a description of these different types of innovations..."[2]

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 identified by making a realistic and objective assessment of the company's intended market for its innovation. It includes identification of the immediately accessible market to which the innovation will initially be introduced, or a new market which may be created by the innovation. Factors in identifying the addressable market may include the location of the company's potential customers, the type of industry to be served and the geographical area it will serve. The addressable market must be objective and realistic.

A 'new' innovation means novel or introduced to the addressable market for the first time. It must be compared to the products, services, processes or methods that may or may not exist in the intended market for the innovation. 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, changes to pricing strategies or changes to goods resulting from seasonal change are examples of improvements that would not be considered significant.

The OECD Oslo Manual (paragraphs 124 and 151) 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.

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.

The EM does not define the meaning of the term 'genuinely focussed' within the context of subparagraph 36040(1)(e)(i). 'Genuine' is defined in the online Macquarie Dictionary as 'Being truly such; real; authentic.' 'Focus' is defined as '3. a central point, as of attraction, attention, or activity. ... 8. to concentrate; to focus one's attention.' In essence, the phrase 'genuinely focussed' is looking to what the company is truly concentrating and focussing their attention on or, put another way, what is the real central point of the company's activities. That is, the central activities of the company must be truly concentrated on developing their innovation for a commercial purpose. Developing an innovation for commercialisation in relation to a new innovation refers to the process of creating that innovation, and it includes a range of activities such as proof of concept activities, market research, prototyping, pilots and user testing, and other activities to prepare for the launch of the new innovation.

(ii) 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.

(iii) 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.

(iv) 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.

(v) 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.

Application of subsection 360-40(1) to the Company

Test time

For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC will be the time immediately after the shares were issued 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 30 June 20XX (the 20XX income year).

Early stage test

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

Paragraph 360-40(1)(a) specifies three ways in which it can be satisfied. One way a company will satisfy the requirement in paragraph 360-40(1)(a) is if it was incorporated in Australia within the last three income years (the latest being the current year).

The Company satisfies paragraph 360-40(1)(a) because the Company was incorporated in Australia in the year ended 30 June 20XX.

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

To satisfy this requirement a company and its 100% owned subsidiaries must have incurred total expenses of $1 million or less in the income year before the current year.

The Company and its 100% owned subsidiary satisfies the requirement in paragraph 360-40(1)(b) as both of them were incorporated in the 20XX income year and, therefore, incurred no expenses in the prior income year (i.e., in the 2021 income year).

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

To satisfy this requirement the Company must have derived total assessable income of $200,000 or less in the income year before the current year.

The Company and its 100% owned subsidiary satisfies the requirement in paragraph 360-40(1)(c) as both of them were incorporated in the 20XX income year and, therefore, incurred no assessable income in the prior income year (i.e., in the 20XX income year).

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

The Company is not listed on any stock exchange in Australia or a foreign country, therefore, paragraph 36040(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 in paragraphs 360-40(1)(a) to (d) have been satisfied.

Not a foreign company

Paragraph 360-40(1)(f) requires that the company is not a foreign company. The Company was incorporated in Australia in 20XX. The Company is not a foreign company. This requirement is satisfied.

Principles-based test

The Company must meet the five requirements in paragraph 360-40(1)(e) to satisfy the principles-based test. Each of these is discussed below.

Genuinely focussed on developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i)

In applying the requirements of subparagraph 360-40(1)(e)(i), the Company must be developing an innovation (product, process, service or organisational method) which is either new or significantly improved for an applicable addressable market.

The platform that the Company is developing would be the first to the market of its kind. The revenue opportunities for the Company are significant and the pathway to commercialisation stems from identified inadequacies of current market offerings that the Company's platform will address.

The Company has demonstrated that it has taken tangible steps to identify a gap in the market, to create an innovative product to fill the gap in the market and to commercialise the innovation to generate revenue.

Subparagraph 360-40(1)(e)(i) is, therefore, satisfied for the time period from 1 September 2021 until 30 June 20XX.

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

The Company demonstrates that its 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 Company's addressable market includes both the Australian market and overseas markets, therefore, there is potential to successfully scale the business. The Company's pricing model together with projected sales increases, has the Company targeting revenue of $XX million, with a profit after tax amount of $XX million.

The Company demonstrates it is able to successfully scale its business, therefore, subparagraph 360-40(1)(e)(iii) is satisfied.

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

The Company demonstrates that its innovation has the potential for high growth within a broad addressable market, its ultimate addressable market being both Australian and global markets. The Company, therefore, addresses a broader market than just the local market and is not confined to a local city, area or region. The Company's market can clearly be expanded to a broader market in the future. Subparagraph 360-40(1)(e)(iv) is therefore satisfied.

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

The Company has demonstrated the potential for it to have competitive advantage within the market, satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles-based test

As each of subparagraphs 360-40(1)(e)(i) to (v) is satisfied, the Company satisfies the principles-based test in paragraph 360-40(1)(e) for the income year ended 20XX.

Overall Conclusion - ESIC

The Company satisfies the early stage test requirements in paragraphs 360-40(1)(a) to (d), is not a foreign company as required by paragraph 360-40(1)(f) and satisfies the principles-based test in paragraph 360-40(1)(e). The Company, therefore, satisfies the eligibility criteria for an ESIC in subsection 360-40(1) and is an ESIC for the period from 1 September 2021 until 30 June 20XX.

[1] At the time the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 was introduced and read a first time in the House of Representatives the EM to the Bill was referring to the Oslo Manual: Guidelines for Collecting and Interpreting Innovation Data, 3^rd Ed., OECD, 2005 and any reference to the Oslo Manual in these reasons for decision is to this edition.

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