Edited version of private advice

Authorisation Number: 1052174376719

Date of advice: 28 September 2023

Ruling

Subject: Early-stage innovation

Question

Does the Company meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following period:

Income year ending on 30 June 20YY

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

1.     The Company was incorporated in Australia on DD MM YYYY. Its equity interests are not listed for quotation in the official list of any stock exchange.

2.     A private ruling was previously issued to the Company confirming that it was qualified for the criteria of an ESIC under subsection 360-40(1) of the ITAA 1997 for the income year ended 30 June 20XX.

3.     The Company is currently undertaking further capital raise during the income year ending on 30 June 20YY to assist with funding for the development of its innovation.

4.     The Company has no subsidiaries. The Company had no assessable income in the income year ended 30 June 20XX.

5.     Total expenses the Company has incurred in the last three income years before the income year ending on 30 June 20YY are set out as follows:

Table 1Total expenses per Income year

6.     The Company has been developing an innovation that offers some unique functions and features in the relevant industry.

7.     The Company states that once developed, its innovation will have a distinct point of difference in product, process and cost comparing to the existing products in the market. The unique features of the Company's innovation make it difficult to replicate.

8.     The Company has identified its initial targeted markets in Australia. The Company estimated that there is an opportunity of significant value in these markets.

9.     The Company states there are potentially many future users of its product both in Australia and overseas.

10.     The Company plans to commercialise its product in three steps over the next X years.

11.     As part of the commercialisation strategy, the Company has closed its first investment round of funding and is also seeking further funding to assist with developing its product from concept to pilot.

12.     In the income year ended 30 June 20XX, the Company has dedicated more than XX% of the total expenses to Research and Development activities.

13.     The Company now has an in-house development team comprising of executives and employees with a variety of experiences in the relevant fields.

14.     Throughout development, the Company has continued to receive commercialisation support from its advisory board, who has helped develop the roadmap for the product.

15.     The Company's initial stakeholder reach has expanded substantially to include some of the leading organisations in the relevant industry.

16.     The Company owns all the intellectual property (IP) that has already been developed that relates to its product and intends to use a variety of means to protect these rights and the IP to be developed.

17.     The Company has provided the relevant information and documents in relation to its product. These information and documents have been referred to in applying the relevant tests to its circumstances.

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

1.     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 it is developing new or significantly improved innovations to generate an economic return.

The early stage test

2.     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)

3.     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).

4.     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.

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

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

6.     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)

7.     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)

8.     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

9.     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

10.   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)

11.     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.

12.     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.

13.     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

14.     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]

15.     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.

16.     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.

17.     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]

18.     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."

19.     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."

20.     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.

21.     '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

22.     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

23.     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 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

24.     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

25.     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)

26.     At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001.

27.     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

(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

28.     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 on 30 June 20YY.

Current year

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

Early stage test

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

30.     The Company was incorporated on DD MM YYYY, which is within the last six income years, subparagraph 360-40(1)(a)(ii) is satisfied if the total expenses incurred by the Company and its 100% subsidiaries for the last three income years before the current year is $1 million or less.

31.     For the last three income years before the current year, the Company did not have any 100% subsidiary and has incurred total expenses of less than $1 million. Subparagraph 360-40(1)(a)(ii) therefore is satisfied.

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

32.     The Company had expenses of $1 million or less in the income year ended 30 June 20XX, being the income year before the current year, paragraph 360-40(1)(b) is satisfied.

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

33.     The Company's assessable income in the income year ended on 30 June 20XX, being the income year before the current year, is $200,000 or less, paragraph 360 40(1)(c) is satisfied.

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

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

Conclusion on early stage test

35.     The Company will satisfy the early stage test for the income year ending on 30 June 20YY, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

100 point innovation test

36.     The Company has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20YY. 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)

37.     There are three interacting elements that needs to be addressed:

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

b.    Developing for commercialisation; and

c.     Genuinely focussed.

38.     The Company is developing an innovation that is a new or significantly improved product for an applicable addressable market.

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

39.     In applying the requirements of subparagraph 360-40(1)(e)(i), the Company must be genuinely focussed on developing an innovation for commercialisation in order to generate economic value and revenue for the company.

40.     The Company's goal is to provide its target markets with an innovative product which offers some unique functions and features that are difficult to replicate.

41.     The Company has a detailed commercialisation strategy for its product covering the next X years.

42.     In achieving the commercialisation plan, the Company has expanded its in-house development team comprising of executives and employees with a variety of experiences in the relevant fields.

43.     The Company predicted that the projected users of its product and its projected revenue would experience an exponential growth in the coming years.

44.     The Company has demonstrated that it is genuinely focussed on developing its innovation for a commercial purpose in order to generate economic value and revenue for the company.

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

45.     The Company is genuinely focussed on developing its innovation for commercialisation initially in Australia and ultimately overseas. The innovation is a new or significantly improved product comparing to existing products in the market.

46.     Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the period from 1 July 20XX until 30 June 20YY, or the date when the product has been fully developed, whichever occurs earlier. Once the product has been fully developed and commercialised, the Company will no longer be developing an innovation for commercialisation and subparagraph 360-40(1)(e)(i) will no longer be satisfied.

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

47.     In applying the requirements of subparagraph 360-40(1)(e)(ii), the Company must be able to demonstrate that it has the potential for high growth within a broad addressable market.

48.     The Company has provided details demonstrating a high growth potential for its business. Therefore subparagraph 360-40(1)(e)(ii) will be satisfied.

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

49.     In applying the requirements of subparagraph 360-40(1)(e)(iii), the Company must be able to demonstrate that it has the potential to successfully scale up the business.

50.     The Company has provided details demonstrating that it has the potential to successfully scale up its business. Therefore subparagraph 360-40(1)(e)(iii) will be satisfied.

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

51.     In applying the requirements of subparagraph 360-40(1)(e)(iv), the Company must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets.

52.     The Company has provided details demonstrating that it has the capacity and potential to address a broader market than just the local market, including the international market. Therefore subparagraph 360-40(1)(e)(iv) will be satisfied.

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

53.     In applying the requirements of subparagraph 360-40(1)(e)(v), the Company must demonstrate that it has potential to be able to have competitive advantage for its business.

54.     The Company has provided details demonstrating that it has competitive advantages for its business and product. Therefore subparagraph 360-40(1)(e)(v) will be satisfied.

Conclusion on principles based test

55.     The Company satisfies the principles based test, as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20XX until 30 June 20YY or the date when its product has been fully developed and is ready for sale, whichever occurs earlier.

Foreign Company Test

56.     The Company was incorporated in Australia it is not a foreign company and paragraph 360-40(1)(f) is therefore satisfied.

Conclusion

57.     The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until the earlier of 30 June 20YY or the date when its product 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.