Edited version of private advice

Authorisation Number: 1052317148240

Date of advice: 17 October 2024

Ruling

Subject: ESIC qualification

Question 1

Does Company X satisfy the Early Stage Test under section 360-40 based on the information provided?

Summary

Company X satisfies the eligibility requirements of an ESIC under section 360-40 during the income year ending 30 June 20XX.

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.

For an investor to be entitled to the early stage investor tax incentives, the company must qualify as an ESIC immediately after the new shares are issued to the investor. If the company no longer meets the ESIC requirements after this test time, this won't affect the investor's potential entitlement to the early stage investor tax incentives.

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.

Early Stage Test

The early stage test requirements are outlined in detail within subsections 360-40(1)(a) to (d).

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

To meet the requirement in subsection 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 its 100% subsidiaries incurred total expenses of $1 million or less or

(iii)            registered in the Australian Business Register (ABR) within the last three income years (the latest being the current year).

The term 'current year' is defined in subsection 360-40(1) with reference to the 'test time'; the 'current year' being the income year in which the company issues shares to the investor.

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

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

To meet the requirement in subsection 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 - subsection 360-40(1)(c)

To meet the requirement in subsection 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 - subsection 360-40(1)(d)

To meet the requirement in subsection 360-40(1)(d), the company must not be listed on any stock exchange in Australia or a foreign country.

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 upon the issue of qualifying shares on a particular date or dates on or after 1 July 20XX and on or before 30 June 20XX.

Current year

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

Early Stage Test

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

Company X was incorporated in Australia on XX date, the current 20XX income year is the six income year of Company X's existence. Across the last 3 income years before the current year, Company X did not have any 100% subsidiaries and it incurred total expenses of less than $1 million. Therefore, the requirements of subparagraph 360-40(1)(a)(ii) are satisfied.

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

Company X had expenses of $1 million or less in the prior income year. Company X did not have any 100% subsidiaries during this time, subsection 360-40(1)(b) is satisfied.

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

Company X's assessable income for the prior income year was $200,000 or less, subsection 360-40(1)(c) is satisfied.

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

None of Company X's issued shares were or are to be listed on a stock exchange during the year ended 30 June 20XX, subsection 360-40(1)(d) is satisfied.

Conclusion for Early Stage Test

Company X satisfies the early stage test during the income year ending 30 June 20XX, as each of the requirements within subsection 360-40(1)(a) to (d) have been satisfied.

Question 2

Does Company X satisfy the principles- based test under subparagraphs 360-40(1)(e)(i) to (v) based on the information provided?

Summary

Company X satisfies the principles-based innovation test requirements under subparagraphs 360-40(1)(e)(i) to (v).

Detailed reasoning

Innovation tests

If the company satisfies the early stage test, the company must also satisfy one of two innovation tests: the objective (100 point) test or the principles-based test.

100 point test - paragraph 360-40(1)(e) and section 360-45

To satisfy the 100-point test the company must obtain at least 100 points by meeting the innovation criteria in the table within section 360-45. The criteria are tested at a time immediately after the relevant shares are issued. If a company satisfies this test, it does not need to satisfy the principles-based test.

Principles-based test - subparagraphs 360-40(1)(e)(i) to (v)

To satisfy the principles-based test, the company must meet five requirements in paragraph 360-40(1)(e). This is tested at a time immediately after the relevant new shares are issued to the investor.

The company can demonstrate that it meets each requirement through existing documentation such as a business plan, commercialisation strategy, competition analysis or other company documents. The company must be able to show that tangible steps have been or will be taken in relation to each of the requirements.

The five requirements of the principles-based test, as outlined in paragraphs 360-40(1)(e) are:

(i)             the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation

(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)

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...'

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 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 - 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. 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)

The company must be able to demonstrate that it has the potential to successfully scale up the business. The company must have operating leverage, where as it increases its market share or enters into new markets, its existing revenues can be multiplied with a reduced or minimal increase in operating costs per unit.

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

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)

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 (Cth).

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

'Innovation tests'

100 Point Test - paragraph 360-40(1)(e) and section 360-45

Company X has not sought to be tested against the 100-point test under section 360-45 for the 'test period'. Company X is electing to seek eligibility by satisfying the principles-based innovation test under subparagraphs 360-40(1)(e)(i)-(v) in order to be issued with a Private Binding Ruling.

Principles-based test - paragraph 360-40(1)(e)

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

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

Company X has provided details on its product that is significantly improved for an applicable addressable market. Therefore, subparagraph 360-40(1)(e)(i) is satisfied.

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

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

Company X has provided details on how it meets this requirement. Therefore, subparagraph 360-40(1)(e)(i) is satisfied.

Once the product has been fully developed, Company X will no longer be 'developing' the product for commercialisation and subparagraph 360-40(1)(e)(i) will no longer be satisfied.

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

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

Company X has provided details on the product's high potential growth within a broad addressable market. Therefore, subparagraph 360-40(1)(e)(ii) is satisfied.

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

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

Company X has provided details on how it has the potential to scale up the business. Therefore, subparagraph 360-40(1)(e)(iii) is satisfied.

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

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

Company X has demonstrated they have the potential to address a broader market than just the local market, including international markets. Therefore, the requirement in subparagraph 360-40(1)(e)(iv) is satisfied.

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

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

Company X has demonstrated the potential for Company X product to have competitive advantages within the addressable market satisfying the requirement in subparagraph 360-40(1)(e)(v).

Conclusion on principles-based test

Company X satisfies the principles-based test as it meets the requirements within subparagraphs 360-40(1)(e)(i) to (v).

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

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

Final Conclusion

Company X meets the eligibility criteria of an ESIC under subsection 360-40(1) during the income year ending 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, 3rd Ed., OECD, 2005 and any reference to the Olso Manual in these reasons for decision is to this edition.