Private ruling: Early stage innovation company eligibility
Date of advice: 25 May 2022
Published: August 2022
Ruling period: Year ending 30 June 20ZZ

Ruling: Q1: 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)? | A1: Yes

Relevant facts and circumstances: Company A is a proprietary company incorporated in Australia on 31 May 20XX and registered on the Australian Business Register on this date. Company A's directors are individual A and individual B. Company A does not have any wholly-owned subsidiaries. In respect of the income year ended 30 June 20YY (i.e. the income year previous to the 20ZZ income year), the Company had expenses of X and assessable income of X. Across the last three income years, the Company incurred total expenses of $X ($X in 20YY, $X in 20XX and $X in 20DD). 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. The Product Company A is focussed on developing a unique medical device, the Product, designed to improve patient care. The Product is specially designed and manufactured, with the final product to improve patient experience and efficacy of the treatment. The Product is aimed at being a lower cost alternative treatment, which would provide cost savings to hospitals and governments. It will also have a lower socio-economic cost stemming from avoiding the consequences of addiction due to the use of other medications. After the initial costs of development of the Product, and once it enters commercial development, it is expected that the cost per unit manufactured will decrease, thus offering Company A economies of scale. The product is designed to assist with pain management and is able to have both a local and international addressable market. The Product is a unique product designed to be used in a specific surgical procedure. Currently there are no known products that could directly compete with the Product. This advantage can be quite significant in fields such as the medical field where regulatory approvals and clinical trials are necessary parts of the process to get new products and methods introduced. This offers advantages as barriers to entry and lead time to prepare for any new competitors. Company A received private rulings for the year ended 30 June 20YY (authorisation number XXX) and for the year ended 30 June 20XX (authorisation number XXX) confirming that Company A is an ESIC in relation to the development of the Product. Since the issue of the 20YY private ruling, Company A has continued to develop its Product and provided a timeline of actions performed in relation to the development of the Product.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-40 | Income Tax Assessment Act 1997 subsection 360-40(1) | Income Tax Assessment Act 1997 paragraph 360-40(1)(a ) | Income Tax Assessment Act 1997 subparagraph 360-40(1)(a)(ii) | 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 subparagraph 360-40(1)(e)(i) | Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(ii) | Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(iii) | Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(iv) | Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(v) | Income Tax Assessment Act 1997 paragraph 360-40(1)(f) | Corporations Act 2001 section 9

Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated. Company A meets the eligibility requirements of an ESIC under subsection 360-40(1). | Detailed Reasoning - Qualifying ESIC: Subsection 360-40(1) outlines the criteria 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. | Detailed Reasoning - The early stage test: The early-stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d). | Detailed Reasoning - 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: 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. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b): To meet the requirement in paragraph 360-40(1)(b), the company and its 100% subsidiaries (if any) must have incurred total expenses of $1 million or less in the income year before the current year. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c): To meet the requirement in paragraph 360-40(1)(c), the company and its 100% subsidiaries (if any) must have derived total assessable income of $200,000 or less in the income year before the current year. | Detailed Reasoning - 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. | 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 [1] or the principles-based test. | Detailed Reasoning - 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 paragraph 360-40(1)(e) are: | Detailed Reasoning - 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 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... 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 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. '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. | Detailed Reasoning - 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. | Detailed Reasoning - 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, whereby it increases its market share or enters into new markets, and its existing revenues can be multiplied with a reduced or minimal increase in operating costs per unit. | Detailed Reasoning - 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. | Detailed Reasoning - 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. | Detailed Reasoning - Foreign company test - paragraph 360-40(1)(f): To meet the requirement at paragraph 360-40(1)(f), the company must not be a foreign company within the meaning of the Corporations Act 2001 at the test time . 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. | Detailed Reasoning - Test time: 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 during the income year ending 30 June 20ZZ. Company A raised capital of $X on 25 February 20ZZ. | Detailed Reasoning - Current year: For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20ZZ (the 20ZZ income year). | Detailed Reasoning - Incorporation or registration - paragraph 360-40(1)(a): As Company A was incorporated on 31 May 20XX, which is within the last six income years, subparagraph 360-40(1)(a)(ii) is satisfied if the incurred expenses for the previous three income years before the current year (being the years ended 30 June 20YY, 20XX and 20DD) is $1 million or less. For the income years ended 30 June 20YY, 20XX and 20DD, Company A's expenditure was less than $1 million, satisfying subparagraph 360-40(1)(a)(ii). Total expenses - paragraph 360-40(1)(b) Company A incurred expenses of $X in the 20YY income year. As Company A had expenses of $1 million or less in the prior income year, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c): Company A's assessable income was $X in the 20YY income year. As Company A's assessable income was $200,000 or less in the prior income year, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No stock exchange listing - paragraph 360-40(1)(d): As Company A is privately owned and is not listed on any stock exchange in Australia or a foreign country at the test time paragraph 360-40(1)(d) is satisfied. | Detailed Reasoning - Conclusion on early stage test: Company A will satisfy the early stage test for the entire 20ZZ income year as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - Principles-based test: In the private rulings for the 20XX and 20YY income years it was concluded that Company A passed the principles-based test in respect of the Product it is developing, and whilst still being developed it will continue to satisfy the principles-based test. Based on the progress made since the 20YY private ruling issued, Company A has continued to satisfy the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period 1 July 20YY to 30 June 20ZZ, and therefore satisfy the principles-based test. | Detailed Reasoning - Foreign Company Test: As Company A was incorporated in Australia, it is not a foreign company and paragraph 360-40(1)(f) is satisfied. | Detailed Reasoning - Conclusion: Company A will meet the eligibility criteria of an ESIC under section 360-40 the period 1 July 20YY to 30 June 20ZZ, or to the date when the Product has been fully developed and is ready for sale, whichever occurs earlier. [1] The objective (100 point) test is not considered for the purposes of this ruling. [2] OECD Oslo Manual, paragraph 124 and paragraph 151.

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 (if any) 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 income year). | the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation | the business relating to that innovation must have high growth potential | the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation | 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 | the company must demonstrate that it has the potential to be able to have competitive advantages for that business.