Private ruling: Early stage innovation company
Date of advice: 9 July 2020
Published: August 2020
Ruling period: Year ending 30 June 20XX.
Date scheme commenced: 1 July 20XX.

Ruling: Q1: Does Entity 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 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 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 subparagraphs 360-40(1)(e)(i) to (iv) | Income Tax Assessment Act 1997 section 360-45

Reasons for decision: Summary: All legislative references are to the ITAA 1997 unless otherwise indicated. | Detailed Reasoning - Question 1 summary:: Entity A meets the eligibility requirements of, an ESIC under, subsection 360-40(1). | 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. 2. A company qualifies as an ESIC if it satisfies the early stage test and one of two 'innovation' tests which are the 100-point innovation test or the principles-based innovation test. | Detailed Reasoning - 'The early stage test': 3. The early stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d) and are outlined below. | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a): 4. 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: 5. 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. 6. 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): 7. 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. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c): 8. 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. | Detailed Reasoning - No stock exchange listing - paragraph 360-40(1)(d): 9. 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 - Not a foreign company - paragraph 360-40(1)(f): 10. To meet the requirement in paragraph 360-40(1)(f) the company, at the test time, must not be a foreign company within the meaning of the Corporations Act 2001 . | Detailed Reasoning - Innovation tests: 11. 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. You have only provided evidence in respect of the principles-based test. The 100-point test will not be addressed in this ruling. | Detailed Reasoning - 'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (v): 12. To satisfy the principles-based test, the company must meet five requirements in 13. paragraph 360-40(1)(e). This is tested at a time immediately after the relevant new shares are issued to the investor. 14. 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. 15. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are as follows: (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. The five requirements in paragraph 360-40(1)(e) are outlined below. | Detailed Reasoning - Developing new or significantly improved innovations for commercialisation: 16. 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...' 17. The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. 18. 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. 19. 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. 20. 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. 21. 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. 22. The company must be genuinely focussed on developing the 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. This requirement draws the distinction between simply having an idea and commercialising an idea. 23. The EM does not define the meaning of the term 'genuinely focussed' within the context of subparagraph 360-40(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 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. | Detailed Reasoning - High growth potential: 24. 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: 25. 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. | Detailed Reasoning - Broader than local market: 26. 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: 27. 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 - Application to your circumstances: Test time 28. For the purposes of this ruling, the test time for determining if Entity A is a qualifying ESIC will be a particular date during the 20XX income year. Current year 29. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX (the 20XX income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years will include the years ending 30 June 20XX, 20XX and 20XX, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year). | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) 30. Entity A was incorporated and registered with the Australian Securities and Investment Commission on 3 April 20XX, which is within the last 3 income years. Subparagraph 360-40(1)(a)(iii) is satisfied. Total expenses - paragraph 360-40(1)(b) 31. As Entity A it had expenses less than $1 million in the prior income year. Paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) 32. Entity A's assessable income for the prior income year is also less than $200,000. Paragraph 360-40(1)(c) is therefore satisfied. No stock exchange listing - paragraph 360-40(1)(d) 33. Entity A is not listed on any stock exchange in Australia or a foreign country. Subparagraph 360-40(1)(d) is satisfied. Not a foreign company - paragraph 360-40(1)(f) 34. Entity A is wholly owned by an Australian public company that is not considered a foreign company within the meaning of the Corporations Act 2001 . Subparagraph 360-40(1)(f) is satisfied. Conclusion on early stage test 35. Entity A will satisfy the early stage test for the entire 20XX income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) and (f) have been satisfied. | Detailed Reasoning - 100-point test: 36. Entity A has not provided evidence of satisfying the 100-point test under section 360-45 for the year ending 30 June 20XX. For Entity A to be a qualifying ESIC it therefore needs to satisfy the principles-based test. | Detailed Reasoning - Principles-based test: Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) 37. Entity A was formed to improve upon and expand the market for the Technology in the mining industry. 38. Entity A has secured an exclusive lease agreement with Entity D for the use of the Technology on pre-development mining projects. 39. Entity A contends that this is the first time that this technology has been applied to specific projects in the mining industry. 40. If the Technology is successfully applied to the Project it will improve the Project's economics and likelihood it will be developed into a mine. 41. It is considered that Entity A has demonstrated that it is genuinely focussed on developing for commercialisation one or more new, or significantly improved, products, processes, services or marketing or organisational methods. Therefore, subparagraph 360-40(1)(e)(i) is satisfied. High growth potential - subparagraph 360-40(1)(e)(ii) 42. Once Entity A has proven that the Technology can be applied at a commercial scale then it proposes to market the Technology and its capability to other mining projects under the exclusivity arrangement with Entity D. 43. Entity A's target market will not be confined to Australia; however, Entity A's immediate focus will be the development of the Project. 44. On this basis, it is considered that Entity A's business relating to the Technology has a high growth potential and therefore subparagraph 360-40(1)(e)(ii) is satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 45. Entity A's business model is to negotiate equity ownership in undeveloped mining projects in return for managing and funding bulk mining trials to validate that the application of the Technology provides improved economic performance thereby facilitating development of the project. 46. The management team recruited by Entity A and know-how developed from the Project will be readily transferable to other projects. 47. It is considered that Entity A has established that it has the potential to successfully scale up its business and that subparagraph 360-40(1)(e)(iii) is satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) 48. Once Entity A has proven that the Technology can be applied at a commercial scale then it proposes to market the Technology to other mining projects in Australia. Entity A's market will not be confined to Australia and it intends to market the Technology globally. 49. It is considered that Entity A has demonstrated that the Technology has the potential to address a broader market than just the local market, including international markets 50. Therefore subparagraph 360-40(1)(e)(iv) is satisfied. Competitive advantages - subparagraph 360-40(1)(e)(v) (i) The world-leading nature of the Technology - the Technology was developed by Entity B and is patented, has commercial application in the mining industry. (ii) The exclusivity arrangement - the exclusive Technology Lease Agreement is not available to Entity A's competitors. (iii) Know-how and expertise held within Entity A - Entity A will develop and retain significant expertise in relation to the application of the Technology to mining projects. This will provide Entity A with credibility and a competitive advantage when negotiating arrangements for other projects. 51. It is considered that subparagraph 360-40(1)(e)(v) is satisfied. Conclusion on principles-based test 52. Entity A satisfies the principles-based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v). Conclusion 53. Entity A meets the eligibility criteria of an ESIC under section 360-40.

Relevant facts and circumstances: Entity A was entered on the Australian Business Register on 1 April 20XX. | Entity A was incorporated on 3 April 20XX. | Entity A does not have any subsidiaries and has not earned any income since its incorporation. | Entity A is not listed for quotation in the official list of any stock exchange in Australia or a foreign country. | Entity A is wholly owned by an Australian public company that is not considered a public company within the meaning of the Corporations Act 2001 . | Entity was formed to improve upon and expand the market for a particular mining Technology ( the Technology ) to be used in projects in the mining industry which are at a pre-development stage. | The Technology, which was developed by Entity B and is patented, has commercial application in the mining industry. | Entity C owns 100% of the XX Mining Project ( the Project ). | Entity A has secured an exclusive lease agreement with Entity D ( Technology Lease Agreement ) for use of the Technology on pre-development mining projects. Entity A proposes to use the Technology on the Project. If the Project proves amenable to use of the Technology, Entity A will have the opportunity to earn a substantial interest in the project which is demonstrated in the terms of an agreement between Entity A and Entity C. | Entity A intends, using the expertise gained with the Project, to apply the Technology to advance other undeveloped mining projects in Australia and then globally once its capabilities expand. | 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 the company and its 100% subsidiaries incurred total expenses of $1 million or less; or | registered in the Australian Business Register ( ABR ) within the last three income years (the latest being the current year). | Entity A contends that there are three key elements to its competitive advantage. These include the world-leading nature of the Technology; the exclusivity arrangement Entity A has for use of the Technology and the know-how and expertise held within Entity A. These advantages are further expanded upon as follows: