Private ruling: Early stage innovation company
Date of advice: 17 May 2022
Published: August 2022
Ruling period: Year ending 30 June 20XB
Date scheme commenced: 1 February 20XB

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: All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated. 1. Company A was incorporated in the ABN register X XXXX 20XB. Company A has no ultimate holding company and no subsidiaries. 2. Company A has acquired the existing intellectual property (IP) from Company B and is continuing to invest in ongoing research providing research and development (R and D) services and by investing in commercialising this IP. Company B is no longer commercialising the IP and has novated the existing IP. Therefore, this ruling applies to Company A. 3. 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 on or after 1 July 20XA, but before 30 June XB. 4. For the financial year ending 30 June XA Company A had assessable income of less than $200,000 and less than $1 million in total expenses. Company A was not trading in 20XA financial year. 5. 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. Details of new Innovation 6. You have advised that your current research priorities are as follows: • A suitable serum using Australian natural plants for use with microcurrent machines; • Australian natural plant C - Australia cousin to plant D but with three times the levels of active Phyto-compounds (asiaticoside, madecassic acid and asiatic acid). You are currently growing this plant in your lab and testing alternative methods for extraction. At this stage you think you will incorporate the extract into a mister but alternative formulations and delivery methods are being considered. You also plan to incorporate this into your forthcoming Australian natural plant ingestibles range. • Extracts - at the present time you use external contractors to manufacture your extracts (sometimes you supply the plant materials, sometimes they source it.) You are currently working with an extracts expert to scope out equipment needed and processes so that you can internally manufacture your own commercial quantities of extracts. • Plant E - you are currently experimenting with dehydration and grinding as opposed to water and alcohol-based extraction for the best way to extract the enzyme bromelain from an Australian fruit. You will be incorporating this into a number of products, and potentially your forthcoming ingestibles range, but for now you have developed, and are about to start selling. 7. You have provided your draft Business Plan. Key data in the Plan are the Business Objectives and strategic 3 Year Business Plan as follows: Business Objectives - Continue to innovate award winning formulas with unique Australian plants aiming to be 'first to market' with novel ingredients through ongoing research and development. Validate efficacy through clinical studies. - Expand First Nations supply chain and product collaborations. - Become a world leader in trusted beauty education in the plant-based beauty category by providing quality self-paced on-line education and treatment plans. - Grow our on-line direct to consumer (DTC) sales, and support our in store sales, through investment in social media, EDM, media marketing, and promotion. - Grow Brand E through education, social media, affiliates and brand ambassadors. - Form critical, strategic retail and distribution partnerships in Australia and globally. - Grow our manufacturing capability, including manufacturing botanical raws in-house to even further improve profit margins and to produce raws not able to be purchased. Strategic 3 Year Business Plan 20XB • Investment round • Appoint CEO • Increase DTC revenue • Increase Social Channel Followers and Engage Ambassador • Engage, appoint and outsource sales & marketing program. 20XC • Investment Round • Revenue Growth • Increase Staff to cover: Marketing, Direct sales, Distribution, Quality • Research and Development • Innovation - extend Australian plants range • Increase Brand Recognition • Explore Global Opportunities • Extend First Nation Supply Agreements • Enhance Manufacturing Facilities and Distribution Systems 20XD • Secure Global Sales Distribution • Revenue Growth • Research and Development • Partnerships • Wellness and Health • Leverage to Akin Products - ingestibles, subscription • Increase Presence in Skin Care Education. 8. The Business Model is explained as: • Brand is vertically integrated. • We research, formulate & manufacture skin care created with Australian plants in-house with capacity to scale to X,XXX units per day. • Registered as a R and D entity. • We own our own formulas (IP). • Margins are healthy. Control is maximised. In-house manufacturing means no need to pay for large production runs upfront. • We use an external sales agency and DTC. • Average unit Retail Price value is $XX-$XXX. COGS relative to RRP is 20% DTC to 70% W/S. • Currently all raws are purchased. In-house manufacture of some botanical extracts is planned which will further improve margins. • We have a large, flexible work-force of women who are passionate about the brand. 9. You explain the processes required for the innovation in respect of potential plant candidates, exploring the most suitable transport mediums, testing for safety and stability. 10. You plan on developing a range of beauty ingestibles next year using Australian plants. You aim to use ingredients and to create formulas that offer a strong point of difference to what is already available in the market. This is currently being developed and is expected to be complete in Quarter X of 20XB. Investor's Pitch Deck 11. You provided a copy of the Investor's Pitch Deck. This document included the following relevant information: • There are currently XX,XXX uniquely Australian plants. New research, new suppliers and new raw materials are coming on stream almost daily. We are constantly innovating. All out formulas: − Have Australian plants as their hero ingredients − Wild-Harvested/Organic − Fragrance-Free − Vegan − Certified Clean − Potent and Evidence-Based - all our claims are backed by clinical studies − Clean Clinical incorporating cutting edge bio-technology • Our Four Pillar approach to formulation and treatment focuses on: − Hydration − Brightening − Calming − Pro-Aging • Our future plans include expanding into Australian plants Beauty and Wellness Ingestibles. • Future Roadmap Company A has identified an Australian plant that has phyto-compound actives. We are in the process of commissioning research to test the extract and validate its efficacy with independent analysis. We intend patenting and trademarking the extract and including it in both our skincare, and ingestible range. Growth Potential 12. Company A's Business plan indicates that Company A has growth potential and a plan to upscale their products. 13. It plans to increase its ability for DTC by investing in social media, google, influencers and other investments to drive DTC. Funding will allow them to design, plan and implement a quality marketing campaign. Company A has selected suitable service providers for sophisticated brand positioning, social media strategy and implementation, content creation with appropriate brand voice and photography, as well as google and social media investment management. 14. Company A's focus on retail has been mostly small salons and spas and in response to demand, are launching a professional range. Their strategy is to support salon owners to become fans and build trust and loyalty from the bottom up. 15. Company A have been approached by several overseas distributors. 16. Company A are planning to manufacture their own extracts and once in their new facility can offer white labelling services to other brands. Scalability 17. Company A has provided income and expenses projections.

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 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 subparagraphs 360-40(1)(e)(v) | Income Tax Assessment Act 1997 section 360-45

Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated. Company A meets the eligibility requirements of an ESIC under subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 18. 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. | Detailed Reasoning - 'The early stage test': 19. 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): 20. 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 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 iii. registered in the Australian Business Register (ABR) within the last three income years (the latest being the current year). 21. 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. 22. 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): 23. 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): 24. 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): 25. 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: 26. 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. | Detailed Reasoning - '100 point test' - paragraph 360-40(1)(e) and section 360-45: 27. 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. | Detailed Reasoning - 'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (v): 28. 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. 29. 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. 30. The five requirements of the principles-based test, as outlined in paragraph 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. | Detailed Reasoning - Developing new or significantly improved innovations for commercialisation: 31. 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... 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. 32. 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. 33. 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. 34. 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. 35. 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." 36. 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. 37. '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: 38. 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: 39. 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. | Detailed Reasoning - Broader than local market: 40. 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: 41. 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): 42. At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001. 43. 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: 44. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date during the income year ending 30 June 20XB. | Detailed Reasoning - Current year: 45. For the purposes of subsection 360-40(1), the current year will be the income year ending 30 June 20XB (the 20XB income year). For clarity, the income year before the current year will be the year ending 30 June 20XA (the 20XA income year). 46. Company A did not exist prior to the 20XB year. | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a): 47. Company A was incorporated on 3 March 2022, which is within the last 3 income years of the 2022 income year. Therefore, Company A satisfies subparagraph 360-40(1)(a)(i). Consequently, paragraph 360-40(1)(a) is satisfied. 48. For completeness, it is noted that Company A would also satisfy subparagraph 360-40(1)(a)(iii) in respect of the 2022 income year as it was 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. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b): 49. 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): 50. As Company A's assessable income for the prior income year is $200,000 or less paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No stock exchange listing - paragraph 360-40(1)(d): 51. As Company A is privately owned and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(d) is satisfied. | Detailed Reasoning - Conclusion on early stage test: 52. Company A will satisfy the early stage test for the entire 20XB income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100-point test: 53. Company A has not provided evidence of satisfying the 100-point test under section 360-45 for the year ending 30 June 20XB. For Company A to be a qualifying ESIC it therefore needs to satisfy the principles-based test. | Detailed Reasoning - Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i): 54. We need to test whether there is a process being developed including third party interaction and automation that will be demonstratively new or significantly better than the industry leader's equivalent process when shares were/are to be issued during the 20XB income year. 55. From the information provided we feel the following innovations and products are seen as being new or significantly improved from what is currently available: • Misters - Plant C formulation still taking place. This is considered an example of a new product being developed. • Moisturisers - Plant B Oil-Free - Formulated, Tested, moving to packaging solution now. Oil-free moisturisers from Plant B is seen as a significantly improved product. Producing an oil-free Australian Plant Moisturiser is considered as innovative. • Moisturisers - Plant E Anti-Oxidant - hero ingredients identified, formulation not yet commenced. Anti-Oxidant moisturiser from Plant E is considered a new or improved product. 56. Paragraph 1.81 of the EM states: In addition, the company must be focussed on developing its innovation for a commercial purpose, or in other words, for the purpose of generating economic value and revenue for the ESIC. This requirement draws the distinction between simply having an idea and generating economic value from that idea. Commercialisation encompasses a spectrum of activities including those leading to the sale of new or significantly improved product, process or service as well as activities involving the implementation of a new, or significantly improved, process or method, where the process, or method directly leads to the generation of economic value for the company. [Schedule 1, item 1, paragraph 360-40(1)(e)(i)] 57. Should any of the three items listed above in paragraph 55 be successfully developed they will increase the economic value of Company A and generate revenue that would otherwise not have been generated if they had not been developed. 58. It is, therefore, considered that Company A is genuinely focussed on developing these new or improved innovations for a commercial purpose. The innovations will be significantly improved products compared to existing products. | Detailed Reasoning - Conclusion on subparagraph 360-40(1)(e)(i): 59. Subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XA until 30 June 20XB or the date when 'The Innovation' has been fully developed if before 30June 20XB, whichever occurs earliest. Once 'The Innovation' has been fully developed, Company A will no longer be 'developing' the products for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii): 60. Company A's Business plan indicates that Company A has growth potential and a plan to upscale their products. It plans to increase its ability for DTC by investing in social media, google, influencers and other investments to drive DTC. Funding will allow them to design, plan and implement a quality marketing campaign. Company A has selected suitable service providers for sophisticated brand positioning, a social media strategy and implementation, content creation with appropriate brand voice and photography, as well as google and social media investment management. 61. Company A's focus on retail has been mostly small salons and spas and in response to demand, are launching a professional range. Their strategy is to support salon owners to become fans and build trust and loyalty from the bottom up. They are focussing on high end spa chains, in particular tourist areas, where Australian Plants make particular sense as a value proposition. 62. Company A have been approached by several overseas distributors and are in discussion with renown expert who are is interested in becoming their Export Partner into the USA, 63. Company A are planning to manufacture their own extracts and once in their new facility can offer white labelling services to other brands. (See Strategic 3 year Business plan). 64. Therefore, it is considered that Company A's innovation has a high growth potential both domestically and overseas. Subparagraph 360-40(1)(e)(ii) will be satisfied. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii): 65. Company A has identified that it has the potential to be able to scale its business and will exhibit operating leverage as it enters new markets. They are already selling into twenty different accounts in Australia and have an Australian Sales & Marketing Strategy which has been implemented this year. They have been increasing revenue sales each month since March 20XA. They have an active account in New York and have a number of international distributors interested to represent the brand in their countries. 66. Company A has shown in its Business Plan forecasts that it has budgeted to effectively scale up its business and net profit over time. 67. Company A has clearly demonstrated the scalability of its product. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv): 68. Company A's Pitch Deck for Investors outlines plans to market their products in Australia, United States, Hong Kong and Germany. 69. Company A has established that it has the potential to address a broader market than just the local market, including international markets. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v): 70. Company A is currently innovating products that are not presently in the market. 71. While there are other Australian brands offering natural skin care containing some Australian Ingredients, Company A claims there is currently no other brand on the market besides their Brand that has as its value proposition exclusively Australian Plants. 72. Whilst Company A expects that their products will be imitated, they feel this is the cost of being a first mover. The multiple international awards they have won will bring attention to their ingredients and products and others will seek to imitate. They are constantly reviewing emerging university research, looking for new plants that might have potential and identifying potential suppliers of these as well as researching new ways of incorporating newly identified plants into innovative formulas. 73. It is considered their uniqueness and use of only Australian Plants provides them with competitive advantages. 74. Company A has demonstrated it has competitive advantages to satisfy subparagraph 360-40(1)(e)(v). | Detailed Reasoning - Conclusion on principles test: 75. Company A 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 20XA until 30 June 20XB or the date when 'The Innovation' has been fully developed and is ready for sale, whichever occurs earlier. | Detailed Reasoning - Foreign Company Test: 76. As Company A was incorporated in Australia it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied. | Detailed Reasoning - Conclusion: 77. Company A meets the eligibility criteria of an ESIC under subsection 360-40(1) of the ITAA 1997 for the period commencing 1 July 20XA until the earlier of 30 June 20XB or the date when the innovation has been fully developed and is ready for sale, whichever occurs earlier.