Private ruling: Early stage innovation company
Date of advice: 3 February 2023
Published: 20 March 2023
Ruling period: x XX 20XX to yy YY 20YY
Date scheme commenced: x XX 20XX

Ruling: Q1: Does Company X meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 ('ITAA 1997') for the period x XX 20XXto yy YY 20YY? | A1: Yes.

Relevant facts and circumstances: 1. Company Y was an Australian proprietary company incorporated in XXX on x YY 20XX. Company Y converted to an unlisted public company, Company X on y XX 20XX. 2. Company X's directors are Taxpayer A, Taxpayer B and Taxpayer C. 3. Company X's registered office and principal place of business is situated at XYZ. 4. Company X does not have any wholly or partly owned subsidiaries. Company X is not part of an income tax consolidated group. 5. For the financial year ending yy YY 20XX, Company X incurred and earned the following: • Total expenses of $xxx • Total income of $yyy 6. Company X's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country. Development of innovation 7. Company X is developing a scientific technology (the 'Product'), which has the potential to deliver huge improvements in military, border security, law enforcement and other related industries. 8. Company X is a joint venture between Company A and Company B, formed for the explicit purpose of commercialising Company A's advancements in this particular scientific technology. 9. The design has never before achieved commercial success. All business activities which the company will undertake are for the purpose of commercialising the technology. 10. Company X's Product enables highly targeted, non-contact detection of targets that have the potential to deliver huge improvements in several related industries. Development stages 11. The first phase of activities will be a series of product development phases; starting from the lab-designed Product and creating equipment that is smaller, more compact, robust and can operate outside. This product development will occur in parallel to discussions with potential customers, ensuring that the product is suitable for real use. The company has estimated xx months of activities to develop the product to a point that it is suitable for a first customer. 12. Company A and Company B have established Company X, with Company X and Company A having entered into a technology transfer agreement which sees that the work done by Company A to date will transfer in full to Company X in early 20YY, conditional upon the arrangement of equity funding by Company X, which Company B is seeking to arrange. 13. From the date the transfer is completed, Company X will commence product development activities on its own. As part of the pre-formation activities, the team that is creating Company X has engaged potential customers including Company D, Company U and Company H to guide the desired performance characteristics of the Product. Commercialisation strategy 14. Company X will be engaging with potential customers and various contracting agencies to design and develop the Product. 15. Company X's commercialisation strategy involves the following: • XX 20XX - Laboratory demonstration of latest technical developments. Explore performance trade-offs towards an optimised design • XX 20XX - XX 20YY - Size, weight and power improvements for commercial readiness. Design and build minimum viable product ('MVP'). • YY 20XY - Demonstration in real environment. • XY - XX 20XY - Performance characterisation and customer trials. • XX 20XY - Commercial sales. 16. To help guide this process, Company X will aim for close engagement with potential customers throughout the product development. Company X will also rely on external parties for R&D and Industrial design, contracting some services to these external parties. 17. The first product is expected to be fully developed by XX 20XY. Following this first commercial product, Company X will continue to develop and sell subsequent products that use the same technology for the detection of other explosives. High growth potential 18. The application of Company X's Product has multiple large & high growth potential industries. There is a wide range of applications that have been identified for the use of Company X's Product by several research and commercial institutions. 19. Growth opportunities for Company X existing on multiple avenues; penetrating the market, expanding into new / adjacent markets, product development & integrations, and market growth itself. 20. The primary addressable market for Company X has been estimated at $xyz. Urban applications have not been quantified as it is a longer-term prospect and more disperse market, however several opportunities have already been identified. Scale up the business 21. Company X is in the early stages of formation, however Company A scientists who achieved the technological breakthrough believe that development of a minimum-viable product within x years is realistic. 22. The team involved in the formation of Company X has a successful track record of commercialising new technologies and introducing them to a global market. 23. Company A and Company B have a track record of successfully partnering to commercialise two other ESICs. Both companies have achieved the initial stages of commercial success, with one listing on the ASX earlier this year. 24. The proposed management team (which will commence employment upon first investment into the company) are highly experienced and supported by Company A and Company B networks. The CEO is a decorated leader in the particular industry. The CTO is a multi-award winner in the Australian scientific community. He has been involved with the development of this technology within Company A over decades and has a long history of collaboration with global players who have devoted resources towards this research program. Broader than local market 25. The market for this Product is global, and Company X has the ability to address this global market through its unique product and experienced team. 26. Through organisations such as Company H or Company U, Company X will have a strong beachhead to enter markets across the world. 27. The market is dominated by a small number of global companies who are keen to be at the forefront of technological innovation. Distributing through one or more global players would allow for rapid expansion throughout the world. Competitive advantages 28. Current attempts at using these types of Products have been largely unsuccessful. Potential competitors will not legally be able to copy Company X's Product due to the exclusive license and will struggle to successfully imitate the breakthrough due to the advanced know-how that has been developed over decades within Company A. 29. The competitive advantage is expected to endure beyond the initial patent life as new innovations build on the initial patent and algorithmic processing of the Product. 30. The unique technology allows for Company X to have a strong competitive advantage. Current technology uses sensitive detectors to search for the artefact. Each false positive takes considerable time to investigate, which will be improved by Company X's Product, ultimately improving the process through improved accuracy. 31. Company X is developing their Product to address a number of discrete markets and is continuing to develop their Product. 32. Company X's Product has been identified as having an international addressable market. Information provided 33. You have provided a number of documents containing detailed information in relation to Company X's Product, including: • Private Binding Ruling ('PBR') Application, dated yy XX 20YY • Response to further questions provided 34. We have referred to the relevant information within these documents in applying the relevant tests to your circumstances. 35. You propose to issue new shares in Company X in the current financial year to various investors to assist in funding the continued development and commercialisation of the Product. Assumption(s) Not applicable.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-15 | Income Tax Assessment Act 1997 section 360-40 | 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 X meets the eligibility requirements of an ESIC under subsection 360-40(1) for the period x XX 20XX to yy YY 20YY. | Detailed Reasoning - Qualifying Early Stage Innovation Company: 36. Subsection 360-40(1) outlines the criteria required for a company to qualify as an Early Stage Innovation Company (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': 37. 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): 38. 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 before the current year, the company 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). 39. 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. 40. 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): 41. 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. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c): 42. 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. | Detailed Reasoning - No stock exchange listing - paragraph 360-40(1)(d): 43. 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': 44. 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: 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. | Detailed Reasoning - 'PRINCIPLES-BASED TEST' - SUBPARAGRAPHS 360-40(1)(e)(i) TO (v): 46. To satisfy the Principles-based Innovation 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. 47. 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. 48. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are: i. the company must be genuinely focussed on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods 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 - subparagraph 360-40(1)(e)(i) ITAA 1997: 49. 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..." 50. The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. [1] 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. 51. Improvements must be significant in nature to meet this requirement. Significant is defined in the online Macquarie Dictionary as " important; of consequence ." 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. 52. 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." 53. 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. 54. For a company to qualify as an ESIC under the principles based test, the company must be "genuinely focussed on developing for commercialisation" their innovation. That is, the central activities of the company must be truly concentrated on developing their 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. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 55. The company must be able to demonstrate that the business relating to the innovation has a high growth potential 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 - subparagraph 360-40(1)(e)(iii) ITAA 1997: 56. The company must be able to demonstrate that it has the potential to successfully scale up the business relating to the innovation. 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 - subparagraph 360-40(1)(e)(iv) ITAA 1997: 57. 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 - subparagraph 360-40(1)(e)(v) ITAA 1997: 58. 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): 59. At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001 (Cth). 60. The dictionary in 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. | Detailed Reasoning - TEST TIME: 61. 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 x XX 20XX, and on or before yy YY 20YY. | Detailed Reasoning - Current year: 62. Therefore, for the purposes of subsection 360-40(1) ITAA 1997 , the current year will be the year ending yy YY 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending yy YY 20YY, 20XX and 20ZZ, and the income year before the current year will be the year ending yy YY 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997: 63. Company X was incorporated in XYZ on y YY 20XY, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) are satisfied. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b) ITAA 1997: 64. In applying the requirements of paragraph 360-40(1)(b), Company X and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20XX income year, being the income year before the current year. 65. Company X incurred expenses of $xx in the 20XX income year. Consequently, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c) ITAA 1997: 66. In applying the requirements of paragraph 360-40(1)(c), Company X and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20XX income year, being the income year before the current year. 67. Company X earned $yy of assessable income in the 20XX income year. Consequently, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997: 68. In applying the requirements of paragraph 360-40(1)(d), Company X must not be listed on any Stock Exchange in Australia or a foreign country at the test time. 69. Company X is not listed on any Stock Exchange in Australia or a foreign country at the test time, so paragraph 360-40(1)(d) is satisfied. | Detailed Reasoning - CONCLUSION FOR EARLY STAGE TEST: 70. Company X satisfies the early stage test for the 20YY income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - THE '100 POINT TEST' - PARAGRAPH 360-40(1)(e) AND SECTION 360-45: 71. Company X has not provided sufficient evidence of satisfying the 100-point test under section 360-45 for the year ending yy YY 20YY. Company X are electing to seek eligibility by satisfying the Principles-based Innovation test under section 360-40(1)(e)(i)-(v), in order to be issued with a Private Binding Ruling. | Detailed Reasoning - Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i) ITAA 1997: 72. 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. 73. Company X is developing a scientific technology (the 'Product'), which has the potential to deliver huge improvements in several related industries. 74. Company X is a joint venture between Company A and Company B, formed for the explicit purpose of commercialising Company A's advancements in this particular scientific technology. 75. The design has never before achieved commercial success. All business activities which the company will undertake are for the purpose of commercialising the technology. 76. Company X's Product enables highly targeted, non-contact detection of targets that have the potential to deliver huge improvements in several related industries. 77. Company X is developing their Product to address a number of discrete markets and is continuing to develop their Product. 78. Company X is genuinely focussed on developing their Product for an applicable addressable market. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997 79. In applying the requirements of subparagraph 360-40(1)(e)(i), Company X must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company. 80. Company X will be engaging with potential customers and various contracting agencies to design and develop the Product. 81. Company X's commercialisation strategy involves the following: • XX 20XX - Laboratory demonstration of latest technical developments. Explore performance trade-offs towards an optimised design • XX 20XX - XX 20YY - Size, weight and power improvements for commercial readiness. Design and build minimum viable product ('MVP'). • YY 20XY - Demonstration in real environment. • XY - XX 20XY - Performance characterisation and customer trials. • XX 20XY - Commercial sales. 82. To help guide this process, Company X will aim for close engagement with potential customers throughout the product development. Company X will also rely on external parties for R&D and Industrial design, contracting some services to these external parties. 83. The first product is expected to be fully developed by XX 20XY. Following this first commercial product, Company X will continue to develop and sell subsequent products that use the same technology for the detection of other explosives. 84. Company X is genuinely focussed on developing their Product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to yy YY 20YY, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier. Once the Product has been fully developed, Company X will no longer be 'developing' the product for commercialisation. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 85. In applying the requirements of subparagraph 360-40(1)(e)(ii), Company X must be able to demonstrate that it has the potential for high growth within a broad addressable market. 86. Company X has high growth potential as their Product is easily and infinitely scalable to a global audience. 87. Growth opportunities for Company X existing on multiple avenues; penetrating the market, expanding into new / adjacent markets, product development & integrations, and market growth itself. 88. Company X has provided details to satisfy this requirement. 89. Company X has demonstrated a high growth potential for their Product, subparagraph 360-40(1)(e)(ii) is satisfied for the period x XX 20XX to yy YY 20YY. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 90. In applying the requirements of subparagraph 360-40(1)(e)(iii), Company X must be able to demonstrate that it has the potential to successfully scale up the business. 91. The Executive team has proven experience with successfully scaling up technology. The proposed management team (which will commence employment upon first investment into the company) are highly experienced and supported by the Company A and Company B networks. The CEO is a decorated leader and has been awarded an Australian Public Sector Innovation Award. The CTO is a multi-award winner in the Australian scientific community. He has been involved with the development of this technology within Company A over decades and has a long history of collaboration with global players who have devoted resources towards this research program. 92. Company X have commenced communications with prospective customers and respected consultants / equipment suppliers who have demonstrated interest in the technology and product. 93. Company X as a company is based on IP, which is a fixed cost that achieves economies of scale when incorporated in a greater number of products. Furthermore, the manufacturing process is expected to achieve large economies of scale. When coupled with greater technology awareness, Company X expects to be a highly scalable business. 94. Company X has provided details to satisfy this requirement. 95. This leverage ensures that Company X has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period x XX 20XX to yy YY 20YY. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 96. In applying the requirements of subparagraph 360-40(1)(e)(iv), Company X must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets. 97. The market is dominated by a small number of global companies who are keen to be at the forefront of technological innovation. Distributing through one or more global players would allow for rapid expansion throughout the world. 98. Company X has provided details to satisfy this requirement. 99. Company X has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied for the period x XX 20XX to yy YY 20YY. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: 100. In applying the requirements of subparagraph 360-40(1)(e)(v), Company X must demonstrate that it has potential to be able to have competitive advantage for that business. 101. Company X's competitive advantage is expected to endure beyond the initial patent life as new innovations build on the initial patent and algorithmic processing of the signal. 102. The unique technology allows for Company X to have a strong competitive advantage. Current technology uses sensitive detectors to search for the artefact. Each false positive takes considerable time to investigate, which will be improved by Company X's Product, ultimately improving the process through improved accuracy. 103. Company X has provided details to satisfy this requirement. 104. Company X has demonstrated that it has competitive advantages for its business, so subparagraph 360-40(1)(e)(v) is satisfied for the period x XX 20XX to yy YY 20YY. | Detailed Reasoning - CONCLUSION FOR PRINCIPLES BASED TEST: Company X satisfies the Principles-based Innovation test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period x XX 20XX to yy YY 20YY, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier. | Detailed Reasoning - Foreign Company Test - subparagraph 360-40(1)(f) ITAA 1997: 105. As Company X was incorporated in Australia, it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied. | Detailed Reasoning - CONCLUSION: Company X meets the eligibility criteria of an ESIC under section 360-40 for the period x XX 20XX to yy YY 20YY or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier. [1] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.79.