Private ruling: ESIC early stage innovation company eligibility
Date of advice: 10 October 2019
Published: December 2019
Ruling period: Year ending 30 June 20ZZ
Date scheme commenced: 1 July 20YY

Ruling: Q1: Does Company A satisfy the criteria of an Early Stage Innovation Company (ESIC) pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 (' ITAA 1997 ')? | A1: Yes, provided the total incurred expenses at each test time is $1 million or less for the last three income years (the latest being the year ended 30 June 20ZZ, the 20ZZ year).

Relevant facts and circumstances: 1. Company A is a proprietary company incorporated in Australia and registered on the Australian Business Register more than 3 years prior to the year ended 30 June 20ZZ (the latest being the 20ZZ year). 2. Company A does not have any wholly owned subsidiaries. 3. For the financial year ended 30 June 20XX, Company A incurred expenses of less than $1 million and earned no income. 4. Company A expects that the total amount of expenses for the years ended 30 June 20XX, 20YY and 20ZZ will be less than $1 million. 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. 6. Company A is developing a unique wearable medical device, the Product, designed to improve patient care. 7. Company A is continuing to develop their Product. This includes the following: a) The product will be specially designed and manufactured, with the final product to improve the patient experience and efficacy of the treatment. b) Once a prototype is manufactured, multi-site clinical trials using it will begin. c) Regulatory approval must be sought from a number of governing bodies across the Australian and international markets. d) Once completed, commercial manufacturing of the Product may begin. 8. Company A anticipates further clinical trials and obtaining the necessary regulatory approvals will occur after 30 June 20ZZ before commercial manufacturing commences. 9. Company A's Product has been identified as having both a local and international addressable market. 10. The Product is aimed at being a lower cost alternative treatment, which would provide cost savings to hospitals and governments. 11. After the initial costs of development of the Product and once the Product enters commercial development, it is expected that the cost per unit manufactured will decrease, thus offering Company A economies of scale. 12. The product is designed to assist with a globally prevalent medical issue, thus making the Product a product that is able to address a broader than local market. 13. 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. 14. 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.

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: Company A meets meet the eligibility requirements of an ESIC pursuant to subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 15. 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': 16. 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): 17. 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). 18. 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. 19. 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): 20. 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): 21. 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): 22. 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: 23. 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: 24. 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 (IV): 25. 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. 26. 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. 27. 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: 28. 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..." 29. 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. 30. 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. 31. 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." 32. 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. 33. 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: 34. 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: 35. 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, 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. | Detailed Reasoning - Broader than local market: 36. 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: 37. 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 - Test time: 38. 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 on or after 1 July 20YY, and on or before 30 June 20ZZ. | Detailed Reasoning - Current year: 39. Therefore, for the purposes of subsection 360-40(1) ITAA 1997 , the current year will be the year ending 30 June 20ZZ. For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ended 30 June 20ZZ, 20YY and 20XX, and the income year before the current year will be the year ended 30 June 20YY. | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997: 40. Company A was incorporated in Australia more than 3 income years before the 20ZZ income year (the 20ZZ income year being the latest). Therefore, Company A will have to satisfy subparagraph 360-40(1)(a)(ii) to satisfy paragraph (a). That is, it will need to have incurred expenses of $1 million or less for the last three income years (the latest being the current year) from the test time as well as being incorporated in Australia within the last 6 income years. Given your projected expenses, subparagraph 360-40(1)(ii) should be satisfied for test times during the 20ZZ income year; however, this will need to be assessed at each relevant test time. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b) ITAA 1997: 41. In applying the requirements of paragraph 360-40(1)(b), Company A and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the relevant prior income year, being the income year before the current year. 42. Company A incurred expenses of less than $1 million in the 20YY income year. Consequently, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c) ITAA 1997: 43. In applying the requirements of paragraph 360-40(1)(c), Company A and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the relevant prior income year, being the income year before the current year. 44. Company A did not earn any assessable income in the 20YY income year. Consequently, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997: 45. In applying the requirements of paragraph 360-40(1)(d), Company A must not be listed on any Stock Exchange in Australia or a foreign country at the test time. 46. Company A will not be 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 - THE '100 POINT TEST' - PARAGRAPH 360-40(1)(E) AND SECTION 360-45: 48. Company A 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: 49. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be developing an innovation which is either new or significantly improved for an applicable addressable market. 50. Company A is developing a unique wearable pain management device called "The Product". This is being developed initially for the domestic market, with the aim of it being globally marketed. 51. The Product is a significant improvement over other similar devices on the market. 52. Company A is genuinely focused on developing the Product, so subparagraph 360-40(1)(e)(i) is satisfied for the year ended 30 June 20ZZ. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997 53. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be genuinely focused on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company. The product is currently in its development phase, which is expected to continue during the year ended 30 June 20ZZ. 54. Work already undertaken to develop Company A's Product is as follows: a) A minimum viable product was completed in using a package of existing off the shelf products to demonstrate the ability for the operation to work and improve patient outcomes. b) The above initial design of the Product is already being trialled in an Australian hospital with positive initial feedback. 55. There are a number of steps which are required to be completed into the future, before the Product is considered to be fully developed for commercialisation: e) The product will be specially designed and manufactured, with the final product to improve the patient experience and efficacy of the treatment. f) Once a prototype is manufactured, multi-site clinical trials using it will begin. g) Regulatory approval must be sought from a number of governing bodies across the Australian and international markets. h) Once completed, commercial manufacturing of the Product may begin. 56. Company A anticipates that the current programme of development will be completed in the year ended 30 June 20ZZ. This will be followed by further clinical trials and obtaining the necessary regulatory approvals before commercial manufacturing commences. 57. Company A is genuinely focused on developing the Product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the year ended 30 June 20ZZ. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 58. In applying the requirements of subparagraph 360-40(1)(e)(ii), Company A must be able to demonstrate that it has the potential for high growth within a broad addressable market. 59. The Product is aimed to address a common issue that affects the global population. The size of the addressable market, both domestically and internationally, is sufficient for Company A to experience high growth. 60. The Product offers a unique way to assist patients and allow the individuals to get back to normal activities sooner. 61. The Product is aimed at being a lower cost alternative treatment, which would provide cost savings to hospitals and governments, hastening its uptake and use. It will also have a lower socio-economic cost stemming from avoiding the consequences of addiction. This will encourage hospitals and governments to choose to use the Product over other methods. 62. Company A has demonstrated a high growth potential for their Product, a unique wearable pain management device called "The Product", so subparagraph 360-40(1)(e)(ii) is satisfied for the year ended 30 June 20ZZ. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 63. In applying the requirements of subparagraph 360-40(1)(e)(iii), Company A must be able to demonstrate that it has the potential to successfully scale up the business. 64. After the initial costs of development of the Product and once the Product enters commercial development, it is expected that the cost per unit manufactured will decrease, thus offering Company A economies of scale. 65. This leverage ensures that Company A has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the for the year ended 30 June 20ZZ. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 66. In applying the requirements of subparagraph 360-40(1)(e)(iv), Company A must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets. 67. The product is designed to assist with a common global issue, thus making the Product a product that is able to address a broader than local market. 68. Company A 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 for the year ended 30 June 20ZZ. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: 69. In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must demonstrate that it has potential to be able to have competitive advantage for that business. 70. 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. No other product offers the combination of significant improvements embodied in the Product. This should at least give Company A a first mover advantage in relation to the Product. 71. 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. 72. The two founders of Company A have extensive experience - one in establishing and scaling a global distribution company, and the other being a professional with extensive experience and a track record of completing clinical trials and publishing results. They, together with the design lead, have a proven track record of developing and commercialising technology and the building of a global business. 73. Company A is looking to patent the product, which will offer further protection for its design and will increase the difficulty for competitors to replicate the Product. 74. Company A has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the for the year ended 30 June 20ZZ. | Detailed Reasoning - CONCLUSION FOR PRINCIPLES BASED TEST: 75. Company A satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the for the year ended 30 June 20ZZ. | Detailed Reasoning - CONCLUSION: 76. Company A will meet the eligibility criteria of an ESIC under section 360-40 for a test time during the period year ended 30 June 20ZZ, provided the total incurred expenses at each test time is $1 million or less for the last three income years (the latest being the 20ZZ year).. [1] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.79.

Reasons for decision: All legislative references are to the Income Tax Assessment Act 1997 ('ITAA 1997') unless otherwise stated. | CONCLUSION FOR EARLY STAGE TEST: Company A satisfies the early stage test for the 20ZZ income year, as each of the requirements within paragraphs 360-40(1)(b) to (d) have been satisfied and provided the total incurred expenses at each test time is $1 million or less for the last three income years (the latest being the 20ZZ year)..