Private ruling: Investors eligibility for tax incentives for early stage investors in innovation companies
Date of advice: 26 November 2018
Published: February 2019
Ruling period: 1 July 20XX to 30 July 20XX
Date scheme commenced: XX XXXX 201X

Ruling: Q1: Does the company the investor, a trust, acquired shares in 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. | Q2: Is the investor, a trust, and each of its unit holders, entitled to a tax offset in relation to the acquisition of shares in the innovation company, pursuant to section 360-15 of the ITAA 1997? | A2: Yes. | Q3: Is each member of the self-managed superannuation funds that are unit holders of the trust entitled to a tax offset in relation to the acquisition of shares in the innovation company, pursuant to section 360-15 of the ITAA 1997? | A3: No. The trustee of the self-managed superannuation funds would be entitled to the share of the tax offset.

Relevant facts and circumstances: 1. The innovation company was incorporated in Australia within the last three income years. It does not have any subsidiaries. 2. In the financial year ended 30 June 20XX, the trustee for the investor, a Trust, subscribed for, and acquired, ordinary shares in the innovation company for an amount in excess of $500,000. A disclosure under section 708 of the Corporations Act 2001 was not required to be issued for the share offering. 3. The Trust and the innovation company were not affiliated at the time of acquisition of the shares. 4. The Trust held less than 30% of the issued ordinary share capital in the innovation company following the transaction. 5. The unit holders of the Trust comprise of a number of individuals and self-managed superannuation funds. 6. None of the unit holders in the Trust are foreign residents. 7. Each unit holder has been issued a determination of their entitlement to an amount of the tax offset in accordance with subsection 360-30(4) of the ITAA 1997. 8. The ordinary shares acquired by the Trust are not shares that constitute an employee share scheme interest pursuant to paragraph 360-15(1)(e) of the ITAA 1997. 9. The Trust at no time has held, directly or through associates, more than 30% of the equity interests in the innovation company or any connected company. 10. The innovation company did not satisfy the requirements of the 100 point innovation test in section 360-45 of the ITAA 1997 at the relevant time. 11. During the financial year ended 30 June 20XX, the total expenditure incurred by the innovation company was less than $1 million, and satisfies the requirements of paragraph 360-40(1)(b) of the ITAA 1997. 12. During the financial year ended 30 June 20XX, the innovation company did not have any assessable income, and satisfies the requirements of paragraph 360-40(1)(c) of the ITAA 1997. 13. The innovation company is not listed on a stock exchange anywhere in the world and satisfies the requirements of paragraph 360-40(1)(d) of the ITAA 1997. 14. The innovation company has developed methods and systems for a particular aspect within the industry to reduce processing times, diminish the risk of fraud, and to make it easier for industry participants to comply with regulatory requirements. 15. The innovation company will own all the intellectual property / patent / trademarks for and associated with the methods and system. 16. The innovation company’s objective is to establish the innovation as the market preferred methods and system within the Australia industry within three years. They intend to expand their interest globally to the larger overseas markets in the industry. The methods and system can be readily adapted to the overseas market at minimal cost. 17. The methods and system were under development at the test time and not ready for pilot testing with potential customers. The innovation company had conducted research, registered its research and development with AusIndustry and claimed the Research and Development tax offset. The innovation company had also applied for a grant under an accelerator program offered by a Government department. 18. The innovation company had established a relationship with other organisations to facilitate introductions and negotiations with potential customers in Australia and to outsource its marketing to drive direct sales. Relationships have been cultivated with a number of potential customers through this arrangement and the innovation company has participated in accelerator / incubator programs and industry conferences. A trial has also since been undertaken with a multinational organisation. 19. The innovation company has projections of the revenue and operating expenses in the next two years based on two scenarios of expansion within their own and other industries. 20. A patent application was filed on XX XXXX 20XX by the innovation company to protect the methods and system from being copied by any competitors and therefore maintain their competitive. The innovation company has also entered non-disclosure agreements and contractual clauses to protect the intellectual property. 21. The innovation company has not identified any direct competitors with the same methods and system for use in the industry. Alternatives to the methods and system currently operate in the industry for other products the methods and system will not be used for.

Relevant legislative provisions: Income Tax Assessment Act 1997 subsection 328-130(2) | Division 360 | section 360-15 | subsection 360-15(1) | subparagraph 360-15(1)(a)(i) | paragraph 360-15(1)(e) | subsection 360-15(2) | subsection 360-15(3) | section 360-20 | section 360-25 | section 360-30 | subsection 360-30(1) | subsection 360-30(2) | subsection 360-30(4) | subsection 360-30(5) | subsection 360-40(1) | paragraph 360-40(1)(a) | paragraph 360-40(1)(b) | paragraph 360-40(1)(c) | paragraph 360-40(1)(d) | subparagraph 360-40(1)(e)(i) | subparagraph 360-40(1)(e)(ii) | subparagraph 360-40(1)(e)(iii) | subparagraph 360-40(1)(e)(iv) | subparagraph 360-40(1)(e)(v) | subsection 995(1) | Corporations Act 2001 section 708 | subsection 708(8) | paragraph 708(8)(a) | paragraph 708(8)(b) | paragraph 708(8)(c) | paragraph 708(8)(d) | subsection 708(10) | subsection 708(11) | paragraph 708(11)(a) | paragraph 708(11)(b) | Superannuation Industry (Supervision) Act 1993 section 62 | paragraph 65(1)(b)

Reasons for decision: Summary: Yes. The innovation company meets the eligibility requirements of an ESIC under subsection 360-40(1) of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: For an investor to be entitled to the tax incentives, the innovation company must qualify as an ESIC. The conditions for a company to qualify as an ESIC at a particular time in an income year are set out in subsection 360-40(1) of the ITAA 1997. The provision specifies that the company must meet at a particular time: ● the early stage test, and ● either the: ● 100-point innovation test, or ● principles-based innovation test. The time referred to is the ‘test time’. In the circumstances, the ‘test time’ for determining if the innovation company would qualify as an ESIC is immediately after the new shares are issued to the Trust – i.e. on or after XX XXXX 201X but before 30 June 20XX. | Detailed Reasoning - Early stage test requirements: To meet the early stage test, the innovation company must meet the four requirements outlined in paragraphs 360-40(1)(a) to (d) of the ITAA 1997. These requirements are: (a) the company must’ve been incorporated or registered in the Australian Business Register within the last three income years (b) the company (plus any wholly-owned subsidiaries of the company) must have total expenses of $1 million or less in the previous income year before the current year (c) the company (plus any wholly-owned subsidiaries of the company) must have assessable income of $200,000 or less in the previous income year before the current year, and (d) the company's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country. For the purposes of this ruling, the current year is the year ending 30 June 20XX, and the income year before the current year is the year ending 30 June 20XX. Under the requirement in paragraph 360-40(1)(a) of the ITAA 1997, the company must’ve been incorporated in Australia or registered in the Australian Business Register within the last three income years (the latest being the current income year in which the requirement is tested). The innovation company satisfies this requirement as it was incorporated within Australia within the last three income years. Further, the innovation company satisfies the other requirements in paragraphs 360-40(1)(b) to (d) of the ITAA 1997 because: ● total expenses for the income year ended 30 June 20XX were less than $1 million ● it did not have any assessable income for the income year ended 30 June 20XX, and ● their shares were not listed on any stock exchange in Australia or a foreign country at the test time. The innovation company therefore satisfies the early stage test for the income year ended 30 June 20XX. The Commissioner notes that the Trust had advised him that the innovation company wouldn’t meet the 100-point innovation test. This means that for the innovation company to qualify as an ESIC it must meet the principles-based innovation test. | Detailed Reasoning - Principles-based innovation test requirements: To qualify under the principles-based test, the innovation company must meet the five requirements outlined in subparagraphs 360-40(1)(e)(i) to (v) of the ITAA 1997. These requirements 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 that business (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 - Genuine focus on developing one or more new or significantly improved innovations for commercialisation: This requires the innovation company to demonstrate that the innovation it is developing is either new or significantly improved in relation to the addressable market. The innovation company’s addressable market is considered to be Australia as the innovation company has identified an available revenue opportunity and potential market demand in the finance industry here from the innovation. In terms of the innovation, the innovation company has identified it as a product and a process for the finance industry with points of difference to the traditional methods and system it seeks to replace. The methods and system aim to improve security and accuracy, reduce processing times and costs, and diminish the risk of fraud and improve the retention of data in the finance industry. The Commissioner understands similar technologies exist for use for other products and alternative methods and systems are offered by other organisations for use in the finance industry but acknowledges that the innovation company’s methods and systems for the target product do not have a direct competitor. It is therefore considered that, based on the observable points of difference, that the innovation company’s innovation is new or a significant improvement to current products and processes that are already available in Australia. However, the innovation company must be genuinely focused 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. At the test time the innovation was under development whereas at present the innovation has undergone a trial with a multinational company. At the test time the efforts to develop the innovation for commercialisation included: ● applying for a grant under an accelerator program offered by a Government department at or about the time of share issue to the Trust ● the creation and update of the business model for business development activities ● establishment of relationships with other organisations to facilitate introductions and negotiations and to drive sales with potential customers ● participated in an accelerator program aimed at promoting and accelerating innovation by identifying and developing commercial solutions to business challenges in collaboration with start-ups in the finance industry ● registration of its research and development with AusIndustry and claimed the tax offset ● the filing of provisional patents for the methods and system, and ● engagement with consultants to complete the development of the methods and system. Based on the above information it is considered that the innovation company is genuinely focussed on developing the innovation for a commercial purpose. Subparagraph 360-40(1)(e)(i) of the ITAA 1997 has therefore been satisfied at the test time. | Detailed Reasoning - High growth potential: This requires the innovation company to demonstrate that it has the potential for high growth within a broad addressable market. The innovation company reports that the market for its methods and system in the finance industry consists is broad within Australia and overseas. ABS data illustrates significantly high transaction data within the Australia finance industry the methods and system are targeted at. The innovation company intends for the methods and system to address the domestic Australian market and then expand to the overseas markets in the finance and other industries. Based on the above information it is considered that the innovation company has high growth potential and satisfies the requirement in subparagraph 360-40(1)(e)(iii) of the ITAA 1997 at the test time. | Detailed Reasoning - Scalability: This requires the innovation company to demonstrate that it has the potential to successfully scale up its business. This means that the innovation 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. It is accepted that the innovation company satisfies this requirement under subparagraph 360-40(1)(e)(iii) of the ITAA 1997 at the test time. The innovation company has demonstrated through its projections that it has the potential to scale up the business by expanding the scope of its methods and system within Australia and then to the worldwide market. The innovation company intends to expand the methods and system to other products in the finance industry. The innovation company has indicated that expansion would not require substantial additional resources to achieve as the methods and systems can be readily adapted to the overseas market at minimal cost. The modelling undertaken provides support to these statements to the extent that revenues are forecast to increase with expansion to market share and on entering new markets with a minimal increase to operating expenditure. | Detailed Reasoning - Broader than local market: This requires the innovation company to demonstrate that it has the potential to address a market that is broader than a local city, area or region. It must also show that its business can be adapted to a national, multinational or global scale in future. It is accepted that the innovation company satisfies this requirement under subparagraph 360-40(1)(e)(iv) of the ITAA 1997 at the test time. The innovation company has demonstrated that methods and system has the potential to address the finance industry within Australia and that it can be adapted to other products within the marketplace at a multinational or global scale in the future. That is, the methods and system may be tailored to accommodate the requirements of its potential customers both here and abroad. | Detailed Reasoning - Competitive advantages: This requires the innovation company to demonstrate that it has the potential to have competitive advantages over its competitors, such as cost or differential advantages, which are sustainable for the business. It is accepted that the innovation company satisfies this requirement under subparagraph 360-40(1)(e)(v) of the ITAA 1997 at the test time. The innovation company has demonstrated that its product (i.e. the methods and system) is rare and substitute products are not readily available in the marketplace. The innovation company has also sought to protect its product from imitation through the registration of patents. | Detailed Reasoning - Conclusion: The innovation company has demonstrated that it satisfies the requirements of the principles-based innovation test in relation to its methods and system for the finance industry. The innovation company therefore qualified as an ESIC pursuant to subsection 360-40(1) of the ITAA 1997 at the test time. | Detailed Reasoning - Question 2: Is the investor, a trust, and each of its unit holders, entitled to a tax offset in relation to the acquisition of shares in the innovation company, pursuant to section 360-15 of the ITAA 1997? | Summary: The investor, a trust, and each of its unit holders, would be entitled to a tax offset in relation to the acquisition of shares in the innovation company. | Detailed Reasoning - Detailed reasoning: The tax incentives for early stage investors are contained in Division 360 of the ITAA 1997. One of the incentives for an investor that purchases new shares in an ESIC is a non-refundable carry forward tax offset. Section 360-15 of the ITAA 1997 provides that an investor is entitled to the tax offset in an income year no matter whether the investment is made directly as a corporation, an individual or indirectly through a trust or partnership. In other words, if the investor is a trust or partnership, special rules in subsection 360-15(2) of the ITAA 1997 apply so that the entitlement to the tax offset flows through to the member of the trust or partnership. As such, each of the unit holders would be entitled to the tax offset in income year ended 30 June 2017, if the Trust would have satisfied certain conditions if it were an individual. Subsection 360-15(1) of the ITAA 1997 provides that an investor is entitled to the tax offset for an income year if it satisfies all of the following conditions. ● the investor is not a widely held company or a wholly-owned subsidiary of a widely held company ● the shares acquired by the investor were newly issued equity interests in a company that satisfies the conditions of an ESIC under subsection 360-40(1) of the ITAA 1997 at the test time. ● the investor and the company were not affiliates of each other at the time the shares were issued. ● the issue of the shares are not the acquisition of ESS interests under an employee share scheme. ● the investor does not hold more than 30% of the equity interests in the company (including any entities connected with the company) immediately after the issue of the shares. In the circumstances of this case, the trust, has satisfied each of the above conditions. That is: ● the Trust is not a widely held company ● the ordinary shares acquired were newly issued equity interests ● the innovation company satisfied the conditions of an ESIC under the principles based innovation test in subsection 360-40(1) of the ITAA 1997 after the issue of the shares (see the answer to question 1) ● the entities were not affiliated with each other at the time of issue of the shares ● the shares are not ESS interests under an employee share scheme, and ● the Trust holds less than 30% of the equity interests in the innovation company after the issue of the shares. The unit holders of the Trust would otherwise be entitled to the tax offset. This is, however, subject to whether the trust meets the sophisticated investor test. | Detailed Reasoning - Limited entitlement to the tax offset for certain kinds of investor: Section 360-25 of the ITAA 1997 provides that the amount of the tax offset for an investor and their affiliates combined in an income year is equal to 20% of the total amount paid for their qualifying investments up to a maximum offset of $200,000. However, section 360-20 of the ITAA 1997 provides that, if the investor is not a sophisticated investor under the Corporations Act 2001 , the total amount of the investment by the investor cannot exceed $50,000 to be able to access the tax offset. An entity may be a sophisticated investor if one of the requirements for the removal of the need for a disclosure document in relation to the issue of the shares as described in subsections 708(8), (10) or (11) of the Corporations Act 2001 was satisfied. These requirements for the removal of the need for a disclosure document include the investor: ● has paid at least $500,000 for the qualifying shares (either as a single offer or including any amounts previously paid for shares of the same class that the investor holds in the same company) ● holds a certificate issued by a qualified accountant that confirms the investor meets certain asset and income requirements, or a company or trust controlled by a person holding the certificate ● was offered the qualifying shares through a financial services licensee who is satisfied the investor has previous investment experience that allows them to assess the offer and sign a written acknowledgement that the licensee hasn't given them a disclosure document in relation to the offer ● meets the requirements of being a 'professional investor' under the Corporations Act 2001 (such as a financial services licensee), or ● has or controls gross assets of at least $10 million (including any assets held by an associate or under a trust the investor manages). In the circumstances of this case, the Trust satisfies the meaning of sophisticated investor. The requirement in paragraph 708(8)(a) of the Corporations Act 2001 has been met because the purchase price of the shares in the innovation company exceeded $500,000. The total amount of the tax offset that all of unit holders combined would be entitled to claim in an income year would therefore be equal to 20% of the $600,000 paid for the qualifying investment. | Detailed Reasoning - Members of trusts: Section 360-30 of the ITAA 1997 provides that a member of a trust, including a unit holder, at the end of an income year is entitled to a carry-forward tax offset for that income year, if the trust were an individual and would be entitled to a tax offset for an income year under subsection 360-15(2) of the ITAA 1997. The amount of the offset is the member’s share of the tax offset as determined by the trustee as a percentage of the notional tax offset amount multiplied by the notional tax offset amount. The notional tax offset amount is the amount of the offset that would be available to the trust if it was an individual as calculated under section 360-25 of the ITAA 1997. The trustee of the Trust can therefore determine each unit holder’s percentage of the notional tax offset amount. Subsection 360-30(5) of the ITAA 1997 however requires that the sum of all percentages determined in relation to all members does not exceed 100% of the amount that the Trust would be entitled to. However, if the terms of the Trust provides that a unit holder would be entitled to a fixed proportion of any capital gain if any asset were disposed of at the end of the income year, then the unit holder's share of the tax offset must be equivalent to that fixed proportion under subsection 360-30(5) of the ITAA 1997. The trustee of the Trust must also give each unit holder written notice of the determination made about their share of the tax offset. The notice must include enough information to enable the unit holder to work out their share of the notional tax offset. This notice must be given to the unit holder within three months of the end of the 2017 income year, or within a further time allowed by the Commissioner under subsection 360-30(4) of the ITAA 1997. It is further noted that subsection 360-15(3) of the ITAA 1997 provides that a trustee of a trust is entitled to a tax offset for an income year if: (a) the trustee would be entitled to a tax offset for the income year if the trustee were an individual, and (b) the trustee is liable to be assessed or has been assessed, and is liable to pay tax, on a share of, or all or a part of, the trust's net income under section 98, 99 or 99A of the Income Tax Assessment Act 1936 for the income year. In other words, if any amount of the tax offset has been applied by the trustee against any tax payable on an assessment of the trust, the unit holders of the trust would be entitled to the remaining proportion of the tax offset. | Detailed Reasoning - Question 3: Is each member of the self-managed superannuation funds that are unit holders of the Trust entitled to a tax offset in relation to the acquisition of shares in the innovation company, pursuant to section 360-15 of the ITAA 1997? | Summary: The members of the self-managed superannuation funds that are unit holders of the Trust are not entitled to the tax offset. It is the trustee of each of the funds that is entitled to the share of the tax offset. | Detailed Reasoning - Detailed reasoning: An investor that is a trust is not entitled to the tax offset pursuant to subparagraph 360-15(1)(a)(i) of the ITAA 1997. However, the special rules outlined in subsection 360-15(2) of the ITAA 1997 operate such that the members of the trust would be entitled to the tax offset if the Trust would have been so entitled under subsection 360-15(1) of the ITAA 1997 if the Trust were an individual. This would be so in the circumstances of this case if those unit holders of the Trust were not self-managed superannuation funds. Where the member of the Trust is itself another trust whose entitlement to the offset, arose by operation of the special rules in subsection 360-15(2) of the ITAA 1997, not subsection 360-15(1) of the ITAA 1997, the offset is not able to pass through to its own members. It is noted that: ● paragraph 1.50 of the explanatory memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Act 2016 indicates that the intent of the law was for the offset to pass through any interposed entities until it ultimately reaches an entity that is not a trust or partnership, and ● Treasury Laws Amendment (2018 Measures No. 2) Bill 2018 has been introduced into Parliament to give effect to that intention. However, prior to the enactment of the amendments, the existing legislation has effect and the incentive cannot flow through to the members of more than one trust. Further, if the offset were to pass through to the members of the self-managed superannuation funds, there would be concerns about the fund complying with its regulatory requirements. In particular: ● whether the investment is consistent with the sole purpose test under section 62 of the Superannuation Industry (Supervision) Act 1993 , and ● the prohibition of the trustee of the fund from giving ‘any other’ financial assistance to a member of the fund (or a relative of the member) using resources of the fund under paragraph 65(1)(b) of the Superannuation Industry (Supervision) Act 1993 . As a result, the trustee of the self-managed superannuation fund, and not the members, would be entitled to the share of the tax offset.