Private ruling: Eligibility as an Early Stage Investment Company (ESIC)
Date of advice: 29 November 2016
Published: May 2017
Ruling period: Year ending 30 June 201X
Date scheme commenced: August 201X

Ruling: Q1: Does the Company 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: The Company was incorporated during the income year ended 30 June 201X. The Company's equity interests are not listed for quotation in the official list of any stock exchange. The Company has no subsidiaries and has nil expenses and nil assessable income for the previous income year. The Company is developing a medical device (the Device), which will simplify the management of a condition. The Company is currently at the stage of finalising an initial design for the Device. The Device The Company's management team includes a number of experienced individuals qualified in various relevant fields. Their experience includes developing and commercialising medical devices. Over the last X years, the Company's leadership team has had numerous meetings and interactions with relevant parties. Through these it became apparent that a solution to this was an unmet market need. The Device is intended to provide a convenient and cost effective solution to the management of the condition. The Device is designed to be used with minimal user input. This is a simpler system than other current technologies on the market, which require more user input, leading to higher risk of user error. The Device is simple to use and relatively small and unobtrusive. Its ease of use and its inconspicuousness is expected to increase compliance amongst users and lead to better health outcomes. Commercialisation strategy At this stage, The Company has developed an initial design for the device. The next steps include finalising the design input requirements, CAD generation and patent filing before creating functional prototypes for user testing. The Company plans to lodge a patent application for the intellectual property associated with the Device. The Company currently intends to subcontract the manufacture of the Device to large contract manufacturers. The contract manufacturer will manufacture the Device on The Company's behalf. The Company will then sell the Device to their business partner(s). Information provided This ruling relies on the information provided by the applicant. You propose to issue new shares in The Company to various investors to assist in funding the continued development and commercialisation of the Device.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-40 | Income Tax Assessment Act 1997 section 360-45 All legislative references are to the ITAA 1997 unless otherwise indicated.

Reasons for decision: Summary: The Company meets the eligibility requirements of, an ESIC under, subsection 360-40(1). | Detailed Reasoning - Qualifying early stage innovation company: 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': 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): 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). 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. 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): 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): 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): 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: 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: 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): 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. 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. 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: For the purposes of Subdivision 360-A, an innovation is considered to be a new or significantly improved product, process, service, marketing or organisational method. 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. 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. 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. '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: 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: 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: 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: The company must be able to demonstrate that it has the potential to have competitive advantages, such as a cost or differential advantage over its competitors which are sustainable for the business as it expands. The company can analyse what competitors in the market offer, and consider whether the company has a differentiating advantage that would allow it to outperform these competitors. | Detailed Reasoning - Application to your circumstances: Test time For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC will be a particular date during the year ending 30 June 201X. Current year For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 201X (the 201X income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years will include the years ending 30 June 201X, 201X and 201X, and the income year before the current year will be the year ended 30 June 201X (the 201X income year). | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) As the Company was incorporated within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. Total expenses - paragraph 360-40(1)(b) As the Company did not incur any expenses in prior financial years, paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) As the Company did not derive any assessable income during the 2016 income year, its assessable income for the prior income year is less than $200,000 and paragraphs 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) As the Company is privately owned and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(a)(d) is satisfied. Conclusion on early stage test The Company will satisfy the early stage test for the entire 201X income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100 point test: The Company has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 2017. For The Company to be a qualifying ESIC it will need to satisfy the principles-based test. | Detailed Reasoning - Principles based test: Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) The Company is developing the Device, which will provide a simpler and more convenient way for patients to manage their condition. The Company has identified its current addressable market as the global market. The Device's simple design and ease of use minimises user error and allows for easier compliance with treatment for users. This has the potential to popularise the device for commercialisation. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) The Company has taken the following steps in developing the Device: a) scoping of market opportunity and unmet need b) assessment of comparative advantages c) formulate device specifications based upon unmet need and comparative advantages required d) prototype Device design e) identification of key personnel for the company - a team of experts have been engaged with a track record in developing and commercialising medical devices f) preliminary budgeting and business plan preparation g) discussions underway to raise seed capital. The Company is currently at the stage of finalising an initial design for the Device. The Device is more than simply an idea, as discussed in the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 . The management team have already begun discussions with investors to raise seed capital and produced a promotional PowerPoint for such purposes. They are also developing a business plan. The timeline provided that the Company plans to lodge a patent application with respect to the intellectual property regarding the Device in the first quarter of the 201X calendar year. Initial functional prototypes are then expected to be ready at the end of this quarter for user testing during the second quarter of the 201X calendar year. To continue developing the Device for commercialisation, the following steps require completion: a) testing and design phase - user testing and design iteration until the end of the 201X calendar year b) produce fully functioning prototypes by the 201X calendar year c) design finalisation during the first quarter of the 201X calendar year. During this time, the Company expects to develop commercial agreements which will come into effect in the second half of the 201X calendar year. This will see the construction of the equipment necessary to manufacture the Device, which when manufactured will be ready for human clinical trials. Once the human trials are completed and approval is obtained, the Device will be ready for sale to customers. The Company will generate revenue via charging a royalty, license fee, or other such payment for the use of their intellectual property in the manufacture of the Device. The above facts demonstrate the Company has taken tangible steps to lead to the sale of the Device, which demonstrates a genuine focus on developing the Device for commercial sale. Conclusion on subparagraph 360-40(1)(e)(i) The Company is genuinely focussed on developing the Device for a commercial purpose. The Device will be a significantly improved product compared to existing products currently in use. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 201X until 30 June 201X or the date when the Device has been fully developed, whichever occurs earliest. Once the Device has been fully developed, The Company will no longer be 'developing' the product for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. High growth potential - subparagraph 360-40(1)(e)(ii) The Device will appeal to patients as it offers a more convenient, simpler and less intrusive way of managing their condition. The Device's simple use mitigates issues of non-compliance. The Company plan to have the Device made on their behalf by large contract manufacturers, to increase manufacturing efficiencies and reduce costs, and will then provide the Device to their business partner(s). This gives the Company the potential to rapidly expand their business. The Company has a high growth potential based on the above factors, summarised below: a) the large and growing market b) the Device's attractiveness to customers, and c) The Company's commercialisation strategy, which affords The Company the potential to address the global market and scale up production. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) The cost of designing and developing the Device for market is a major expense for The Company. Once the Device has been fully designed, developed and tested through human clinical trials, it will be able to commercially market the Device and increase sales to consumers via resellers. The Company will generate economic value through their direct supply of the Device to their partner(s). This strategy's purpose is to generate significant economic value while reducing the costs that would be incurred by The Company had they manufactured and marketed the product themselves. This will allow them to leverage the providers' / manufacturers' efficient logistics and supply chains to achieve economies of scale to lower unit cost for the end consumer. It also allows The Company to have multiple manufacturing sites, giving them the ability to scale up manufacturing if and when necessary. Selling to resellers can also reduce marketing costs where it avoids the additional costs of marketing directly to the end consumer. Such arrangements are planned to be made with a number of different businesses to allow the Company the flexibility to meet market demand. The Company plans to contract for a set number of units to be produced, thus guaranteeing a minimum number of sales. By using this approach after the completion of the Device's design, The Company will be able to generate increased revenue with only a minimal increase in operating costs. This operating leverage affords the Company the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) The Company's Device will be able to be used by patients across the globe. Thus, the addressable market is on a global scale and is not confined to a local city, area or region. The Company's Device initial target market is at a national level. The Company has demonstrated the Device has the potential to address a broader market than just a national market, including international markets. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. Competitive advantages - subparagraph 360-40(1)(e)(v) The Device's differentiating features may give it a competitive advantage. Medical devices such as this must go through an approval process in every country in which it is sold. This, combined with the patent they may hold, as well as the already established partnerships for the manufacture and supply of the Device, may give rise to a high barrier of entry for a competitor to replicate the Device. The Company plans to lodge a patent application with respect to the intellectual property regarding the Device. If a provisional patent is held, it may be cheaper for a competitor to license the use of the Company's intellectual property, rather than developing it themselves. The Company has a first mover advantage within the market given that this device is currently not available to consumers. The Company has demonstrated the potential for the Device to have competitive advantages, thus satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test The company 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 201X until 30 June 201X or the date when the Device has been fully developed and is ready for sale, whichever occurs earlier. Conclusion The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 201X until the earlier of 30 June 201X or the date when the Device has been fully developed and is ready for sale, whichever occurs earlier.