Private ruling: Early stage innovation company status
Date of advice: 10 September 2019
Published: November 2019
Ruling period: Year ended 30 June 2017
Date scheme commenced: 1 July 2016

Ruling: Q1: Did Company A meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997) when it issued shares on Date X? | A1: Yes

Relevant facts and circumstances: 1. Company A was incorporated in Australia on Date A. Its equity interests are not listed for quotation in the official list of any stock exchange and on Date X Company A issued shares to an investor. 2. Company A has two subsidiaries IP Co and Trading Co. 3. All three companies were incorporated in the year ended 30 June 2017. 4. On Date B Company A and Trading Co assigned their intellectual property (IP) rights in respect of the business which will use the innovation to IP Co with Trading Co licencing the IP from IP Co. On the same date Company A signed an agreement with Trading Co that required Trading Co to develop and operate the business. 5. Documents in respect of the innovation being developed were provided and the relevant information within these documents were used in applying the relevant tests.

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

Reasons for decision: Summary: All legislative references are to the ITAA 1997 unless otherwise indicated. | Summary: Company A meets the eligibility requirements of an ESIC under subsection 360-40(1) on Date X. | Detailed Reasoning - Qualifying Early Stage Innovation Company: 7. 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': 8. 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): 9. 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). 10. 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. 11. 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): 12. 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): 13. 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): 14. 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: 15. 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 - 'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (v): 16. 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. 17. 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. 18. 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: 19. 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..." [1] 20. 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. 21. 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. 22. The OECD Oslo Manual defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. However, it is important to recognise that an innovation can also consist of a series of smaller incremental changes that together constitute a significant change. [2] 23. In discussing services innovation activity, paragraph 111 of the OECD Oslo Manual states, "Innovation activity in services also tends to be a continuous process, consisting of a series of incremental changes in products and processes. This may occasionally complicate the identification of innovations in services in terms of single events, i.e. as the implementation of a significant change in products, processes or other methods." 24. 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." 25. 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. 26. '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: 27. 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: 28. 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: 29. 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: 30. 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 31. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date during the income year ending 30 June 2017 being Date X. Current year 32. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2017 (the 2017 income year). | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) 33. As Company A was incorporated on Date A, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. Total expenses - paragraph 360-40(1)(b) 34. As Company A and its two subsidiaries were all incorporated in the year ended 30 June 2017 it had no expenses in the prior income year (the 2016 income year) and paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) 35. As Company A and its two subsidiaries were all incorporated in the year ended 30 June 2017 it had no assessable income in the prior income year (the 2016 income year) and paragraph 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) 36. As Company A is privately owned and is not listed on any stock exchange in Australia or a foreign country paragraph 360-40(1)(d) is satisfied. Conclusion on early stage test 37. Company A satisfied the early stage test for the entire 2017 income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - Principles based test: The company is genuinely focussed on developing a new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) - 'the company' 38. In this case there are three companies in the group. Company A and its 100% subsidiaries IP Co and Trading Co. 39. Although dealing with Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements TR 2010/3 , paragraphs 65 to 67 provides some insight on the interaction between the companies in the group. These paragraphs state: 65. The doctrine of a corporation's 'directing mind and will' was explained by Millet J in El Ajou v. Dollar Land Holdings plc and another (referred to with approval on appeal) as follows: Since a company is an artificial person, the knowledge of those who manage and control it must be treated as the knowledge of the company.... Those who 'constitute the directing mind and will of the company' are the company for this purpose. Their minds are its mind; their intention its intention; their knowledge its knowledge. 66. In circumstances where a number of entities share a common controller, the controller's knowledge of one of the group's affairs can generally be attributed to another member of the same group. In Endresz v. Whitehouse Ormiston JA referred to 'the principle applicable to controlling directors'. He quoted from Ford's Principles of Corporations Law as follows: A distinction has to be drawn between the case where the director is a controller of two companies and where the director is only one of several directors of two companies. In the former case each company will know what the other knows because they each have the same directing mind and will: attribution of the director's knowledge to each company does not depend on the existence of a duty but on the director being identified with each company as its directing mind and will. 67. The directing mind and will of a private company need not be limited to its board or one or more directors. Case law establishes that different persons may for different purposes satisfy the requirements of being an entity's directing mind and will. 40. In determining which company to test, section 360-40 exists to allow an investor to determine their eligibility to an offset under section 360-15. In applying the tests in section 360-15 'the company' that must pass the tests referenced in 360-40 is the company that issued the shares to investors. 41. As the shares were issued by Company A it is Company A that must pass the tests in section 360-40. 42. If we return to paragraphs 65 to 67 of TR 2010/3, IP Co and Trading Co are 100% subsidiaries of Company A and Company A will know what each subsidiary is doing at any given point of time as the intentions and knowledge of all three companies would be shared. However a company is still an artificial person, and by making a reference to 'the company', subparagraph 360-40(1)(e)(i) we have to apply the test to each company in isolation and not the group. 43. In addition section 360-15 also sets a specific point in time in which the section 360-40 test is undertaken. This is when the shares were issued by Company A on Date X. So what we are testing is whether Company A was genuinely focussed on developing a new or significantly improved innovation on Date X. 44. On Date X Company A, would have been making the decisions in respect of the future direction and development of the business. This is because they held the capital of the group and was the only company in the group with the finances available to undertake any activities in respect of the development of the business. 45. Once the two agreements were signed and formalised the directors of Trading Co, acting on behalf of Trading Co, were the ones making the decisions in respect of the development of the business. Company A made this possible by lending the funds needed to Trading Co to develop the business. 46. In effect the signing of the agreements and the making of the loan were the conclusion of Company A's direct involvement in respect of the development of the business. From Date B (which was after Date X) Company A could no longer be seen as the company developing the business. Going forward Trading Co was developing the business and Company A benefited through increased dividends. 47. However the shares were issued on Date X which was when Company A was still directly in control of the development of the business. The company is genuinely focussed on developing a new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) - the innovation 48. Information provided by Company A demonstrated that their innovation will be a significant improvement within their target market. The company is genuinely focussed on developing a new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) - genuinely focussed 49. Although the development of the business was taken over by Trading Co, the activities undertaken by Trading Co demonstrate the activities that Company A would have undertaken if they had not transferred the development of the business to Trading Co. 50. As Trading Co had undertaken activities to develop the business, including the development of the innovation, there was a clear genuine focus in building the business which incorporates the innovation. Conclusion on subparagraph 360-40(1)(e)(i) 51. There is a genuine focus on developing the business which until the agreements were signed was being directly controlled by Company A. It was only after the agreements were completed that the responsibility to develop and operate the business transferred to Trading Co. 52. Therefore subparagraph 360-40(1)(e)(i) was satisfied on Date X. High growth potential - subparagraph 360-40(1)(e)(ii) 53. Information provided by Company A demonstrated the potential for high growth. 54. Therefore subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 55. Information provided by Company A demonstrated that it should be able to generate increased revenue without increasing its operating costs affording the potential to successfully scale up the business. 56. This means that on Date X the future business, which was still controlled directly by Company A, had the potential to scale up. Therefore subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) 57. Information provided by Company A has demonstrated that the business has the potential to address a broader market than just the local market. 58. This means that on Date X the future business, which was still controlled directly by Company A, had the potential to address a broader market than a local market. Therefore subparagraph 360-40(1)(e)(iv) will be satisfied.. Competitive advantages - subparagraph 360-40(1)(e)(v) 59. Information provided by Company A has demonstrated the potential for the business to have competitive advantages. 60. This means that on Date X the future business, which was still controlled directly by Company A, had the potential to have competitive advantages within its addressable market. Therefore subparagraph 360-40(1)(e)(v) is not satisfied. Conclusion on principles test 61. Company A satisfies the principles based test as it satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) on Date X. Conclusion 62. Company A meets eligibility criteria of an ESIC under section 360-40 on Date X. [1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76. [2] OECD Oslo Manual, paragraph 124 and paragraph 151.