Private ruling: Early stage innovation company
Date of advice: 30 June 2017
Published: November 2017
Ruling period: Year ending 30 June 201B
Date scheme commenced: 1 July 201A

Ruling: Q1: Does Company A satisfy the requirements to be an early stage innovation company as determined in accordance with subsection 360-40(1) of the Income Tax Assessment Act 1997 ? | A1: Yes


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

Reasons for decision: Summary: All legislative references are to the ITAA 1997 unless otherwise indicated. | Detailed Reasoning - Question 1:: Does Company A Pty Ltd satisfy the requirements to be an early stage innovation company as determined in accordance with subsection 360-40(1) of the Income Tax Assessment Act 1997 ? | Summary: Company A meets the eligibility requirements of an ESIC under subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 30. 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 'test time’ for determining whether an entity is a qualifying ESIC is the time immediately after the relevant ESIC shares are issued. 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’: 31. The early stage test requirements are outlined in paragraphs 360-40(1)(a) to (d). | Detailed Reasoning - Incorporation or Registration – paragraph 360-40(1)(a): 32. 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). 33. 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. 34. It is considered that a company will satisfy the incorporation test in subparagraph 360-40(1)(a)(i) where, immediately after the issue of shares to the investor, the company had been incorporated in either: ● that part of the current year which precedes the issue of shares; or ● one of the two income years prior to that year 35. 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): 36. 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): 37. 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): 38. 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: 39. 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: 40. 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. Company A is not applying the 100 point test under section 360-45 for the year ending 30 June 201B. For Company A to be a qualifying ESIC it will need to satisfy the principles-based test. | Detailed Reasoning - 'Principles-based test’ – subparagraphs 360-40(1)(e)(i) to (iv): 41. 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. 42. 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. 43. 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: 44. 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. 45. 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. 46. 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. 47. 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. 48. '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: 49. 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: 50. 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: 51. 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: 52. 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 53. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date on or after 1 July 201A, but before 30 June 201B. Shares in Company A were issued to members of the public in February 201B. 54. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 201B (the 201B income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years includes the years ending 30 June 2015 to 30 June 201B. The income year before the current year is the year ending 30 June 201A (the 201A income year). | Detailed Reasoning - 'The early stage test’: 55. Company A was incorporated after 1 July 201A, which is within the current income year and satisfies paragraph 360-40(1)(a). 56. The year before the current year is the year ended 30 June 201A. As company A was incorporated in the year ended 30 June 201B, it could not have incurred any expenses in the year ended 30 June 201A, thereby satisfying paragraph 360-40(1)(b). 57. Company A had nil assessable income for the year ended 30 June 201A, thereby satisfying paragraph 360-40(1)(c). 58. As Company A is a private company that has not been listed for quotation on any foreign or domestic stock exchange that company satisfies paragraph 360-40(1)(d). As all criteria have been met, the early stage test has been satisfied. | Detailed Reasoning - 'Principles-based test’: Developing new or significantly improved innovations for commercialisation – subparagraph 360-40(1)(e)(i) 59. Subparagraph 360-40(1)(e)(i) requires two main elements to be present for the provision to be satisfied, being that the company is 'genuinely focussed’ and is 'developing new or significantly improved innovations for commercialisation.’ 60. Company A states that its focus is on three related projects. . 61. The research has application beyond Australia, to a global market. The particular test is used globally, and therefore the addressable market is potentially worldwide. 62. Changes to the particular tests are regarded as 'new or significantly improved’ being more accurate and reliable. Genuinely focussed on developing for commercialisation 63. Company A has entered into separate Licence Agreements with a University and Company B, two Commercial Research Agreements with a University, and a Supply Agreement with Company B. 64. Under the Licence Agreement with a University, the University grants Company A a worldwide licence to use the Licensed IP on the terms and conditions in the Agreement, including developing the IP, marketing, manufacturing, distributing, export or importing, make all reasonable efforts to bring the Licensed IP, modifications and products to market, and sublicensing the IP to allow other entities to use the IP. 65. Under the Licence Agreement with Company B, Company B grants Company A a worldwide licence to use the Licensed IP on the terms and conditions in the Agreement, including developing and commercialising the IP, take all reasonable steps to bring the Licensed IP and products to market, use reasonable endeavours, business judgement and acumen to commercialise the Licensed IP and products, and sublicensing the IP to allow other entities to use the IP. 66. The Licence Agreements with both the University and Company B have been entered into ensuring Company A has licence to use the IP. These agreements give ownership rights to both the background IP, i.e. research done prior to Company A being involved in the research projects, and foreground IP, i.e. the research done since entering into the contracts. 67. Company A has undertaken to commercialise the IP by either manufacturing or producing the new products and processes in its own right, partnering with another entity or sub-licencing the IP to another entity to commercialise on its behalf. 68. Under both Licence Agreements, Company A will undertake to take all reasonable efforts to bring the IP and products to market. 69. One of the main roles of the CEO is to seek out commercialisation opportunities. 70. Under the Commercial Research Agreements with the University, Company A will contribute over $X million within the first two years of the project, and Company A will also contribute over $X million within the first two years in relation to the projects. 71. Although it is difficult to accurately predict economic benefits for company A, if the research work is successful it is expected that there will be a marketable product at the end of the two year term of the Commercial Research Agreements. 72. Given the potential global market for the improved tests, if Company A was to licence its intellectual property, it would expect to receive royalties, and royalties on any sub-licencing agreement, resulting in substantial royalty revenue. Conclusion on subparagraph 360-40(1)(e)(i) 73. Subparagraph 360-40(1)(e)(i) requires two main elements to be present for the provision to be satisfied, being that the company is 'genuinely focussed’ and is 'developing new or significantly improved innovations for commercialisation.’ Company A is genuinely focussed on research in three related projects relating to prostate cancer developing significantly improved products or processes for commercialisation. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied. High growth potential 74. Due to the inaccuracies of the current testing, it is expected that the innovations applied by Company A will result in Company A’s product replacing the current testing. 75. The new testing will have global application enabling high growth potential. 76. Company A is currently developing key relationships with potential partners to enable it to sell its product in a larger market. 77. The agreements allow for the technology to be applied to other products, although Company A is currently focussing on one particular product. 78. Company A has a high growth potential in improved testing. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability 79. The testing process uses an improved method. As a result, once the test is ready for commercialisation it is cost effective for the test to be made available on a worldwide basis. 80. Company A anticipates entering into partnership agreements with large companies who have experience in commercialising the particular testing, which will allow Company A to leverage off the capabilities of the partners. Alternatively, Company A may licence the IP to various companies, which would allow for the business to be scaled up quicker due to lower costs for Company A. 81. Sub-licencing of IP to various companies will lead to a large increase in revenue with minimal increase in expenses, due to both economies of scale and the rationalisation of ongoing operating costs once the projects are completed and commercialisation begins. 82. As Company A meets its milestones, it will also have the ability to raise additional capital which will provide on-going funding for research and product development. 83. Company A has the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market 84. If successful, the innovation and technology relating to improving the accuracy of testing, will enable the testing to expand beyond Australia to a global market. 85. The technology is an improvement on current testing, and will likely replace the current tests, which are falling due to inaccuracy of results, and be applicable to a global market. 86. Company A has the ability to address the global market as the testing is the same globally and therefore does not need adapting for the overseas market. 87. By partnering with various companies or licencing the IP, Company A can quickly gain access to a worldwide market. 88. Company A has demonstrated that its technology has the potential to address a broader market than just the Australian market, including global markets. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. Competitive advantages 89. The patent applications which are the subject of the licence agreement and sub-licence agreement have been preceded by years of research. To the best of Company A’s knowledge, there is no other party conducting the same research anywhere in the world. 90. The rights to the IP under the licencing and sub-licencing agreements give Company A a strong competitive advantage. The supply agreement with Company B ensures Company A has supply of a product, and Company B cannot supply the product to a competitor of Company A, also providing competitive advantage. 91. The long lead times in researching the innovation present a high barrier to entry for any potential competitor. It would be cheaper for someone to licence the IP of Company A than develop their own product which is one of the methods Company A may use to commercialise its innovation to maximise its economic value. 92. Company A has demonstrated the potential for its technology to have competitive advantages within the research industry, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles-based test 93. Company A satisfies the principles-based test as it satisfies all of the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period ending 30 June 201B. Conclusion 94. Company A meets the eligibility criteria of an ESIC under subsection 360-40(1) for the period ending 30 June 201B. In particular, Company A met the eligibility criteria at the 'test time’ immediately after the issue of shares to new investors in February 201B.

Relevant facts: 1. Company A is a private company incorporated in Australia in 201A. None of its equity interests are listed on any stock exchange. The directors of the company are Taxpayer A, Taxpayer B and Taxpayer C. | 2. Shares in Company A were issued to members of the public in February 201B. | 3. Company A was established to conduct certain research. Its research is designed to provide an innovative new testing product and process which, if successful, will revolutionise certain testing in Australia and globally. | 4. Company A was incorporated in order to conduct various projects leading to the development of a commercially viable test. | 5. Company A is currently working on X related projects that it is aiming to technically develop and commercialise. | 6. It is expected that the new product will be commercially viable by December 201C. | 7. Company A has entered into X Commercial Research Agreements with a University in January 201B. These agreements set out the basis for collaboration between Company A and a University to conduct the programs researching the X projects for a 2-year period. | 8. According to the agreements, the overall aims of these programs are to: | ● Identify, improve and/or modify the testing process; and | ● Improve and/or modify the patents. | 9. Company A entered into a Licence Agreement with a University in December 201A with the University as the licensor, and Company A as the licensee. | A. The Licensor is the wholly owned commercial development company of the University and is authorised to deal with the Licensed IP. | B. The Licensor grants Licensee and the Licensee accepts a licence to use the Licensed IP on the terms and conditions specified in this Agreement. | 11. The agreement grants Company A a licence to use certain intellectual property. | 12. There is a lump sum licence payment, followed by future payments based on a percentage of licensee gross sales (subject to a minimum amount) or a percentage of sub-licencing revenue derived by Company A. | 13. The General Terms of the agreement includes: | Scope of Licence and Licensee Undertakings: The Licensor grants to the Licensee on and subject to the terms of this Agreement, a worldwide licence to do the following in the Field: | (a) to use any method or process comprising the Licensed IP (including sublicence others to use such method or process); | (b) to develop (including make Modifications to) the Licensed IP; and | (c) to do the following in respect of any Product: | (i) market, manufacture, distribute, hire, sell or otherwise dispose of Licensed Products (and offer to do any of those things); | (ii) use, export or import Licensed Products; | (iii) keep Licensed Products for any of the purposes above (including by way of one or tiers of sublicences) | (Licence Rights): To maintain the Licence, the Licensee must: | (a) pay the Licence Payments to the Licensor as set out in Item 5 of the Details, and any other amounts provided for in this Agreement. Unless otherwise specified in Item 5, the Licence Payments shall be paid at the same time as the reports to be provided under clause 9; | (b) enter into the Commercial Research Agreement | (c) make all reasonable efforts to bring the Licensed IP, Modifications and Products to market; | (d) not use the Licensed IP other than in accordance with the Licensed Rights in the Field of use; and | (e) otherwise comply with the terms of this Agreement and the Commercial Research Agreement. | 14. Company A entered into a licencing agreement with Company B in January 201B with Company B as the Licensor, and Company A as the Licencee. Company B had previously entered into a licencing agreement with the University. | A. The Licensor is authorised by an agreement to deal with the Licensed IP in the manner set out in this Agreement. | B. The Licensor grants the Licensee and the Licensee accepts a licence to use the Licensed IP on the terms and conditions specified in this Agreement. | 16. The agreement with Company A is a sub-licence agreement to allow Company A to use certain intellectual property. | 17. The agreement allows Company A to develop and modify using the intellectual property under the sub-licence, and to commercialise the intellectual property or any products arising from its use. | 18. To maintain the rights to the sub-licence, Company A must comply with the Research Agreement and take all reasonable efforts to bring the intellectual property and products to market. | 19. There is a flat rate licence payment, and then future payments based on gross sales (subject to a minimum amount) or a percentage of sub-licencing revenue derived by Company A. | 20. The general terms of the agreement include: | Scope of Licence: The Licensor grants to the Licensee on and subject to the terms of this Agreement, a worldwide licence in the Field of Use: | (b) to develop (including make Modifications to) the Licensed IP; | (c) to Commercialise the Licensed IP and any Products. | The Licensee shall pay the Licence Payments to the Licensor, and any other amounts provided for in this Agreement. | (b) take all reasonable efforts to bring the Licensed IP and Products to market; | This Agreement shall not transfer or otherwise affect ownership of Licensed IP. | Subject to the rights reserved to the Licensor in this Agreement: | (a) the Licensee has the exclusive right to exercise the Licence Rights in connection with the Field of Use; and | (b) the Licensor must not and must use reasonable endeavours to ensure that the University does not, except as provided in the Head Licence Agreement, (i) itself use or exploit in any way the Licensed IP in connection with the Field of Use or (ii) directly or indirectly permit, allow or grant any licence, right or other interest whatsoever to a third party to use or exploit in any way the Licensed IP in connection with the Field of Use. | Licensee Commercialisation: The Licensee shall Commercialise the Licensed IP in accordance with this Agreement. | The Licensee warrants that it shall: | (a) use reasonable endeavours, business judgement and acumen to Commercialise the Licensed IP and the Products; | (b) obtain and maintain all reasonably necessary authorisations, accreditations, registrations, regulatory approvals and endorsements for Products created by or under licence from or with the authority of the Licensee and the use by the Licensee or by a third party or under licence from or with the authority of the Licensee of the Licensed IP; | (c) comply with all applicable laws, regulations and government requirements of each country, state or area in which Products are produced, marketed or sold by the Licensee; | (d) in any sublicense of Licensed IP it enters into, ensure that it is a condition of the sublicense that: | (i) the sublicensee complies with all laws, regulations and government requirements for each country, state or area in which Products are produced, marketed or sold by the sublicensee; and | (ii) the sublicensee gives to the Licensor a covenant enforceable by the Licensor that the sublicensee will comply with its obligations referred to in (d)(i). | 21. Company A entered into a supply agreement with Company B in January 201B. This agreement provides for the supply of a certain product. Company B will be the exclusive supplier of the product to Company A. There is a clause in the contract restricting Company B from supplying the product to a third party if it becomes aware the supply would allow the third party to develop, use, market or sell a product which would be the same product or competitive with any product to be made by Company B. | 22. Company A ('Collaborating Partner’) entered a Commercial Research Agreement with the University ('University’) in December 201A to conduct X of the X research projects. Relevant sections include: | RECITALS: A. The Parties have identified a particular commercial research and development activity in which they desire to collaborate. | 'Commercialisation’ means use for commercial purposes or results, and includes the use, sale, marketing, distribution, production, licensing, practical application or other commercial application of Project Material including the provision or exploitation of a product, process, or service reliant on that IP or to license a third party to do any of these things. | 'Project Material’ means all Material arising out of, developed or otherwise brought into existence for the purpose of performing or pursuant to, a Project, including Material copied or derived from that Material. | Ownership and Commercialisation of Project Material: All right, title and interest in and to the Project Material (including all IP rights associated with Project Material), vest in the Collaborating Partner upon creation. | The Collaborating Partner will share the benefits from Commercialisation of Project Material with the University as set out in Annexure 2. | Description of Development Program: The overall aim of the Development Program is to improve and/or modify the research described in the Background Materials patents. | 23. In the first year of operation, it is budgeted that Company A will contribute almost $X million to the University, and almost another $X million in the second year in relation to the research projects. | 24. Company A ('Collaborating Partner’) entered a Commercial Research Agreement with the University ('University’) in January 201B. Relevant sections include: | 'Commercialisation’ means use for commercial purposes or results, and includes: | the use, sale, marketing, distribution, production, licensing, practical application or other commercial application of Derivative Material including the provision or exploitation of a product, process, or service reliant on that Material or to license a third party to do any of these things; | to use any method or process comprising the Derivative Material (including sublicensing others to use such method or process); | to develop (including make Modifications to) the Derivative Material; and | to do the following in respect of any Product: | (i) market, manufacture, distribute, hire, sell or otherwise dispose of Products (and offer to do any of those things); | (ii) use, export or import Products; | (iii) keep Products by way of one or tiers of sublicences). | 'Project Material’ means all Material arising out of, developed or otherwise brought into existence for the purpose of performing or pursuant to the Project, including Material copied or derived from that Material and/or an enhancement, improvement, modification or adaption thereof. | Revenue sharing from Commercialisation: The Collaborating Partner must share the benefits from Commercialisation of Derivative Material with the University and/or Company B. | Description of Development Program: The overall aim of the Development Program is to identify, improve and/or modify the research described in the Background Material patents. | 25. In the first year of operation, it is budgeted that Company A will contribute over $X00,000 to the University, and almost $X00,000 in the second year. | 26. Company A has entered into service contracts with a number of people. In addition, under the Commercial Research Agreement, the University is employing leading researchers in the field. | 27. The main service contracts are as follows: | Taxpayer A has many years’ experience in research, and is responsible for implementing and directing the development activities in accordance with the Commercial Research Agreements. | Taxpayer B is Chief Executive Officer (CEO) of Company A and is experienced in corporate governance, management, strategic planning and business development, and is responsible for seeking out commercialisation opportunities when products are ready for commercialisation. | 28. Leading researchers in the field are employed as part of these research projects, including an overseas professor. | 29. You have provided information in a number of documents in relation to your private ruling application, including: | ● Certificate of registration of Company A; | ● Provision of services of Taxpayer A; | ● Provision of services of Taxpayer B; | ● Licence Agreement dated December 201A between a University, as Licensor, and Company A, as Licensee; | ● Licence agreement dated January 201B between Company B, as Licensor, and Company A, as Licensee; | ● Commercial Research Agreement dated December 201A between a University (University) and Company A (Collaborating Partner); | ● Commercial Research Agreement dated January 201B between a University (University) and Company A (Collaborating Partner); | ● Supply Agreement between Company B and Company A.