Private ruling: Early stage innovation company
Date of advice: 11 February 2021
Published: March 2021
Ruling period: 1 July 20XX to 30 June 20YY
Date scheme commenced: 1 July 20XX

Ruling: Q1: Does Company A satisfy the criteria of an Early Stage Innovation Company ('ESIC') pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 ('ITAA 1997') for the period 1 July 20XX to 30 June 20YY? | A1: Yes


Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-15 | Income Tax Assessment Act 1997 section 360-40 | Income Tax Assessment Act 1997 section 360-45

Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 ('ITAA 1997') unless otherwise stated. Company A meets the eligibility requirements of an ESIC pursuant to subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 29. 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': 30. 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): 31. 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 before the current year, 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). 32. 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. 33. 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): 34. 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): 35. 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): 36. 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: 37. 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: 38. 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 (v): 39. 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. 40. 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. 41. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are: i. the company must be genuinely focussed on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods ii. the business relating to that innovation must have a high growth potential iii. the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation iv. the company must demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business, and v. the company must demonstrate that it has the potential to be able to have competitive advantages for that business. | Detailed Reasoning - Developing new or significantly improved innovations for commercialisation: 42. 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..." 43. The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. [1] The company's addressable market is the revenue opportunity or market demand arising from the innovation or the related business. The addressable market must be objective and realistic. 44. Improvements must be significant in nature to meet this requirement. Significant is defined in the online Macquarie Dictionary as " important; of consequence ." Customising existing products or minor changes resulting from software updates, pricing strategies or seasonal changes are examples of improvements that would not be considered significant. 45. 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." 46. The company must be genuinely focussed on developing the innovation for a commercial purpose in order to generate economic value and revenue for the company. This requirement draws the distinction between simply having an idea and commercialising an idea. 47. For a company to qualify as an ESIC under the principles based test, the company must be "genuinely focussed on developing for commercialisation" their innovation. That is, the central activities of the company must be truly concentrated on developing their innovation for a commercial purpose. 'Commercialisation' includes a range of activities that involve the implementation or sale of a new or significantly improved innovation that will directly lead to the generation of economic value for the company. | Detailed Reasoning - High growth potential: 48. The company must be able to demonstrate that the business relating to the innovation has a high growth potential within a broad addressable market. This refers to the company's ability to rapidly expand its business. Companies that are limited to supplying local customers will not meet this requirement. | Detailed Reasoning - Scalability: 49. The company must be able to demonstrate that it has the potential to successfully scale up the business relating to the innovation. The company must have operating leverage, whereas it increases its market share or enters into new markets, its existing revenues can be multiplied with a reduced or minimal increase in operating costs. | Detailed Reasoning - Broader than local market: 50. 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: 51. 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 - Foreign Company test - paragraph 360-40(1)(f): 52. At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001 (Cth). 53. The dictionary in section 9 of the Corporations Act 2001 (Cth) defines a foreign company to mean: (a) a body corporate that is incorporated in an external Territory, or outside Australia and the external Territories, and is not: (i) a corporation sole; or (ii) an exempt public authority; or (b) an unincorporated body that: (i) is formed in an external Territory or outside Australia and the external Territories; and (ii) under the law of its place of formation, may sue or be sued, or may hold property in the name of its secretary or of an officer of the body duly appointed for that purpose; and (iii) does not have its head office or principal place of business in Australia. | Detailed Reasoning - TEST TIME: 54. For the purposes of this ruling, the 'test time' for determining if Company A is a qualifying ESIC, will be upon the issue of qualifying shares on a particular date or dates on or after 1 July 20XX, and on or before 30 June 20YY. | Detailed Reasoning - Current year: 55. Therefore, for the purposes of subsection 360-40(1) ITAA 1997 , the current year will be the year ending 30 June 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending 30 June 20YY, 20XX and 20ZZ, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997: 56. Company A was incorporated on x XX 20XX, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(iii) are satisfied. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b) ITAA 1997: 57. In applying the requirements of paragraph 360-40(1)(b), Company A and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20XX income year, being the income year before the current year. 58. Company A incurred $xx in expenses in the 20XX income year. Consequently, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c) ITAA 1997: 59. In applying the requirements of paragraph 360-40(1)(c), Company A and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20XX income year, being the income year before the current year. 60. Company A earned $yy in income in the 20XX income year. Consequently, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997: 61. In applying the requirements of paragraph 360-40(1)(d), Company A must not be listed on any Stock Exchange in Australia or a foreign country at the test time. 62. Company A is not listed on any Stock Exchange in Australia or a foreign country at the test time, so paragraph 360-40(1)(d) is satisfied. | Detailed Reasoning - CONCLUSION FOR EARLY STAGE TEST: 63. Company A satisfies the early stage test for the 20YY income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - THE '100 POINT TEST' - PARAGRAPH 360-40(1)(E) AND SECTION 360-45: 64. Company A has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20YY. Company A are electing to seek eligibility by satisfying the principles based Innovation test under section 360-40(1)(e)(i)-(v), in order to be issued with a Private Binding Ruling. | Detailed Reasoning - Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i) ITAA 1997: 65. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be developing an innovation which is either new or significantly improved for an applicable addressable market. 66. Company A is developing complementary medicine products from particular raw materials which were previously trialled and tested by Company B. 67. Company A is using standard processing methods to produce medicines that are naturally produced, but potent like pharmaceuticals. 68. Company A is developing this technology by taking certain raw materials and processing them to produce medicines that are natural but potent like pharmaceuticals. 69. The resultant products are new chemicals that have never been described before, and as medicines, constitute a new drug class. 70. The primary areas of success with the products developed to date have been in significant treatment of certain illnesses. These are all pharmaceutical outcomes with worldwide commercial application. 71. The innovation focus of Company A is twofold - the further development of complementary medicines into world recognised, commercially distributed pharmaceutical products, and the improvement of the process to supply an improved quality product from a reduced quantity of raw material. 72. Some of the main strengths of the products under development by Company A are that they are derived from particular sources, and their application relates to a wide range of common conditions, suffered by people all over the world, which makes these products very appealing from a commercial investment perspective. 73. Company A is genuinely focussed on developing their technology to produce pharmaceutical products, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 20XX to 30 June 20YY. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997 74. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company. 75. The work that has already been undertaken to develop Company A's Product is as follows: • Company B first started testing the raw materials approximately x years ago. Natural medicine products have since been developed, manufactured and marketed to a mail order database. • Research work was performed at the end of 20TT, with positive results on various measures of treatment and surprise results with overcoming medical resistance. • Current raw material supply is from Country X. In 20ZZ, growing trials in State Y and State Z supported the view that a commercial crop was achievable. 76. The current development being performed by Company A is as follows: • The efficacy of the existing Product has been demonstrated with informal human trials conducted to date • In addition to production trials the company is undertaking, laboratory studies are to be conducted, with the goal to optimise Product potency and identify the chemical structures of these new medicines. 77. There are a number of steps which are required to be completed into the future, before the technology is considered to be fully developed for commercialisation: • The future plan is to manufacture and market new Products that can achieve these desirable high-dose medicines outcomes but delivered in a practical manner. The plan is to produce a new Product that is about 3 times more potent than the current Product. • The current research emphasis is on laboratory and in-vivo (animal, human) testing. Until now, human trials have been informal, such as consumer feedback. To fully develop the product, formal testing and trials will need to be undertaken. • When developing pharmaceutical medicines for human consumption, it is essential that extensive testing is undertaken to validate efficacy and ensure any side effects can be clearly identified and mitigated as part of the development process. • The results of formal human trials will support all areas of the business, including: o Promotion of the product to peers/professionals via published results of the trials; o Market development opportunities to the public achieved through publicity (tv, radio, newspaper); o Attraction of additional capital to scale commercialisation; o Attraction of a manufacturing/distribution partner to assist scale and market development; 78. Company A anticipate that the current programme of development will be completed within a x year timeframe. 79. Within the next xx months, the production process will have been simplified and the time frame to achieve results will have been reduced from the time currently required. 80. Within the next x - y years, the potency and subsequent efficacy will have been further improved from the existing (current) Product. 81. Further laboratory and human trials will have been undertaken and the results support the commercialisation and marketing of the end products. 82. Once the company achieves TGA approval for the products to be listed as complementary medicines, this will support them being distributed through pharmacy and health food outlets in Country X and assist with export opportunities. 83. In addition, due to the application of this product to health issues suffered worldwide, the company is developing an export distribution plan that includes international on-line marketing capability, to enable marketing of the products worldwide within the next y - z years. 84. Company A is genuinely focussed on developing their technology to produce pharmaceutical products, for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 85. In applying the requirements of subparagraph 360-40(1)(e)(ii), Company A must be able to demonstrate that it has the potential for high growth within a broad addressable market. 86. Company A's high growth results will come from a new range of pharmaceutical products, combined with the wide application of these products for relief of common conditions suffered by people worldwide. 87. Here exists an opportunity to demonstrate with human trials that Company A's complementary medicines are a safe and effective treatment of certain illnesses. 88. Being recognised as a pharmaceutical, will enable Company A to grow into a new market, the medicine prescription market, for the relief of complex medical conditions. 89. Company A's addressable market is very broad and covers the global population worldwide. 90. Company A has demonstrated a high growth potential for their technology to produce pharmaceutical products, so subparagraph 360-40(1)(e)(ii) is satisfied for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 91. In applying the requirements of subparagraph 360-40(1)(e)(iii), Company A must be able to demonstrate that it has the potential to successfully scale up the business. 92. The ability to successfully scale up their business can be demonstrated from Company A's increased sales from an increasingly efficient use of resources. 93. The increased sales of Company A's new products being developed can be achieved with the resources currently available to Company A, but a further significant increase in sales will result from successful laboratory tests and human trials undertaken on the pharmaceutical products being developed. 94. Improvements in the production process will assist supply and support the increased sales from a global medicine market. 95. To scale production, it is envisaged that an extension of the current production facilities will be required, together with contract manufacture of some elements. 96. Company A is the only company in the world using these particular raw materials in complementary medicine. 97. This leverage ensures that Company A has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 98. In applying the requirements of subparagraph 360-40(1)(e)(iv), Company A must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets. 99. Currently, Company A services the local market through the online sale of complementary medicines. By using mail order sales for their range of products, Company A achieves large scale human trial results and post marketing data which demonstrates efficacy, safety and demand. 100. The market for both pharmaceutical and non-pharmaceutical products is significant, and significant scale will eventually be achieved by partnering with a manufacturer / international distributor with an existing pharmaceutical distribution channel. 101. Company A's current customers are part of the world's ageing population, where age related diseases are becoming increasingly common. 102. The United Nations estimate that the over-65 age group was approximately 11% of the world's population in 2007 and will increase to 22% by 2050. Many of these affected people use dietary supplements or complementary medicines to help mage or prevent the onset of their conditions. 103. Company A believes that all people have a fundamental human desire to relieve pain and to prolong life, and this belief fuels Company A's search for effective treatment and medications. 104. Company A can demonstrate a significant demand for the development of new pharmaceutical products that treat these age related, and non-age related, human conditions. 105. Company A has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: 106. In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must demonstrate that it has potential to be able to have a competitive advantage for that business. 107. Company A's pharmaceutical products would be: • Potent; • Cost-effective; • Target many disease states; and • Without any side effects. 108. The pharmaceutical industry has an excellent track record for producing potent medicines but are unable to achieve the goal of being cost effective or without side effects. 109. High tech pharmaceutical development comes with a very high price tag, mostly in the A$1 - A$2 billion range. Company A has managed to produce pharmaceutical strength medicines without the billion dollar price tag. 110. Company A has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - CONCLUSION FOR PRINCIPLES BASED TEST: Company A satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - Foreign Company Test - subparagraph 360-40(1)(f)) ITAA 1997: 111. As Company A was incorporated in Australia, it is not a Foreign Company and therefore paragraph 360-40(1)(f) is satisfied. | Detailed Reasoning - CONCLUSION: Company A meets the eligibility criteria of an ESIC under section 360-40 for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - Other references (non ATO view): Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 [1] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.79.

RELEVANT FACTS AND CIRCUMSTANCES | 1. Company A is an Australian proprietary company incorporated on x XX 20XX. | 2. Company A's directors are Taxpayer A and Taxpayer B. | 3. Company A has no subsidiaries. Company A is wholly owned by Company B. | 4. For the financial year ending 30 June 20XX (the previous income year), Company A incurred $xx in expenses and earned $yy in income. | 5. Company A's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country. | Background Facts: 6. Company B was incorporated on z ZZ 20ZZ and entered into a licence agreement on y YY 20YY to manufacture, market, wholesale and retail complementary medicines for human consumption using particular raw materials. | 7. During 20ZZ, further research identified health benefits associated with the use of those raw materials, and significant research and development was undertaken. | 8. Company B produced complementary medicine based on the particular raw material. Using human volunteers, it became clear that these medicines outperformed the other prototypes, particularly in certain medical treatment. | 9. Company B commercialised its technology in 20ZZ. | 10. Company B successfully met the 100 point test as outlined in s 360-45 of the Income Tax Assessment Act 1997 ('ITAA 1997') during the 20ZZ financial year, and continued to qualify under this section as an ESIC until the 20XX financial year, after which it no longer qualified as an ESIC pursuant to s360-40(1)(a)(ii), as it was outside the 6 income year window, although it did meet the expense and income requirements outlined in s 360-40(1)(b) and s 360-40(1)(c) respectively. | 11. After qualifying as an ESIC in 20ZZ, Company B did not admit any new investors between 20ZZ and 20XX, and none of the shareholders in Company B qualify for, nor have registered for, the ESIC concessions. | 12. In XX 20XX, under the small business restructure rollover provisions as outlined in Subdivision 328-G of the ITAA 1997, the Intellectual Property ('IP') developed by Company B was transferred to Company A. | 13. Company B continues to hold the licence agreement to develop other related products into pharmaceuticals as per the 20ZZ licence agreement. | 14. A new company was formed to enable new investors to become shareholders in Company A and invest to develop these new products. While the different raw materials are almost identical in makeup, one raw material is renewable and the other is not readily renewable. The testing and research undertaken to date on both products has demonstrated that the potency of one raw material is superior to the other material. | 15. These new products are separate to the licence still held by Company B for the manufacture, market, wholesale and retail of pharmaceutical medicines for human consumption solely in respect of another particular raw material. | 16. Company A is continuing to develop the technology to produce a pharmaceutical product from a particular raw material. | Development of the pharmaceutical products: 17. Company A is developing complementary medicine products from a particular raw material ('Product'). | 18. Company A has the benefit of further developing technology successfully trialled and tested previously by Company B. | 19. Company A uses standard processing methods to produce medicines that are naturally produced, but potent like pharmaceuticals. | 20. With capital investment, Company A will have the ability to extend this technology to recognised pharmaceutical products. | 21. Company A is developing this technology by taking certain materials and producing medicines that are natural but potent like pharmaceuticals. | 22. By processing certain raw materials, Company A will achieve improved availability, allowing these materials to reach their full potential. | 23. The primary areas of success with the products developed to date have been in significant medical treatment of particular illnesses. These are all pharmaceutical outcomes with worldwide commercial application. | 24. The next stage of development is in the validation of the efficacy of this technology, including laboratory and human trials. | 25. Company A's technology has been identified as having an international addressable market. | Information provided: 26. You have provided a number of documents containing detailed information in relation to Company A's technology including: | (a) Private Binding Ruling ('PBR') Application, dated x XX 20XX | (b) Response to further questions provided | (c) A copy of Company B's Licence Agreement dated y YY 20YY | (d) Responses to various emails | 27. We have referred to the relevant information within these documents in applying the relevant tests to your circumstances. | 28. You propose to issue new shares in Company A to various investors to assist in funding the continued development and commercialisation of the pharmaceutical product technology.