Private ruling: Early stage innovation company eligibility
Date of advice: 24 September 2021
Published: December 2021
Ruling period: x XX 20XX to y YY 20YY
Date scheme commenced: x XX 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 x XX 20XX to y YY 20YY? | A1: Yes

Relevant facts and circumstances: Company A is an unlisted Australian private company incorporated in XXX on z ZZ 20ZZ. Company A's directors are Taxpayer A and Taxpayer B. Company A's registered office is situated at YYY. Company A's principal place of business is situated at ZZZ. For the financial year ending x XX 20XX, Company A incurred and earned the following: • Total expenses of $xyz • Total income of $zyx 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. Company A is not part of a consolidated tax group, nor is it planning to join such a group. Company A has no 100% owned subsidiaries. Company A owns xy% shareholding in Company B (equal to x of the y shares issued) which was incorporated in ZZ 20ZZ. Company A is designing / developing / investigating the effect of a product on various changes associated with a particular condition. Company A's focus will be on providing a safe, standardised and affordable product to the Australian and international markets. Company A will study a number of blends for experimental assessment in consultation with Company C. Company A is the only company studying and testing the above formulations. If successful, Company A's product will provide a new and unique solution to individuals suffering from or experiencing this particular condition. Company A considers their new development for use in the industry is highly innovative. Company A is developing / investigating the effect of a product on various changes associated with a particular condition to address a number of discrete markets and is continuing to develop their product. Company A's product has been identified as having an international addressable market. Company A has sought investment to develop a successful formula to treat this condition incorporating its optimal blend. Company A has trademarks in place for its product names. Information provided You have provided a number of documents containing detailed information in relation to Company A's product, including: • Private Binding Ruling ('PBR') Application, dated x XX 20XX • Response to further questions provided We have referred to the relevant information within these documents in applying the relevant tests to your circumstances. Company A has issued shares at different times to assist in funding the continued development and commercialisation of the product. Assumption(s) Not applicable.

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) for the period x XX 20XX to y YY 20YY. | 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 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). 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 (v): 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 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 - subparagraph 360-40(1)(e)(i) ITAA 1997: 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..." 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. 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. 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." 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. 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 - subparagraph 360-40(1)(e)(ii) ITAA 1997: 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 - subparagraph 360-40(1)(e)(iii) ITAA 1997: 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 - subparagraph 360-40(1)(e)(iv) ITAA 1997: 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 - subparagraph 360-40(1)(e)(v) ITAA 1997: 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): At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001 (Cth). 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: 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 x XX 20XX, and on or before y YY 20YY. | Detailed Reasoning - Current year: Therefore, for the purposes of subsection 360-40(1) ITAA 1997 , the current year will be the year ending y YY 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 y YY 20YY, 20XX and 20ZZ, and the income year before the current year will be the year ending x XX 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997: Company A was incorporated in XXX on x XX 20ZZ, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) are satisfied. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b) ITAA 1997: 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. Company A incurred total expenses of $xyz in the 20XX income year. Consequently, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c) ITAA 1997: 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. Company A earned $xyz in assessable 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: 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. 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: 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: Company A has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending y YY 20YY. Company A is 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: 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. Company A is designing / developing / investigating the effect of a product on various changes associated with a particular condition. Company A's focus will be on providing a safe, standardised and affordable product to a number of markets. Company A will study a number of blends for experimental assessment in consultation with Company C. According to Company A, the company is the only one studying and testing the above formulations/blends. Given that no other company is studying the above formulations, if successful, Company A's product will provide a new and unique solution to individuals with this particular condition. There is one other company undertaking a similar trial - Company D. However, this company is using only one variation and not multiple products to solve one aspect of the condition. To date, no other company has studied individual ingredients for this condition, they have only undertaken broad "product" trials. This has only provided anecdotal evidence as to their effectiveness. Further, no other company has undertaken a multi-phase clinical trial on the use of this product for this condition. This is the aim of Company A's research. Company A considers their new development for use in the particular industry is highly innovative through the incorporation of this product. Company A is genuinely focused on developing their product for an applicable addressable market, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 20YY. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997 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. Company A has been genuinely focussed on developing their product and have undertaken considerable work up to y YY 20YY. Since ZZ 20ZZ, Company A has undertaken the initial phase of its project. This initial phase included a review of literature and study design. Specifically, during the year ended y YY 20YY, Company A has undertaken a more detailed phase to design their study. There are a number of steps which are required to be completed into the future, before the product is considered to be fully developed for commercialisation: • During FYZZ, Company A will select x treatment groups, including relevant controls, for experimental assessment in consultation with Company C. • Company A (in conjunction with Company C) will administer x treatments to their established model to determine the effects on functional outcomes. Company A anticipate that the current programme of development will be completed in the 20ZZ financial year. Company A is genuinely focussed on developing their product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 20YY, or the date when their product has been fully developed and is ready for client use, whichever occurs earlier. Once the product has been fully developed, Company A will no longer be 'developing' the product for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 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. Company A has extremely high growth potential as Company A will target two key broad markets with its product, being: • Market 1, and • Market 2 As such, Company A anticipates that there is a large market for their product of approximately xyz people per year. Once their product is fully developed, Company A is intending to launch initially in XX, and will then seek to explore new markets globally, with YY, ZZ and QQ, ideally in that order. Company A have export licences and global distribution partners in place to be able to achieve this. Company A has demonstrated a high growth potential for their product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period x XX 20XX to y YY 20YY. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 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. Company A's board and management team is highly experienced and has extensive expertise across the fields of research, project management and finance. It is with this management team and expertise that Company A is confident that it can successfully scale up their business. Company A's business is built on partnerships with XXX's leading importer and distributor of the product. In this regard, Company A already has an import, export and wholesalers and manufacturers license in place. An early mover advantage has been identified and it can gain a substantial market share with limited competition. Company A is already operating in the market, through its xx% owned subsidiary Company B. Adding a new product into the existing supply chain is expected to be far more seamless than developing the supply chain from scratch. Company A has also already partnered with a distribution partner - Company D. In relation to the costs and financial modelling - there will be a complex formula to determine the product cost based on: • Trials undertaken to costs to date; • Government subsidies available. 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 x XX 20XX to y YY 20YY. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 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. As outlined above, the potential addressable market for Company A's product is approximately xxx individuals per year. The need addressed by Company A is global. As such, Company A's product is intended to be made available locally, domestically and worldwide by anyone who has experienced this particular condition. Thus, the addressable market is on a global scale and is not confined to a local city, area or region. Company A is confident it has the capability to expand on a national and global scale. Company D is already established in international markets such as the XX and the YY and it can easily access these channels when the product is ready. Company A also have partners that are very large players in the global market such as XYZ and will be able to leverage their position and power to get the products into international channels. 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 x XX 20XX to y YY 20YY. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must demonstrate that it has potential to be able to have competitive advantage for that business. Company A's project will ultimately culminate in the development of a new formula to treat a particular condition, incorporating its preferred blend. This new blend and new product present a competitive advantage for the business. Barriers to entry in this market are substantial. A new entrant would be required to not only design and develop a similar product, but also engage distribution partners. This presents another significant competitive advantage for Company A. Company A has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period x XX 20XX to y YY 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 x XX 20XX to y YY 20YY, or the date when their product has been fully developed and is ready for client use, whichever occurs earlier. | Detailed Reasoning - Foreign Company Test - subparagraph 360-40(1)(f) ITAA 1997: As Company A was incorporated in Australia, it is not a Foreign Company and 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 x XX 20XX to y YY 20YY, or the date when their product has been fully developed and is ready for client use, whichever occurs earlier. [1] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.79.