Private ruling: Tax incentives for early stage inventors
Date of advice: 27 June 2022
Published: October 2022
Ruling period: Year ending 30 June 20ZZ

Ruling: Q1: Does the entity meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997) for the period 1 July 20YY to 30 June 20ZZ? | A1: Yes.

Relevant facts and circumstances: 1. The entity is a proprietary company incorporated in XYZ on w WW 20WW. It was registered in the Australian Business Register (ABR) on w WW 20WW. 2. The entity's director is Taxpayer A. 3. The entity's registered office and primary place of business is located in XYZ, Australia. 4. The entity holds provisional Intellectual Property ('IP') rights to their products until ZZ 20ZZ. 5. For the 3 income years ending before the current year, the entity incurred total expenses of less than $1 million. 6. For the financial year ending 30 June 20ZZ, the entity incurred total expenses of less than $1 million and earned total assessable income of less than $200,000. 7. The entity's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country. 8. The entity has the objective to increase the customer experience. 9. The entity is developing a product to assist with a leisure activity. 10. The entity's product has an electronic construction and is powered a vessel. 11. The entity's product can be used in different weather conditions. 12. The product is multifunctional. It includes an action camera mount in the rear. 13. The entity has a programmable platform on which additional add-on features can be developed and added to the product in the future. 14. The entity's product will appeal to different participant types. 15. The prototype has been designed for a test period of at least 6 months. Testing has commenced in ZZ 20ZZ. 16. The entity is planning on launching the product at a high-profile industry expo, to be held on z ZZ 20ZZ. 17. The entity is also planning on launching a social media marketing campaign to attract both retailers and consumers. 18. There are a number of competitive products on the market at a lower price point compared to the product. However, the entity's product is the first electronic variety in the market. 19. The entity's product has been identified as having an international addressable market. Information provided 20. You have provided a number of documents containing detailed information in relation to the entity's product. 21. We have referred to the relevant information within these documents in applying the relevant tests to your circumstances. 22. You propose to issue new shares in the entity to various investors to assist in funding the continued development and commercialisation of the Product.

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: Detailed Reasoning - Qualifying Early Stage Innovation Company: 1.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': 2.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): 3.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 any 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). 4.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. 5.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): 6.To meet the requirement in paragraph 360-40(1)(b), the company and any 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): 7.To meet the requirement in paragraph 360-40(1)(c), the company and any 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): 8.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': 9.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: 10. 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): 11. 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. 12. 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. 13. 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: 14. 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..." 15. 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. 16. 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. 17. 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." 18. 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. 19. 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: 20. 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: 21. 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: 22. 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: 23. 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): 2.At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001 (Cth). 3.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: 4.For the purposes of this ruling, the 'test time' for determining if the entity is a qualifying ESIC, will be upon the issue of qualifying shares on a particular date or dates on or after y YY 20YY, and on or before z ZZ 20ZZ. | Detailed Reasoning - Current year: 5.Therefore, for the purposes of subsection 360-40(1) ITAA 1997 , the current year will be the year ending z ZZ 20ZZ (the 20ZZ income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending z ZZ 20ZZ, 20YY and 20XX and the income year before the current year will be the year ending y YY 20YY (the 20YY income year). | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997: 6.The entity was incorporated in Queensland and registered in the ABR on w WW 20WW, which is outside the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) and (iii) are not satisfied. 7.The entity was incorporated within the last six income years. For the 3 income years ending before the current year, the entity incurred total expenses of less than $1 million, therefore the requirements of subparagraph 360-40(1)(a)(ii) are satisfied. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b) ITAA 1997: 8.In applying the requirements of paragraph 360-40(1)(b), The entity and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20YY income year, being the income year before the current year. 9.The entity incurred total expenses of less than $1 million in the 20YY income year. Consequently, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c) ITAA 1997: 10. In applying the requirements of paragraph 360-40(1)(c), The entity and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20YY income year, being the income year before the current year. 11. The entity earned assessable income of less than $200,000 in the 20YY income year. Consequently, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997: 12. In applying the requirements of paragraph 360-40(1)(d), The entity must not be listed on any Stock Exchange in Australia or a foreign country at the test time. 13. The entity 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: 14. The entity satisfies the early stage test for the 20ZZ 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: 15. The entity has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20ZZ. The entity 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: 16. In applying the requirements of subparagraph 360-40(1)(e)(i), The entity must be developing an innovation which is either new or significantly improved for an applicable addressable market. 17. The entity is developing a Product to assist with a leisure activity. 18. The entity's Product has an electronic construction and is powered from a vessel. 19. In summary, the entity's Product is a different product compared to competitors on the market due to its electronic construction. 20. The entity is significantly improving this variety of fishing equipment to be commercially scalable. 21. The entity is genuinely focussed on developing their Product for an applicable addressable market. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997 22. In applying the requirements of subparagraph 360-40(1)(e)(i), The entity must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company. 23. The entity has undertaken the following work to develop their Product for a commercial purpose: • From ZZ 20ZZ - A prototype has been designed for a test period of at least 6 months • ZZ 20ZZ - The final parent application to be submitted as the entity has an approved provisional patent for the Product 24. Presently, the entity is planning on launching their Product at a high-profile industry expo, to be held on z ZZ 20ZZ in XYZ, USA. 25. 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: • ZZ 20ZZ - ZZ 20ZZ - Launch of product at the industry expo, planning to take pre-orders for delivery in 20AA, launch of marketing campaign for the product and final patent application to be submitted • ZZ 20ZZ - Engineers begin design of the Product for manufacturer • ZZ-ZZ 20ZZ - next funding round if the launch at the industry expo in ZZ 20ZZ is successful • ZZ-ZZ 20ZZ - Testing performed by users and influencers in different geographic areas, final prototype of the Product to be designed • From AA 20AA - retail sales of the Product to commence 26. The entity aims to further develop the Product by adding features. 27. Upon commercialisation of their business and gaining traction on the primary version of the Product, the entity is planning on developing a smaller and cheaper version of the Product targeted at other participants. 28. The entity's Product is protected by a provisional global patent with rights in over 170 countries until ZZ 20ZZ. Upon expiry of the provisional patent in ZZ 20ZZ, the entity is in the process of applying for final patents in Australia and USA. 29. The entity is registered with AusIndustry and is in their second year of qualifying for the ATO's R&D tax incentive. 30. The entity is genuinely focussed on developing their Product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 20YY to 30 June 20ZZ, 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, the entity will no longer be 'developing' the Product for commercialisation. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 31. In applying the requirements of subparagraph 360-40(1)(e)(ii), The entity must be able to demonstrate that it has the potential for high growth within a broad addressable market. 32. The entity has high growth potential as their Product is easily and infinitely scalable to a global audience. 33. The entity's Product is the first electronic variety in the market with no reliability on environmental factors. 34. The electronic construction of the Product provides demonstratable benefits in reliability and effectiveness compared to existing products on the market which currently mainly rely on environmental factors. 35. The entity's Product is addressed at both direct consumers, as well as resellers and retailers. 36. Further product family growth is also achievable by developing a smaller and cheaper version of the Product. This is part of the entity's development plan once they have gained traction for the primary version of their Product. 37. The entity has demonstrated a high growth potential for their Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period 1 July 20YY to 30 June 20ZZ. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 38. In applying the requirements of subparagraph 360-40(1)(e)(iii), The entity must be able to demonstrate that it has the potential to successfully scale up the business. 39. The entity is currently conducting testing of the first version of their Product, and plan on launching it at the industry expo in ZZ 20ZZ. Their Product is not yet proven at large scale, however there are no barriers to scale which confirms the entity has potential to successfully scale up the business successfully. 40. The entity anticipates that 0.9% of the global addressable market or 8.3% of the total addressable market over a 5-year period will adopt to their Product. 41. The entity is anticipating high interest from their addressable market upon their launch at the industry expo in ZZ 20ZZ. 42. This leverage ensures that the entity has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period 1 July 20YY to 30 June 20ZZ. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 43. In applying the requirements of subparagraph 360-40(1)(e)(iv), The entity must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets. 44. The entity has estimated the turnover of the total addressable global market at $3.6 billion which will re-occur every 5 years based on the estimated lifespan of the product. 45. The entity's Product can be easily adopted by any participant globally. 46. As a result, the entity has the potential to address a broader than local market and to adapt its business to access global markets. 47. The entity 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 20YY to 30 June 20ZZ. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: 48. In applying the requirements of subparagraph 360-40(1)(e)(v), The entity must demonstrate that it has potential to be able to have competitive advantage for that business. 49. The electronic make-up adopted by the entity in their Product, will provide a competitive advantage, as it is the first electronic variety of the product on the market and has no competitors. 50. The Product is provisionally patented globally to expire in ZZ 20ZZ. The entity is in the process of applying for final patents in Australia and USA to protect its unique electronic construction. 51. Other varieties of the product on the market are non-electronic, at a much lower price bracket and provide lower effectiveness compared to the entity's Product. Compared to competitor products on the market, the entity's product differs due to its electronic construction and multi-functional manufacture. 52. Many other varieties of the products' functionality rely on environmental factors. Therefore, the effectiveness of those varieties of the product is drastically reduced in certain environmental conditions. 53. The Product's electronic construction provides reliability and much higher effectiveness which can successfully operate in any environmental conditions. 54. The entity has demonstrated that it has competitive advantages for its business, so subparagraph 360-40(1)(e)(v) is satisfied for the period 1 July 20YY to 30 June 20ZZ. | Detailed Reasoning - CONCLUSION FOR PRINCIPLES BASED TEST: The entity 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 20YY to 30 June 20ZZ, 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: 55. As the entity was incorporated in Australia, it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied. | Detailed Reasoning - CONCLUSION: The entity meets the eligibility criteria of an ESIC under section 360-40 for the period 1 July 20YY to 30 June 20ZZ, or the date when their Product has been fully developed and is ready for client. [1] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.79.