Private ruling: Early Stage Innovation Company
Date of advice: 11 December 2019
Published: February 2020
Ruling period: Year ending 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Does entity A meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes.

Relevant facts and circumstances: 1. The Company was incorporated on Date X. Its equity interests are not listed for quotation on the official list of any stock exchange. 2. In the previous income year The Company had expenses of $X and assessable income of $X. 3. The Company is developing a product and information that details its development was provided. 4. The Company is developing new technology in its addressable market. 5. The Company has established patents for its product locally and overseas. 6. The Company's investment strategy is to have a tranch of investment as outlined in information attached to the private ruling application. 7. The Company considers it has potential to be able to successfully scale up its business. 8. Proceeds from investor funding will allow the Company to move from sample manufacturing to a more linear process within a single factory -with the initial machinery and equipment being suitable for substantially increased volumes to meet demand. This factory setup will be repeated in each new market locally and overseas. This manufacturing process will remain the same and in each instance will use local raw materials which are already compliant with all of the different countries' standards and regulations. 9. Manufacturing of the Company's product is expected to be profitable. Information provided 10. You have provided information in a number of documents and phone conversations in relation to the product, including: a. your private ruling application dated XX and attachments thereof; b. our phone conversations with your representative on various occasions; and c. supplementary information provided in email dated XX. 11. We have referred to the relevant information within these documents and conversations in applying the relevant tests to your circumstances. You propose to issue new shares in the Company to various investors to assist in funding the continued development and commercialisation of the innovation.

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 360-40(1) | Income Tax Assessment Act 1997 paragraph 360-40(1)(a) | Income Tax Assessment Act 1997 paragraph 360-40(1)(b) | Income Tax Assessment Act 1997 paragraph 360-40(1)(c) | Income Tax Assessment Act 1997 paragraph 360-40(1)(d) | Income Tax Assessment Act 1997 paragraph 360-40(1)(e) | Income Tax Assessment Act 1997 subparagraphs 360-40(1)(e)(i) to (iv) | Income Tax Assessment Act 1997 section 360-45

Reasons for decision: Summary: All legislative references are to the ITAA 1997 unless otherwise indicated. | Summary: The Company meets the eligibility requirements of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) | Detailed Reasoning - Qualifying Early Stage Innovation Company: 12. 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. 13. A company qualifies as an ESIC if it satisfies the early stage test and one of two 'innovation' tests which are the 100-point innovation test or the principles-based innovation test. | Detailed Reasoning - 'The early stage test': 14. The early stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d) and are outlined below. | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a): 15. 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: · incorporated in Australia within the last three income years (the latest being the current year); or · 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 · registered in the Australian Business Register (ABR) within the last three income years (the latest being the current year). 16. 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. 17. 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): 18. 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): 19. 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): 20. 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: 21. 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. You have only provided evidence in respect of the principles-based test. The 100-point test will not be addressed in this ruling. | Detailed Reasoning - '100-point test' - paragraph 360-40(1)(e) and section 360-45: 22. 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): 23. To satisfy the principles-based test, the company must meet five requirements in 24. Paragraph 360-40(1)(e). This is tested at a time immediately after the relevant new shares are issued to the investor. 25. 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. 26. 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. The five requirements in paragraph 360-40(1)(e) are outlined below. | Detailed Reasoning - Developing new or significantly improved innovations for commercialisation: 27. 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...' 28. The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. 29. The company's addressable market is identified by making a realistic and objective assessment of the company's intended market for its innovation. It includes identification of the immediately accessible market to which the innovation will initially be introduced, or a new market which may be created by the innovation. Factors in identifying the addressable market may include the location of the company's potential customers, the type of industry to be served and the geographical area it will serve. The addressable market must be objective and realistic. 30. A 'new' innovation means novel or introduced to the addressable market for the first time. It must be compared to the products, services, processes or methods that may or may not exist in the intended market for the innovation. 31. 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. 32. The OECD Oslo Manual (paragraphs 124 and 151) defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. However, it is important to recognise that an innovation can also consist of a series of smaller incremental changes that together constitute a significant change. 33. The company must be genuinely focussed on developing the 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. This requirement draws the distinction between simply having an idea and commercialising an idea. 34. The EM does not define the meaning of the term 'genuinely focussed' within the context of subparagraph 360-40(1)(e)(i). 'Genuine' is defined in the online Macquarie Dictionary as 'being truly such; real; authentic." Focus is defined as "3. A central point, as of attraction, attention, or activity... 8. To concentrate; to focus one's attention." In essence, the phrase 'genuinely focussed' is looking to what the company is truly concentrating and focussing their attention on or, put another way, what is the real central point of the company's activities. That is, the central activities of the company must be truly concentrated on developing their innovation for a commercial purpose. Developing an innovation for commercialisation in relation to a range of activities such as proof of concept activities, market research, prototyping, pilots and user testing, and other activities to prepare for the launch of the new innovation. | Detailed Reasoning - High growth potential: 35. 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: 36. 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. | Detailed Reasoning - Broader than local market: 37. 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: 38. 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 39. For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC will be a particular date during the income year ending 30 June 20XX. Current year 40. For the purposes of subsection 360-40(1), the current year will be the year ending 41. 30 June 20XX (the 20XX income year). | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) 42. The Company was incorporated and registered with the Australian Securities and Investment Commission (ASIC) within the last 3 income years. Subparagraph 360-40(1)(a)(iii) is satisfied. Total expenses - paragraph 360-40(1)(b) 43. The Company did not trade in 20XX year and it had expenses less than $1 million in the prior income year. Paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) 44. The Company's assessable income for the prior income year is also less than $200,000 as it did not trade. Paragraph 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) 45. The Company is privately owned and is not listed on any stock exchange in Australia or a foreign country. Subparagraph 360-40(1)(d) is satisfied. Conclusion on early stage test 46. The Company will satisfy the early stage test for the entire 20XX income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100-point test: 47. The Company has not provided evidence of satisfying the 100-point test under section 360-45 for the year ending 30 June 20XX. For the Company to be a qualifying ESIC it therefore needs to satisfy the principles-based test. | Detailed Reasoning - Principles-based test: Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) 48. The Company has established patents for its "innovation", locally and overseas. The patent granting process involves having the 'innovation' challenged by patent examiners in each jurisdiction as to its originality, which has been successful in all countries pursued 'The Innovation' will be the first to offer such a product / process. 49. The phrase 'genuinely focussed on developing' looks to the activity on which the company is truly concentrating and focussing its attention. In this respect, The Company is starting with a single factory to service the local market. It is considered that the Company has demonstrated that it is genuinely focussed on developing its innovation for commercialisation. Conclusion on subparagraph 360-40(1)(e)(i) 50. The Company is genuinely focussed on developing 'the Innovation' for a commercial purpose. 'The Innovation' will be a significantly improved product compared to existing products. 51. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the relevant time period or the date when 'The Innovation' has been fully developed, whichever occurs earliest. Once 'the Innovation' has been fully developed, the Company will no longer be 'developing' the product for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. High growth potential - subparagraph 360-40(1)(e)(ii) 52. The Company expects to appeal to a wide range of entities in its industry. 53. The Company's manufacturing of product has very high growth potential as it is expected to be profitable from a very low volume. 54. The Company already has established supply lines of raw locally and overseas that meet their cost parameters for profitable production. 55. Therefore, it is considered that the Company's innovation has a high growth potential both domestically and overseas. Subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 56. The Company has established that it has the potential to successfully scale up its business. This is supported by the budgets it supplied with the application which demonstrate that over time the Company will establish operating leverage where increases in its market share can multiply its revenues with only marginal increase in operating costs. This operating leverage affords the Company the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market - subparagraph 360-40(1)(e)(iv) 57. The Company's product will initially be targeted at the local market but is intended for worldwide use. It will be released globally once it gains traction in the initial targeted market. 58. Proceeds from investor funding will allow the Company to move from sample manufacturing to a more linear process within a single factory, with the initial machinery suitable for substantially increased volumes to meet demand. This factory setup can then be repeated in each new market, locally and overseas. The manufacturing process will remain the same and uses raw materials which are already compliant with all the standards and regulations of different countries. These roll-out principles demonstrate that the Company has access to a much broader global market. 59. The Company has demonstrated that the product has the potential to address a broader market than just the local market, including international markets. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. Competitive advantages - subparagraph 360-40(1)(e)(v) 60. The Company's manufacturing processes and simplicity of installation gives them a pricing advantage over traditional production of their product, as well as being more energy-efficient. Conclusion on principles test 61. The Company satisfies the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20XX until 30 June 20XX or the date when 'the Innovation' has been fully developed and is ready for sale, whichever occurs earlier.