Private ruling: Early stage innovation company
Date of advice: 28 February 2020
Published: April 2020
Ruling period: Year ended 30 June 2020
Date scheme commenced: 1 July 2019

Ruling: Q1: Does The Company 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 in Australia in the 2018 income year. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. The Company has a 100% subsidiary. 3. The Company and its 100% subsidiary incurred expenditure of under $1 million in the year ended 30 June 2019 and had assessable income of under $200,000. 4. The Company was incorporated in order to develop and commercialise a product. 5. The Company has an Agreement with its subsidiary, entitling it to commercialise the product/s on favourable terms (if the products are successfully developed) in Australia and Country A in consideration for performing early stage research and development (R&D). Relevant legislative provisions Income Tax Assessment Act 1997 Subdivision 360-A Income Tax Assessment Act 1997 section 360-40 Income Tax Assessment Act 1997 section 360-45


Reasons for decision: Detailed Reasoning - Qualifying Early Stage Innovation Company: 6. 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': 7. 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): 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). | Detailed Reasoning - 'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (v): i. the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation ii. the business relating to that innovation must have a high growth potential iii. the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation iv. the company must demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business, and v. the company must demonstrate that it has the potential to be able to have competitive advantages for that business. | Detailed Reasoning - Developing new or significantly improved innovations for commercialisation: "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..." | Detailed Reasoning - Application to your circumstances: Test time Current year | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) Total expenses - paragraph 360-40(1)(b) Assessable income - paragraph 360-40(1)(c) No stock exchange listing - paragraph 360-40(1)(d) Conclusion on early stage test | Detailed Reasoning - Principles based test: Developing new or significantly improved innovations - subparagraph 360-40(1)(e)(i) 37. The Company will conduct a number of activities, including experiments, to determine the safety and limited efficacy of a product. 38. As the Company will be undertaking early stage development of these new therapies, it is considered that the Company is developing an innovation. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) 39. To satisfy this part of test, it is not sufficient for a company to have an innovative idea - instead it must be taking or planning to take tangible steps to develop an innovation to the point where it will generate revenue for the company. The pre-commercialisation stage may involve a range of activities such as market research, developing a proof of concept, prototyping, user testing, setting up manufacturing and marketing processes, and other business development activities to prepare for the launch of a product or service. 40. If its therapies are successfully developed, the Company intends to undertake the process of registration with Therapeutic Goods Administration (TGA) and will market the registered product in Australia and Country A. 41. The Company is currently performing experiments to determine the safety and limited efficacy of the product. 42. As part of its commercialisation strategy, the Company group intends to enter into collaboration and/or licensing agreements with large relevant companies. Conclusion on subparagraph 360-40(1)(e)(i) High growth potential - subparagraph 360-40(1)(e)(ii) 45. The global specific market in 2018 was valued at $120 billion and is estimated to be growing at a compound annual growth rate of 12.6% ( Reuters ). The product (if successfully developed) will meet a large unmet medical need, and will have the potential to take a significant share of that market. 46. In short, once TGA approved, there is potential for high growth in the Australian & Country A market. 47. The Company can reasonably demonstrate a high growth potential exists. Subparagraph 360-40(1)(e)(ii) is satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 48. Given the nature of the product development industry, and the specific area in particular, the cost of developing treatments and getting them to market is very high. However in the later stages costs of development will reduce. 49. It is accepted that the Company can demonstrate the potential to successfully scale up its business. Subparagraph 360-40(1)(e)(iii) is satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) 50. This disease affects people worldwide. Given that the products have the potential to meet a large, currently unmet medical need, it has the potential to be able to address a broader a market that is broader than a local city, area or region. It will able to used anywhere covered by TGA approval, effectively meaning it will access markets covered by that jurisdiction for use at hospitals, health care providers and so on. 51. In short, the market for the Company's potential therapies is broader than the local market. Subparagraph 360-40(1)(e)(iv) is satisfied. Competitive advantages - subparagraph 360-40(1)(e)(v) 52. The Company has an exclusive right to develop and commercialise in Australian & Country A. 53. The Company has demonstrated the potential for its platform to have competitive advantages, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test Conclusion

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: | 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. | 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. | 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. | 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. | 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. The Company has applied for this ruling on the basis that it meets the principles-based test. | 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: | 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: | The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. The company's addressable market is the revenue opportunity or market demand arising from the innovation or the related business. The addressable market must be objective and realistic. | 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 defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. An innovation can also consist of a series of smaller incremental changes that together constitute a significant change. | The company must be genuinely focused on developing the innovation for a commercial purpose in order to generate economic value and revenue for the company. This requirement draws the distinction between simply having an idea and commercialising an idea. | 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. | 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. | 'Commercialisation' is discussed further at paragraph 1.81 in the EM which states "Commercialisation encompasses a spectrum of activities including those leading to the sale of new or significantly improved product, process or service as well as activities involving the implementation of a new, or significantly improved, process or method, where the process or method directly leads to the generation of economic value for the company." | 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. | 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, 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. | 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. | 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. | 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 2020. | For the purposes of subsection 360-40(1), the current year will be the year ended 30 June 2020 (the 2020 income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years will include the years ended 30 June 2020, 2019 and 2018, and the income year before the current year will be the year ended 30 June 2019 (the 2019 income year). | As the Company was incorporated in the 2018 income year, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. | As the Company and its 100% subsidiaries had expenses of under $1 million in the prior income year, paragraph 360-40(1)(b) is satisfied. | As the Company and its 100% subsidiaries had assessable income below $200,000 for the prior income year, paragraph 360-40(1)(c) is satisfied. | As 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. | The Company will satisfy the early stage test for the entire 2020 income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Based on the above, the Company is clearly genuinely focussed on developing the innovation for commercial purposes. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 2019 until 30 June 2020. | The Company is genuinely focussed on developing the product and potential therapies for a commercial purpose. The process is an innovation and consequently subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 2019 until 30 June 2020. | 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 2019 until 30 June 2020. | The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 2019 until the earlier of 30 June 2020.