Private ruling: Early Stage Innovation Company eligibility
Date of advice: 24 November 2016
Published: April 2017
Ruling period: Year ending 30 June 20YY
Date scheme commenced: 1 July 20XX

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

Relevant facts and circumstances: Company A Company A was incorporated in Australia in 20xx. It is a private company with none of its equity interests listed on any stock exchange. Taxpayer X is the founder and sole director of Company A. Company A does not own any subsidiary companies. 1. Company A is 100% owned by Company B, acting as trustee for the Unit Trust. 2. Company A is developing a product for use in various sectors. 3. Company A is the company currently undertaking all research, development and commercialisation activities in relation to the development of the product. 4. The intellectual property ('IP') relating to the product, being the provisional patent and international patent application, is owned by Company A. 5. New shares in Company A will be issued to various investors to assist in funding the continued development and commercialisation of the product. The product 6. The product being developed by Company A will provide increased levels of efficiency compared to similar products currently available. 7. The product will be able to be produced using manufacturing techniques. 8. Company A holds the international patent application and Australian provisional patent covering the product technology. 9. As part of the product development, Company A has designed and produced prototypes primarily as a proof-of-concept to demonstrate the viability of the technology to potential customers. 10. Company A has collaborated with an Organisation to optimise the performance of the product technology. Further testing has occurred as part of potential customer visits. 11. Company A was a recipient of funding from a Program. Company A has completed the expression of interest stage for the specific grant with AusIndustry and is currently progressing with the application process. 12. The prototype product requires further refinement and enhancements to extend the technology for specific customer application within the target market. 13. Company A intends to engage specialised research and development (R&D) staff to undertake further refinement to the product. 14. Potential customers have been identified and Company A is in negotiations with interested parties. The first customer orders will be in the form of 'adaptation projects' that will become the bridge between the proof-of-concept and commercialisation for each individual customer's requirements. 15. The product is not expected to be fully developed, or to start generating revenue for Company A, until the end of the 20ZZ calendar year. 16. Company A is looking to commercialise the product. 20XX income year 17. Company A lodged a company income tax return for the year ending 30 June 20XX (20XX income year) and declared the following: a. total income at item 6 of $M, and b. total expenses at item 6 of $N. 18. The Company A profit and loss statement for the 20XX income year reports the following: a. total income of $M, and b. total operating expenses of $N. Information provided 19. You have provided a number of documents containing detailed information in relation to Company A, including: a. Concise Business Plan, including technical details of the product b. Profit and loss statement for the year ending 30 June 20XX c. Australian provisional patent d. application for an international patent, and e. Narrative explanations in response to additional Tax Office questions. We have referred to information within these documents in applying the relevant tests to your circumstances.

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: Summary: All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated. | Detailed Reasoning - Qualifying early stage innovation company: 20. 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': 21. 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): 22. 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 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). 23. 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. 24. 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): 25. 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): 26. 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): 27. 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: 28. 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: 29. 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 (iv): 30. To satisfy the principles-based test, the company must meet the 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. 31. 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. 32. 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 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: 33. For the purposes of Subdivision 360-A, an innovation is considered to be a new or significantly improved product, process, service, marketing or organisational method. 34. 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. 35. 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. 36. 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. 37. '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: 38. 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: 39. 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 per unit. | Detailed Reasoning - Broader than local market: 40. 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: 41. 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 - Test time: 42. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date on or after 1 June 20XX, but before 30 June 20YY. | Detailed Reasoning - Current year: 43. Therefore, for the purposes of subsection 360-40(1), 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 20WW. | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a): 44. Company A was incorporated in 20xx, which is within the last 3 income years outlined above, therefore subparagraph 360-40(1)(a)(i) is satisfied. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b): 45. To meet the requirement in paragraph 360-40(1)(b), Company A 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 did not own any 100% subsidiaries during the 20XX income year. 46. Company A reported total expenses of $N at item 6 of their 20XX company tax return. This amount corresponds to the total operating expenses incurred by Company A in the profit and loss statement for the 20XX income year. 47. As the incurred total expenses for Company A during the 20XX income year is less than $1 million, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c): 48. To meet the requirement in paragraph 360-40(1)(c), Company A must have derived total assessable income of $200,000 or less in the 20XX income year. Company A did not own any 100% subsidiaries during the 20XX income year. 49. Company A reported total income of $M at item 6 of their 20XX company tax return. This amount corresponds to the total income derived by Company A in the profit and loss statement for the 20XX income year. 50. As the total assessable income derived by Company A in the 20XX income year is less than $200,000, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No stock exchange listing - paragraph 360-40(1)(d): 51. Company A is privately owned and is not listed on any stock exchange in Australia or a foreign country. Therefore, paragraph 360-40(1)(d) is satisfied. | Detailed Reasoning - Conclusion on early stage test: 52. Company A will satisfy the early stage test for the entire 20YY income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100 point test: 53. Company A has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20YY. For Company A to be a qualifying ESIC it will need to satisfy the principles-based test. | Detailed Reasoning - Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i): 54. Company A is developing a product for use in various sectors. 55. The product being developed by Company A will provide increased levels of efficiency compared to currently available products. 56. The product will be able to be produced using manufacturing techniques. 57. At the relevant test time, Company A will hold the International patent application and Australian provisional patent covering the product technology. 58. Company A has strategic relationships with current market leaders. | Detailed Reasoning - Addressable market: 59. Company A has identified its initial addressable market as the Industry, with an entry point being the Specific market. Customers in the Specific market are looking for products with greater efficiency. 60. A summary analysis of the Specific target market is provided. | Detailed Reasoning - Genuinely focussed on developing for commercialisation: 61. Company A has taken the following steps in developing the core technology for the product: a. Prototype design b. Validation c. Testing - in collaboration with an Organisation. d. Customer visits - further testing has occurred as part of potential customer visits. e. Recipient of funding from the Program f. Completing the expression of interest stage for the specific grant and currently working with AusIndustry to progress the application process, and g. Filing for both an Australian provisional patent and International patent. 62. To continue developing the product for commercialisation, the following steps require completion: a. Technology enhancements - The prototype product requires further refinement and enhancements to extend the technology for specific customer application within the target market. b. Research and development (R&D) - The future work program includes engaging specialised R&D staff to undertake further refinement to the product. Further testing of the product will occur as the R&D work is finalised. c. Customer orders - potential customers have been identified and Company A is in negotiations with interested parties. The first customer orders will be in the form of 'adaptation projects' that will become the bridge between the proof-of-concept and commercialisation for each individual customer's requirements. An adaptation project is one in which the core technology is adapted to suit specific performance targets as set out with potential customers. 63. The above facts demonstrate that Company A is taking tangible steps to lead to the development of the product. This demonstrates a genuine focus on developing for commercialisation a product for initial application in the Specific market. 64. The product is not expected to be fully developed, or to start generating revenue, until the end of the 20ZZ calendar year. 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. 65. The initial revenue stream for Company A will arise from services and prototypes, which includes adapting the product technology for customers' specific requirements. 66. Company A has prepared and provided a business plan document that outlines the potential of the product technology, market potential, business model and operational risks. | Detailed Reasoning - Conclusion on subparagraph 360-40(1)(e)(i): 67. Company A is genuinely focussed on developing a product for a commercial purpose. The product will be a new or significantly improved product compared to benchmark competitors' products. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 June 20XX until 30 June 20YY provided the product is not fully developed and ready for sale during this time period. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii): 68. Company A is looking to commercialise the developed product and achieve earnings via customers. 69. Company A has a three-phase business model covering the next 6 years, consisting of various revenue streams. 70. Phase 1 of the business model is expected be a two year process, which will involve the adaption of the product intellectual property for the customer's specific requirements. 71. The product market is a global market with a broad range of market segments. 72. There is demand within the global product market for a product that offers increased efficiency and performance. The product being developed by Company A offers an opportunity to address this demand. 73. The potential initial customers identified by Company A are global businesses. 74. The product being developed by Company A presents a new option for businesses within the product market. Company A's business relating to the development of the product has a high growth potential in a large global market. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii): 75. The discrete phases of the Company A business model describe Company A's roadmap to scale the business. 76. Cost modelling and price points have been an integral consideration during the gestation of the product from early concept work. The first customer orders will be in the form of 'adaptation projects' that will become the bridge between proof-of-concept and commercialisation for each individual customer's requirements. 77. Company A has the potential to enter into larger unit volume deals. 78. This would see Company A transition revenue streams from the adaptation phase through to the product development phase. 79. As Company A expands sales of a developed product and associated technology, the business will generate increased revenue with a lesser increase in operating costs. This operating leverage ensures Company A has the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv): 80. Company A has identified their first customers will be global companies supplying products to the Specific industry. 81. Company A has applied for an International patent covering the product technology. 82. The product being developed by Company A has the potential to address the global product market. This addressable market is on a global scale and is not confined to a local city, area or region. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v): 83. The product being developed by Company A promises significant improvements when compared to the benchmark product on the market. 84. Compared to competitors' products, the Company A product will have a number of significant advantages that will lead to considerable savings. 85. Furthermore, the product will be produced using manufacturing techniques. 86. Company A holds patents for the core technology IP and unique features of the product. 87. Company A has demonstrated the potential for the product to have competitive advantages for customers within the global product market, satisfying subparagraph 360-40(1)(e)(v). | Detailed Reasoning - Conclusion on principles test: 88. 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 commencing 1 July 20XX until 30 June 20YY, provided the product is not fully developed and ready for sale during this time period. | Detailed Reasoning - Conclusion: 89. Company A meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until 30 June 20YY, provided the product is not fully developed and ready for sale during this time period