Private ruling: Early stage innovation company qualification
Date of advice: 29 May 2023
Published: 17 July 2023
Ruling period: Year ending 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Does Company X 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. Company X was incorporated in Australia on Date X. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. Company X has no subsidiaries and had expenses of less than $X million and no assessable income in the previous income year, i.e. the year ended 30 June 20XX. 3. Company X plans to develop and commercialise a suite of world first diagnostic tests using new technology. The Company has primarily focused on activities towards development of the "A test" in the income year ending 30 June 20XX and this has been identified as the "Innovation" for the purposes of this ruling. 4. The addressable market for Company X's Innovation is a worldwide market. 5. Company X has provided information to support the commercialisation strategy for its Innovation. 6. Company X has undertaken R&D activities in relation to the innovation for the income year ending 30 June 20XX. 7. You have advised Company X does not have any shareholders that are considered to be "affiliates" of Company X under section 328-130 of the Income Tax Assessment Act 1997. Broadly, an affiliate of Company X exists where Company X is reasonably expected to act in accordance with a shareholder's directions or wishes, or together with them in relation to business affairs (and vice versa).

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-40

Reasons for decision: Summary: All legislative references are to the ITAA 1997 unless otherwise indicated. | 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 6 income years (the latest being the current year), and across the last 3 of those income years before the current year it 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. ' 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 is genuinely focused on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods; and ii. the business relating to those products, processes, services or methods has a high growth potential; and iii. the company can demonstrate that it has the potential to be able to successfully scale that business; and iv. the company can 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 can 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: 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..." [1] 15. 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. 16. 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. 17. The OECD Oslo Manual 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. [2] 18. In discussing services innovation activity, paragraph 111 of the OECD Oslo Manual states: Innovation activity in services also tends to be a continuous process, consisting of a series of incremental changes in products and processes. This may occasionally complicate the identification of innovations in services in terms of single events, i.e. as the implementation of a significant change in products, processes or other methods. 19. 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.' 20. 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. 21. '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: 22. 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: 23. The company must be able to demonstrate that it has the potential to successfully scale up the business. 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 per unit. | Detailed Reasoning - Broader than local market: 24. 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: 25. 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): 26. At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001. 27. The dictionary in section 9 of the Corporations Act 2001 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: 28. For the purposes of this ruling, the test time for determining if Company X is a qualifying ESIC will be a particular date during the income year ending 30 June 20XX. | Detailed Reasoning - Current year: 29. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX (the 20XX income year) and the prior income year will be the year ending 30 June 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a): 30. As Company X was incorporated on Date X, which is within the last 3 income years, the requirement in subparagraph 360-40(1)(a)(i) is satisfied. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b): 31. As Company X had expenses of $1 million or less in the prior income year (the 20XX income year) the requirement in paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c): 32. As Company X's assessable income in the prior income year (the 20XX income year) is $200,000 or less, the requirement in paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No stock exchange listing - paragraph 360-40(1)(d): 33. Company X is not listed on any stock exchange in Australia or a foreign country. As a result, the requirement in paragraph 360-40(1)(d) is satisfied. | Detailed Reasoning - Conclusion on early stage test: 34. Company X 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 innovation test: 35. As an alternative to satisfying the principle-based test for a qualifying ESIC, a company may be a qualifying ESIC if it has at least 100 points for meeting certain objective innovation criteria. The 100 point test is provided as an alternative innovation test providing the company with a self-assessment test. 36. Company X has not requested the Commissioner to consider application of the 100 point test. Principles based test | Detailed Reasoning - Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i): 37. There are three interacting elements that needs to be addressed: (a) New, significantly improved, product, process, service or marketing method or organisational method - the Innovation (b) Developing for commercialisation, and (c) Genuinely focussed. 38. According to Company X the Innovation does not exist in the Australian and global markets. 39. Company X's Innovation will be a significant improvement on comparable diagnostic products in the market. | Detailed Reasoning - Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i): 40. Company X has taken preliminary steps in developing the Innovation. 41. Company X plans to raise additional funding to help with commercialisation of the Innovation. | Detailed Reasoning - Conclusion on subparagraph 360-40(1)(e)(i): 42. Company X is genuinely focussed on developing the Innovation for a commercial purpose. The Innovation will be a significantly improved product compared to existing products on the market. 43. Therefore, the requirement in subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XX until 30 June 20XX or the date when the Innovation has been fully developed, whichever occurs earliest. Once the Innovation has been fully developed, Company X will no longer be developing this product for commercialisation and the requirement in subparagraph 360-40(1)(e)(i) will no longer be satisfied. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii): 44. Company X expects the Innovation to appeal to the Australian and global population. 45. If the commercialisation strategy set out by Company X is successful, Company X will achieve its mission to develop the Innovation for application in its target markets. Each market presents potential for high growth. 46. Therefore, the requirement in subparagraph 360-40(1)(e)(ii) will be satisfied. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii): 47. Given that the Innovation will be made available globally, it is expected that Company X has the potential to use the Innovation to successfully scale up its business. 48. Company X's strategy for the use of the Innovation will be able to generate increased revenue and operating leverage. Therefore, the requirement in subparagraph 360-40(1)(e)(iii) will be satisfied. | Detailed Reasoning - Broader than local market- subparagraph 360-40(1)(e)(iv): 49. Company X's Innovation will initially be targeted at the Australian and specific international markets but is intended for worldwide use. 50. The ultimate addressable market is on an Australian and global scale and is not confined to a local city, area or region. 51. Company X has demonstrated the Innovation has the potential to address a broader market than just the local market, including international markets. Therefore, the requirement in subparagraph 360-40(1)(e)(iv) will be satisfied. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v): 52. Company X's Innovation has differentiating features which may give it a competitive advantage. 53. In addition, the Innovation has first mover advantage. 54. Company X has demonstrated the potential for the Innovation to have competitive advantages within the 'addressable market'. Therefore, the requirement in subparagraph 360-40(1)(e)(v) will be satisfied. | Detailed Reasoning - Conclusion on principles test: 55. Company X 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. | Detailed Reasoning - Foreign Company Test: 56. As Company X was incorporated in Australia, it is not a Foreign Company. Therefore, the requirement in paragraph 360-40(1)(f) is satisfied. | Detailed Reasoning - Conclusion: 57. Company X meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until the earlier of 30 June 20XX or the date when the Innovation has been fully developed and is ready for sale, whichever occurs earlier. [1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76. [2] OECD Oslo Manual, paragraph 124 and paragraph 151.