Private ruling: Early Stage Innovation Company
Date of advice: 28 February 201Z
Published: August 2017
Ruling period: Year ending 30 June 201Z
Date scheme commenced: 1 July 201Y

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 201Y. It is a private company with none of its equity interests listed on any stock exchange. 2. The Company has no subsidiaries. 3. The Company has not yet generated any assessable income in the current year and has total expenses of less than $1 million in the previous income year, i.e. the year ended 30 June 201Y. 4. The Company is developing an app that they have demonstrated to be new to the market. 5. The functions provided by the App are more extensive than current competitors in the market. There is currently no App available. The Company has the opportunity to own this gap in the global market. 6. The target market is large, numbering in the millions. 7. The Company has identified its initial market as Australian with expansion into the International markets. Commercialisation strategy 8. The Company is still in the research and development (R&D) phase. 9. A prototype has been developed and being tested both overseas and in the Australian market.

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 ITAA 1997 unless otherwise indicated. | Summary: The Company meets the eligibility requirements of, an ESIC under, subsection 360-40(1). | 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 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). 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 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): 7. 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): 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 (iv): 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 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: 14. For the purposes of Subdivision 360-A, the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 201Y ('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. 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. 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, 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: 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 - Application to your circumstances: Test time 26. 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 201Z. Current year 27. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 201Z (the 201Z income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years will include the years ending 30 June 201Z, 201Y and 201X, and the income year before the current year will be the year ending 30 June 201Y (the 201Y income year). | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) 28. As the Company was incorporated on DDMMYY, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) / (ii) / (iii) is satisfied. Total expenses - paragraph 360-40(1)(b) 29. As the Company 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) 30. As the Company's assessable income for the prior income year is less than $200,000 and paragraphs 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) 31. As the Company is privately owned and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(a)(d) is satisfied. Conclusion on early stage test 32. The Company will satisfy the early stage test for the entire 201Z income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100 point test: 33. The Company has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 201Z. For the Company 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): 34. According to the Company the App will provide the ability to users to access unprecedented precise knowledge to the market. Although it will initially be targeted at the Australian market, the App has been identified as having a wider global addressable market. | Detailed Reasoning - Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i): 35. The Company has taken the following steps in developing the App: a. development of a prototype b. building of a functional App 36. The Company have engaged with third parties who have interest in the App. 37. The Company will continue to develop the App to shape the commerciality of the App for potential customers to increase direct sales. | Detailed Reasoning - Conclusion on subparagraph 360-40(1)(e)(i): 38. The Company is genuinely focussed on developing the App for a commercial purpose. The App will be a significantly improved product compared to existing products. 39. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 201Y until 30 June 201Z or the date when the App has been fully developed, whichever occurs earliest. Once the App 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. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii): 40. The Company has focused the App for users in the global market for both commercial and private purposes. 41. The Company expects the App to appeal to a wide range of users including manufacturers in the relevant industry. 42. The Company is developing the App themselves. They will make their revenue through premium subscriptions and sponsorships. If the commercialisation strategy is successful, this may give App the ability to increase sales through referrals and retail outlets. 43. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii): 44. Given that the App will be available globally, it is expected that the App has the potential to successfully scale up its business. 45. The Company's strategy for the use of the App will be able to generate increased revenue from both the commercial and private users. Given the local market in Australia and the market opportunities internationally this operating leverage affords the Company 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): 46. The Company have engaged with an International company to deliver the App to certain international locations. 47. The App can be used locally, domestically and worldwide by operators. Thus, the ultimate addressable market is on a global scale and is not confined to an area or region. 48. The Company demonstrated the App 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. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v): 49. The App offers differentiating features to that of their competitors which may give it a competitive advantage. 50. Being the first to offer certain features the App has the first market advantage. The Company has demonstrated the potential for the App to have competitive advantages within the relevant community, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test 51. 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 201Y until 30 June 201Z or the date when the App has been fully developed and is ready for sale, whichever occurs earlier. Conclusion 52. The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 201Y until the earlier of 30 June 201Z or the date when the App has been fully developed and is ready for sale, whichever occurs earlier.