Private ruling: Early Stage Innovation Company
Date of advice: 18 January 2017
Published: June 2017
Ruling period: Year ended 30 June 20YY
Date scheme commenced: 1 July 20YY

Ruling: Q1: Does Company 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. Company A was incorporated in Australia in 20xx. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. It is a start-up company and had expenses of $1 million or less in the previous income year. It has not yet generated any revenue so its assessable income was $200,000 or less. 3. Company A was formed to develop a new product in an existing (although expanding market) and will build its plant from the ground up and intends to develop the most technologically advanced high volume plant in the market. 4. Company A has identified its ultimate market as being in purchasers of XXX. Its target in the first year of release being mainly purchasers in the Australian market with a limited international release (focussing on Country X). Commercialisation strategy 5. Company A is in the process of acquiring the land in which it will build its premises complex. 6. The next steps involve: ● design and building of their premises ● design and install the equipment on site ● conduct research and development into their end ● begin to produce the product ● when ready release the product onto the market. 7. Company A's target market is in Australia and internationally. 8. Company A provided estimates of its market share when the product is released. Information provided 9. You have provided information in a number of documents and phone conversations in relation to Company A's status as an ESIC, including: a. The private ruling application. b. The Information Memorandum c. Financial projections d. Biography of key personnel e. Media articles f. Letter from entity interested in being Company A's distributor g. Audited financial statements 10. We have referred to the relevant information within these documents and conversations in applying the relevant tests.

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. Company A 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 a 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 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…” 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 Company A is a qualifying ESIC will be a particular date during the income year ending 30 June 20YY. Current year 27. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2017 (the 2017 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 2017, 2016 and 2015, and the income year before the current year will be the year ending 30 June 2016 (the 2016 income year). | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) 28. As Company A was registered within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. Total expenses - paragraph 360-40(1)(b) 29. As Company A had expenses of $1 million or less in the prior income year, paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) 30. As the assessable income for the prior income year is $200,000 or less paragraph 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) 31. Company A 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. Company A will satisfy the early stage test for the entire 2017 income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100 point test: 33. Company A does not believe it would satisfy the 100 point test under section 360-45. For them to be a qualifying ESIC it will need to satisfy the principles-based test. | Detailed Reasoning - Principles based test: Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) 34. Company A has provided details of what it intends to do in the production process in order to release its product into the market and the business proposition highlights the growth in demand for this product. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) 35. Company A is currently at the design phase of its plant and equipment. The construction and implementation phase will happen over a number of years. 36. Once operational Company A can begin to produce their product will go market when ready. Conclusion on subparagraph 360-40(1)(e)(i) 37. Company A is genuinely focussed on developing the distillery for a commercial purpose. It will be a significantly improved production process when compared to existing producers. 38. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20YY until 30 June 20YY. Once 'the plant and equipment has been fully developed and installed Company A will no longer be 'developing' it for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. High growth potential - subparagraph 360-40(1)(e)(ii) 39. There is a growing demand for the product Company A will produce. 40. There is already a large commercial value in the market and this value will grow as the market grows. 41. Company A intends to build a plant large enough to produce the product in high volumes. 42. Company A provided financial estimates outlining their revenue growth once their product is released in the market. 43. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 44. The design and building of the plant will take place before Company A will begin to produce its product. 45. The costs of establishing the plant will end before Company A begins to receive income and the plant will be designed so that production can be scaled up when demand increases without incurring additional capital expenses. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) 46. Company A will produce a product that is already being sold in large quantities globally. It intends to enter that market and compete with existing producers. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. Competitive advantages - subparagraph 360-40(1)(e)(v) 47. Company A's competitors are all long standing and use technology available when they first build their production plants and Company A will have a technological advantage over them The new features built into the production process will provide the differentiating features which may give Company A a competitive advantage at the production stage. 48. In addition, if the design process produces intellectual property that Company A can exploit (or protect first use advantage from any intellectual property developed for use in its production process), Company A will retain ownership of that intellectual property. 49. Company A has the first mover advantage in respect of technological upgrades to this product's production process. Company A has demonstrated the potential for their production process to have competitive advantages over other producers, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test 50. Company A 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 20YY until 30 June 20YY. Conclusion 51. Company A meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20YY until the earlier of 30 June 20YY.