Private ruling: Early stage innovation company
Date of advice: 27 September 2017
Published: February 2018
Ruling period: Year ending 30 June 2018
Date scheme commenced: 1 July 2017

Ruling: Q1: Does Company A satisfy the requirements to be an early stage innovation company as determined in accordance with section 360-40(1) of the Income Tax Assessment Act 1997 ? | A1: Yes


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 indicated. | Detailed Reasoning - Question 1:: Does Company A satisfy the requirements to be an early stage innovation company as determined in accordance with subsection 360-40(1) of the Income Tax Assessment Act 1997 ? | Summary: Company A meets the eligibility requirements of an ESIC under subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 39. 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 ‘test time’ for determining whether an entity is a qualifying ESIC is the time immediately after the relevant ESIC shares are issued. 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’: 40. The early stage test requirements are outlined in paragraphs 360-40(1)(a) to (d). | Detailed Reasoning - Incorporation or Registration – paragraph 360-40(1)(a): 41. 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). 42. 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. 43. It is considered that a company will satisfy the incorporation test in subparagraph 360-40(1)(a)(i) where, immediately after the issue of shares to the investor, the company had been incorporated in either: ● that part of the current year which precedes the issue of shares; or ● one of the two income years prior to that year 44. 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): 45. 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): 46. 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): 47. 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: 48. 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: 49. 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. Company A is not applying the 100 point test under section 360-45 for the year ending 30 June 2018. For Company A to be a qualifying ESIC it will need to satisfy the principles-based test. | Detailed Reasoning - ‘Principles-based test’ – subparagraphs 360-40(1)(e)(i) to (iv): 50. 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. 51. 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. 52. 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: 53. 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. 54. 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. 55. 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. 56. 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. 57. ‘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: 58. 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: 59. 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: 60. 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: 61. 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 62. 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 July 2017, but before 30 June 2018. To date Shares in Company A were issued to members of the public in 30 June 2017. This is a test time that this ruling does not apply to. 63. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2018 (the 2018 income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years includes the years ending 30 June 2016 to 30 June 2018. The income year before the current year is the year ending 30 June 2017 (the 2017 income year). | Detailed Reasoning - ‘The early stage test’: 64. Company A was registered in 2017, which is within the year before the current income year and satisfies paragraph 360-40(1)(a). 65. The year before the current year is the year ended 30 June 2017. Company A was incorporated in 2017. In the period between incorporation and 30 June 2017, Company A incurred expenses of less than $100,000. Company A holds 100% of shares in Company B, which is therefore a 100% subsidiary of Company A. Company B did not incur any expenses during the year ended 30 June 2017. Consequently, paragraph 360-40(1)(b) is satisfied. 66. Company A and Company B had nil assessable income for the year ended 30 June 2016, thereby satisfying paragraph 360-40(1)(c). 67. As Company A is a private company that has not been listed for quotation on any foreign or domestic stock exchange that company satisfies paragraph 360-40(1)(d). As all criteria have been met, the early stage test has been satisfied. | Detailed Reasoning - ‘Principles-based test’: Developing new or significantly improved innovations for commercialisation – subparagraph 360-40(1)(e)(i) 68. Subparagraph 360-40(1)(i) requires two main elements to be present for the provision to be satisfied, being that the company is ‘genuinely focussed’ and is ‘developing new or significantly improved innovations for commercialisation.’ 69. Company A states that its focus is on developing product Series 1, 2 and 3. Over the period from early 2017 to mid 2018, possibly earlier, the product Series 2 will be developed to incorporate improvements from the product 1 for the purpose of commercialisation of the product. 70. The research has application beyond Australia, to a dealer network in New Zealand, and potentially to a worldwide market. 71. The addressable market includes ● Businesses in Australia with 5 or more employees and with a turnover of more than $2 million per-annum; ● Education at all levels, pre-school, primary, secondary and tertiary; ● Government at all levels, Federal, State and Local; ● Not-For-Profit Institutions; ● Charitable Institutions; ● Social and Sporting Clubs; ● Other unincorporated entities; ● Police services; ● Fire Protection and other emergency services; and ● Religious Services. 72. The product line is considered to be unique with no other product worldwide having all of its features. Genuinely focussed on developing for commercialisation 73. After developing the product Series 2 through six stages from early 2017 to mid 2018, the seventh stage will be commercialisation of the product. 74. The addressable market has been identified as numerous businesses, education facilities, government departments, not-for-profit organisations, police and religious services. 75. The product Series 2 will be distributed throughout Australia and New Zealand via a Dealer/Installer Network through various business sectors. 76. The uniqueness of the product Series 2 having several features which are not all available in existing products has the potential for a wide cross-section of markets in Australia and overseas. 77. The underlying reason to develop the product Series 2 through six stages was to develop a product with a broad market for the purpose of commercialisation. Revenues are forecast to grow to approximately $2,000,000 in the first year after funds from the share issue are received. Conclusion on subparagraph 360-40(1)(e)(i) 78. Subparagraph 360-40(1)(e)(i) requires two main elements to be present for the provision to be satisfied, being that the company is ‘genuinely focussed’ and is ‘developing new or significantly improved innovations for commercialisation.’ Company A is genuinely focussed on developing the product Series 2, a significantly improved product, for commercialisation. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied. High growth potential 79. Company A has identified deficiencies in other systems and produced a product which incorporates several features of improvements and innovations not available in other systems. 80. The significantly improved product will have appeal across a wide addressable market, based upon the following facts: ● Demand – The product uniquely incorporates a wide range of features into the one product increasing demand across a wide cross section of the community; ● Cost savings – By incorporating more features into one product, the cost of installing the product offers significant cost advantages over the cost of installing separate systems; ● Flexibility – The range of features enables the product to be used by a wide addressable market. 81. Company A is currently developing key relationships in Australia and New Zealand using a Dealer/Installer Network comprising selected businesses. The unique features of the product Series 2 will attract wider international support. 82. Conservative forecasting of sales revenue indicates that revenue from the product will over double from the first year of commercialisation to the second year with substantial increases in subsequent years. Sales of the product are forecast to be profitable from the second year of commercialisation. 83. Company A has a high growth potential both nationally and internationally. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability 84. Company A is developing the product Series 2 with an intention to finalise development around mid 2018 with a view for placing the product on the market for commercialisation. 85. The product Series 2 will be sold to a wide addressable market via a Dealer/Installer Network in Australia and New Zealand. The product Series 2 will have several innovative features which are not all available in other similar products. It is not known if there are any other products in the world with all of the innovative features. The product Series 2 may therefore have a potential world-wide market. 86. Company A has the potential to increase the scale of its operation from Australia and New Zealand, to a world-wide market. Given that the same product will be available globally, it is expected that Company A will be able to generate increased revenue at a greater rate than increases in operating costs. 87. 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. Broader than local market 88. Company A is based in Australia and also has Dealer/Installer Networks in New Zealand. 89. The product Series 2 will have unique features all in one product. In the absence of similar products world-wide, it is expected that there will be international demand for the product. The product Series 2 may therefore have a potential world-wide market. 90. Company A has the ability to address the global market as the technology involved in the innovations is the same globally and therefore does not need adapting for the overseas market. 91. Company A has demonstrated that its technology has the potential to address a broader market than just the Australian and New Zealand markets, including global markets. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. Competitive advantages 92. The product system delivers a significant competitive advantage over traditional systems in that there is virtually no installation costs. 93. Each of the units of the product system is totally autonomous, enabling units in the system to still operate even if one unit is involved in a fire or is damaged in some way. This provides significant competitive advantage over traditional systems which are vulnerable to power outages. 94. The product system is unique in providing several features, which are all available within the one system. This uniqueness gives Company A a significant competitive advantage, as it appears that there is no other system worldwide that provides all of these features. The cost of installing the product offers significant cost advantages over the cost of separate systems and the cost of installing those systems. 95. Company A has demonstrated the potential for its technology to have competitive advantages within the particular industry, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles-based test 96. Company A satisfies the principles-based test as it satisfies all of the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 2017 until 30 June 2018 or the date when the product systems has been fully developed and is ready for sale, whichever occurs earlier. Conclusion 97. Company A meets the eligibility criteria of an ESIC under subsection 360-40(1) for the period commencing 1 July 2017 until 30 June 2018 or the date when the product systems has been fully developed and is ready for sale, whichever occurs earlier. | Detailed Reasoning - Further issues for you to consider: The following information does not form part of the private ruling. We have reviewed facts for the company for the year ended 30 June 2017 that are relevant to the Early Stage Test and Principles Based Test described in the private ruling. We consider Company A would have met the requirements of the tests and qualified as an ESIC for the year ended 30 June 2017.

1. In 2017, Company B was registered. Company A currently holds 100% of the shares in Company B. | a. Company B is the operating company for the group. | b. To date the company has not generated any assessable income. | 2. Company A is a private company registered in Australia in 2017. None of its equity interests are listed on any stock exchange. | 3. The company had three founders who hold the roles of executive chairman, chief executive officer, directors and business development manager. | 4. Shares in Company A were issued to members of the public in mid 2017. | 5. The Share Offer in mid 2017 raised funds with the only eligible investors being superannuation funds. | 6. Company A is a new company established to deliver a range of new and highly innovative products and systems to the Australian and international market place. | 7. The company’s focus is on a particular product. All of the research and development (R & D) work was undertaken during the year ended 30 June 2017 by the executive chairman as an In-Kind contribution. In the year ending 30 June 2018 the R & D will be conducted by Company A. | 8. Company A has been established to develop the products and to realise the identified potential. The company will be highly focussed on developing the product, with revenues forecast to grow to approximately $2,000,000 in the first year after funds are received. | 9. The product is easily and cost effectively deployed across any site. | 10. There are two product streams. There is a full complement of products in each stream that all work together to provide the best possible system for any situation. Installation costs are minimised compared to current systems. | 11. The product has a market-ready range of products on offer, the hardware and software have been fully developed. A small number of systems were manufactured and installed and have been operational for over 18 months. The directors have moved forward and have been targeting a range of different applications. The number of installed systems is in excess of 30 systems. | 12. The directors plan to offer the product and are currently quoting and winning new business based predominantly on website generated enquiries. | 13. A product program was implemented in late 2016 based on experience, customer feedback and capabilities enquiries. The decision was taken to extensively re-develop the hardware platform with three major goals: | a. to design for scalable production; | b. significant hardware cost reduction; and | c. to design a hardware platform to enable significant increase in capability and performance in the future, using an ongoing development program of software upgrades. | 14. The first stage product Series 2 objectives are to develop the new hardware platform with a software development to mimic the capabilities and performance of the current Series 1 products. The time line to complete this stage and release the Series 2 product was mid 2017. | 15. Following on from the product Series 2 release the objective is to continue with the software development to develop a range of Series 3 products with enhanced features and extended capabilities. These Series 3 products are expected to be ready to add to the Series 2 products range during the first quarter of 2018. | 16. The release of the Series 3 products is expected to expand the market opportunities and stimulate growth. This release will extend the product differentiation and minimize any potential impact of competition entering the market. | 17. The product system has been developed to be innovative in a number of significant ways providing a significant competitive advantage over traditional systems by significantly reducing installation costs. | 18. The product provides significant competitive advantage over traditional systems. | 19. The uniqueness of the product system is also evident in its flexibility which provides for a variety of features which are all available within the one system. It appears that there is no other system worldwide that provides all of these features. The cost of installing the product offers significant cost advantages over the cost of separate systems and the cost of installing those systems. | 20. During the period early-mid 2017 a document was put together to outline the proposed system structure and potential operating characteristics of the product. | Stage 1: 21. The ideas and concepts behind the new product Series 2 come from acknowledging the limitations of product Series 1, customer feedback/capability enquiry and a forward vision think tank bringing new ideas together. Product Series 2 will bring together both new and significantly improved modifications to extensively expand the capabilities of product Series 1 with the intent to broaden the local and international market opportunities, reduce manufacturing costs, improve energy efficiencies and enhance manufacturing scalability. | 22. Following on from the completion of the development, the decision was made to design a hardware based development platform incorporating the hardware components required by a system as outlined in the document. | Stage 2: 23. This stage involves development to be completed by the end of mid 2017. | 24. This completed the project work on product 2 carried out in the 2016-2017 financial year. Further stages of the project will continue into the 2017-2018 financial year. | 25. All R & D work undertaken during the 2016-2017 financial year was provided as an In-Kind contribution to Company A by the executive chairman. | 26. This stage will design the initial hardware based development platform for the product Series 2. | 27. This stage aims to have the product Series 2 development platform manufactured. | 28. This stage involves basic visual inspection, and where required some functional testing. | 29. This stage aims to start the software of the product Series 2 to meet the desired functionality outlined in the document. | 30. Extensive in-house testing will be undertaken and when ready customer trials will be conducted to prepare the system for commercialisation. | 31. The timeline for this is targeted at completion by the end of mid 2018. However, it is an R & D project where the research component will not always produce the desired outcomes requiring additional R & D. This may push the timeline out and extend the project into the 2018-2019 year. | Stage 7 (mid 2018 or earlier if ready) | 32. The final stage will proceed the system to commercialisation, automating production, production testing and configuration, and launching the products into the market. | 33. The product’s addressable market consists of: | 34. Company A will deliver its products and systems to the addressable market by wholesale distribution to its Dealer/Installer Network in Australia and New Zealand. The Dealer/Installer Network will be comprised of selected businesses. | 35. The product range is totally unique; the range of functionality provides no direct competitors in the market at this time. | 36. There are a small number of systems in the market that provide some of the functionality. Most of these are uncompetitive because of the cost of the installation. | 37. The directors are only aware of two similar products in the market; one which provides limited functionality in its product range. The second product is made expressly for the construction industry and also has limited functionality. | 38. Comparison with competitors reveals disadvantages of existing products as follows: | ● Very high installation costs; and