Private ruling: Early stage innovation company
Date of advice: 7 September 2022
Published: November 2022
Ruling period: Year ending 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Does the Company qualify as an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997) for the 2022 financial year? | A1: Yes

Relevant facts and circumstances: The Company was incorporated in Australia in in the 20XX income year. The Company's equity interests are not listed for quotation in the official list of any stock exchange. The Company did not have expenses in the year ended 30 June 20XX. The Company did not have revenue in the year ended 30 June 20XX. The Company has created an app in the security sector. The Company is working with other businesses to develop the app. The initial version of the app provides all the requirements for the minimal viable product (MVP) and can be deployed 'as is' in several markets. The MVP is expected to be fully developed and ready for use by initial customers in late 20XX. The business partnerships ensure that the product and platform will meet all requirements of customers as the business scales up. Development of the app will be an ongoing process, and the app is expected to be further developed and offer additional features in future releases. The initial phase of the Company's sale plan is focusing on target markets. The app will initially be aimed at local operators with national footprints. The second phase of the Company's strategy is to target national clients and some international clients. The Company will develop additional verticals focusing on large enterprise and will expand into foreign markets. Phase 2 will also push into e-commerce and points of contact businesses, and will incorporate pay per transactions into the revenue model. Phase three will include pursuing increased growth and globalisation, and additional monetisation options. As the app advances through its development phases it will be sold in larger and more lucrative markets. The sales strategy will allow the Company to concentrate all its available funding on its products. The Company believes that it will be generating positive cash flows within 12 months of go to market. The funds will be used to expand the product range and enter other markets. The Company aims to enter the target markets in late 20XX and ramp up sales in 20XX. The sales effort will be led by the management team and the business development team. To date the Company has: • Developed a technical White Paper. • Created a detailed system design. • Created a detailed product plan. • Developed process flows. • Established a visual design across all engagement layers. The Company has a fee structure. The Company forecasts growing revenue in 20XX, 20XX, and 20XX. There are a number of competitor products available, but these products are focussed on particular transactions and interactions and are not suitable for all of the needs of the target markets. The Company identified that it has the following competitive advantages: • The Company is adopting a bottom-up market approach to build a user base that drives adoption. • De facto ubiquity gives advantage vs other solution and is the best barrier to entry. • The app can sit above or alongside government and other solutions. • The app is unique in offering delegation to other users. • The app is a one-time, for life app. • There are no substitute products.

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

Reasons for decision: Detailed Reasoning - Qualifying Early Stage Innovation Company: 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: 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): 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). 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. 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): 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): 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): 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: 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: 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) 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. 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. 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: 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] 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. 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. 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] 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." 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." 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. '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: 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: 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: 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: 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): At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001. 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 - Application to your circumstances: Test time 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 20XX. Current year For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX (the 20XX income year). The income year before the current year will be the year ending 30 June 20XX (the 20XX income year). | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) The Company was incorporated in the 20XX income year, which is within the last X income years. Subparagraph 360-40(1)(a)(i) / (iii) is satisfied. Total expenses - paragraph 360-40(1)(b) The Company was incorporated in the 20XX income year and did not have any expenses in the prior income year (the 20XX income year). Paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) The Company was incorporated in the 20XX income year and did not have any assessable income in the prior income year (the 20XX income year). Paragraph 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) The Company is not listed on any stock exchange in Australia or a foreign country. Paragraph 360-40(1)(d) is satisfied. Conclusion on early stage test The Company satisfies the early stage test for the 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: The Company has not provided any evidence that it satisfies the 100-point test in section 360-45 for the year ending 30 June 20XX. For the Company to be a qualifying ESIC it will need to satisfy the principles based test. Principles based test Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) The Company has developed an app in the security sector. The app will initially be released in target markets (the addressable market). The Company advises that there are no substitute products available for the target markets. There are other competitor products available, but these products are focussed on particular transactions and interactions and are not suitable for all of the needs of the target markets. After the initial phase the Comapny, will enter other sectors. The app will initially be aimed at local operators with national footprints, with the later stages targeting national and international clients. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) The Company has taken the following steps in developing the app: • developed a technical White Paper. • created a detailed system design. • created a detailed product plan. • developed process flows. • established a visual design across all engagement layers. The Company is working with other businesses to create a minimal viable product (MVP) that can be deployed in the target sectors. The Company anticipate that the MVP will be delivered in late 20XX. The Company has also developed a pricing structure for sales of the app. Conclusion on subparagraph 360-40(1)(e)(i) 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. Therefore 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 app has been fully developed, whichever occurs earliest. Once the app has been fully developed, the Company will no longer be developing the app for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. High growth potential - subparagraph 360-40(1)(e)(ii) The Company has adopted a phased sales plan, and will initially target the target markets. The Company aims to enter these markets in late 20XX and ramp up sales in 20XX. The Company consider that they will generate positive cash flows within XX months of going to market and will use the revenue to expand its product and enter other sectors. With each phase of its sales plan the Company aims to increase its consumer base. Therefore subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) The sales plan initially focusses on target markets. The Company anticipates that it will generate positive cash flows within XX months of going to market and will use the revenue to expand the app and enter new sectors in phase 2. The Company will target national and international clients in later phases, focusing on large enterprises, and will push into e-commerce and points of contact businesses. The Company forecasts revenue growth annually over the next X years. The Company has also developed partnerships with businesses who have helped develop the app and will ensure that the app meets the requirements of customers as demand for the app grows. The development of the app will be an ongoing process, and the app is expected to be further developed and will offer additional features in future releases. As the app is developed it will be sold into larger and more lucrative markets. Given that the app will expand into international markets and grow its revenue streams, the company does have potential to successfully scale up its business. Therefore subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) The app will initially be targeted at Australian markets in its initial roll-out and will then expand into foreign markets. The ultimate addressable market is on a global scale and is not confined to a local city, area or region. 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. Competitive advantages - subparagraph 360-40(1)(e)(v) The app has the following differentiating features which may give it a competitive advantage: • It can be used for life • It offers delegation to other app users There are currently no substitute products, and as the app is adopted it will gain ubiquity which will create a barrier for other products that enter the market. The Company has demonstrated the potential for the app to have competitive advantages within the 'addressable market'. Therefore subparagraph 360-40(1)(e)(v) will be satisfied. Conclusion on principles test The Company 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 app has been fully developed and is ready for sale, whichever occurs earlier. | Detailed Reasoning - Foreign Company Test: The Company was incorporated in Australia and is not a Foreign Company. Paragraph 360-40(1)(f) is satisfied. Conclusion The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until 30 June 20XX or the date when the app 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.