Private ruling: Early Stage Innovation Company
Date of advice: 2 March 2017
Published: August 2017
Ruling period: Year ended 30 June 20YY
Date scheme commenced: 1 July 20XX.

Ruling: Q1: Does Company A qualify as an Early Stage Innovation Company under section 360-40 of the Income Tax Assessment Act 1997 at any time during the income year ending 30 June 20YY? | A1: Yes

Relevant facts and circumstances: 77. Company A was incorporated and registered in the Australian Business Register on Date A. Its equity interests are not listed for quotation in the official list of any stock exchange. 78. Company A has no subsidiaries and expenses of amount A in the previous income year, i.e. the year ended 30 June 20XX. Its assessable income in the 20XX income year was Amount B. 79. Company A is developing Product A. Full details of Product A and its intended use was provided with the ruling application. 80. Patent information in respect of Product A shows that Company A holds all patents over Product A. 81. Information of the addressable and target markets was provided in the application. 82. Financial forecasts and details of Company A's commercialisation strategy were also provided. 83. Other information, including promotional material, regarding Product A was also provided. 84. We referred to the relevant information within the documents provided and conversations with the applicant in applying the relevant tests to your circumstances.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-15 | Income Tax Assessment Act 1997 section 360-40 | Income Tax Assessment Act 1997 section 360-45 | Income Tax Assessment Act 1997 section 975-505 | Income Tax Assessment Act 1997 section 975-150

Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated. | Summary: Company A meets the eligibility requirements of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) | Detailed Reasoning - Detailed Reasoning: 85. Subsection 360-40(1) outlines the criteria required for a company to qualify as an 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': 86. 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): 87. 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). 88. 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. 89. 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): 90. 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): 91. 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): 92. 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: 93. 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: 94. 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): 95. 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. 96. 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. 97. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are: iv. the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation v. the business relating to that innovation must have a high growth potential vi. the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation vii. 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 viii. 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: 98. 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…” 99. 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. 100. 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. 101. 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.” 102. 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.” 103. 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. 104. '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: 105. 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: 106. 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: 107. 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: 108. 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 109. 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 110. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20YY (the 20YY 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 20YY, 20XX and 20WW, and 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) 111. As Company A was incorporated on Date A, which is within the last 3 income years, subparagraph 360-40(1)(a)(i)/(iii) are satisfied. Total expenses - paragraph 360-40(1)(b) 112. As Company A had expenses of less than $1 million in the prior income year, paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) 113. As Company A's assessable income for the prior income year is less than $200,000, paragraph 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) 114. As 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 115. Company A will satisfy the early stage test for the 20YY income year, as each of the requirements within paragraphs 360 40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100 point test: 116. Company A has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20YY. For Company A 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) 117. According to Company A, the innovation is Product A, which has been identified as having a wider addressable market, and will expand out to worldwide marketing. 118. Company A will be the first to offer such a product. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) 119. Company A has conducted market research and identified a need in the addressable market. has led to Company A developing Product A. 120. Currently Company A is in discussions with Entity A to test the prototype currently under construction. 121. Once testing is complete Company A will be initially target a specific area of the market which they believe is ideal for rapid expansion. Sales will be pursued by the steps outlined in the ruling application: Conclusion on subparagraph 360-40(1)(e)(i) 122. Company A is genuinely focussed on developing Product A for a commercial purpose. Product A will be a significantly improved product compared to existing products. 123. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XX until 30 June 20YY or the date when Product A has been fully developed, whichever occurs earliest. Once Product A has been fully developed, Company A will no longer be 'developing' the product for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. High growth potential - subparagraph 360-40(1)(e)(ii) 124. The information provided demonstrates that Product A has the potential to expand out into the market globally, therefore subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 125. Company A is planning on introducing Product A into new markets. Whether Company A or a third party manufactures Product A, the cost per unit could be reduced as it expands production. 126. Given that Product A will be available globally, and expanded into other industries thus increasing revenue, it is expected that Company A has the potential to successfully scale up its business. 127. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) 128. Company A has demonstrated that Product A 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) 129. Bas Product A will be the first product of its kind on the market, Company A has the first mover advantage. Company A has demonstrated the potential for Product A to have competitive advantages within the professional business community, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test 130. 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 20XX until 30 June 20YY or the date when Product A has been fully developed and is ready for sale, whichever occurs earlier. Conclusion 131. Company A meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until the earlier of 30 June 20YY or the date when Product A has been fully developed and is ready for sale, whichever occurs earlier.