Private ruling: Early Stage Investment Company (ESIC)
Published: August 2017
Ruling period: Year ending 30 June 2017
Date scheme commenced: 1 July 2016

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: The Company was incorporated in Australia in the 2016 financial year. Its equity interests are not listed for quotation in the official list of any stock exchange. The Company and its wholly owned subsidiary had expenses of less than $1 million in the previous income year, i.e. the year ended 30 June 2016. It and its subsidiary have not yet generated any revenue so its assessable income was $200,000 or less. The Company is developing a technology system (the system). The Company is currently at the stage of developing a Minimum Viable Product (MVP). The Company has highlighted several key differentiators of the system from its competitors. The intellectual property (IP) of the business is owned by the Company. Commercialisation strategy The Company has developed an Alpha version of the system. This Alpha version has been demonstrated to a dozen organisations. The company has developed a program of work for development of the system. The Company has identified market segments as initial targets for the system. Within each of the identified market segments, the Company has identified specific potential customers. The company has outlined that it will pursue product sales through a combination of channels. Information provided The ruling relies on the information provided by the applicant. You propose to issue new shares in the Company to various investors to assist in funding the continued development and commercialisation of the system.

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: 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: Incorporated in Australia within the last three income years (the latest being the current year); or 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 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 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): 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): 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. | Detailed Reasoning - 'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (iv): 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: The company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation The business relating to that innovation must have a high growth potential The company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation 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 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: 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…” 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. 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 - 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 2017. Current year For the purposes of subsection 360-40(1), the current year will be the year ending 30June 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) As the Company was incorporated within the last 3 income years, subparagraph 360-40(1)(a)(iii) is satisfied. Total expenses - paragraph 360-40(1)(b) As the Company 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) As the Company did not derive any assessable income during the 2016 income year, its assessable income for the prior income year is less than $200,000 and paragraph 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) As the Company is privately owned and 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 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: The Company has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 2017. For the Company 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) The Company is developing a technology system. The Company has identified its current addressable market as the global market. You have stated the system is the first system to offer several unique features and functionalities. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) The Company has taken the following steps in developing the system: Scoping of market opportunity, potential and unmet need. Detailed specifications for the system. Development of an Alpha version of the system Demonstration of the Alpha version of the system in a dozen organisations. Sales and marketing strategy. Cash flow budgeting and management; and Pilot programme development. The timeline provides that the Company plans to continue developing the system for commercialisation, the following steps are planned for the 2017 calendar year: Development of an internet based Minimum Viable Product (MVP). Commissioning and development of a Minimum Buyable Product (MBP). Distribution model development. Completion of a comprehensive Full Product (FP). The Company plans to run pilot R programmes with a select group of pilot customers who will road test the system within their organisations. The company will use the results and findings from the pilot customers to further fine-tune its product and customer 'immersion documentation', 'user guides', and its understanding of the timelines and activities required for successful customer product immersions. A small amount of revenue is expected to be generated from the implementation of the pilot programme. The above facts demonstrate that the Company has taken tangible steps to lead to the sale of its product, which demonstrates a genuine focus on developing the system for commercial sale Conclusion on subparagraph 360-40(1)(e)(i) The Company is genuinely focussed on developing the system for a commercial purpose. The system will be a significantly improved product compared to existing systems. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 2016 until 30 June 2017 or the date when the system has been fully developed, whichever occurs earliest. Once the system 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. High growth potential - subparagraph 360-40(1)(e)(ii) The Company expects the system to appeal to a wide range of users and businesses. You have stated that your target markets are experiencing significant growth as customers drive to become more efficient. You believe the system will span these markets by offering a comprehensive solution. The Company is developing the system MVP themselves and will pursue product sales through: Targeted direct sales. Reseller/Consultant channels. Online sales through the Company website The Company has a marketing and sales strategy that that sets out the tangible steps that will be taken to capitalise on the growth opportunities in their targeted markets. The following factors indicate that the system has high growth potential: The system is a technology driven cloud-based product. A revenue model that is based on a low annual per-user licencing fee. Pricing matrix, based on discounting of volume and / or multiyear purchases. A multi- layered / multi-channel marketing strategy. Reseller/consultant network. The above factors indicate that the system has the potential to rapidly expand its customer base across the Australian and global professional services market. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) Given that the system will be available globally via distribution through the company website, it is expected that the Company has the potential to successfully scale up its business through this channel and via direct sales. The system business model is based on its ability to lock clients into its product solution for the long-term, ensuring that it has the ability to generate valuable, sustainable and increasing recurring revenue streams as its client base grows. The Company's projections have been provided to us. By using the approach of renewable annual licence sales, The Company states that as it expands its sales, it will be able to generate increased revenue with only a minimal increase in its costs: The Company plans significant up-selling to existing system customers with new products and features released as 'bolt-ons' to a customer's existing product suite. The purchase of additional products will generate further system sales by either: Necessitating the pre-requisite purchase of the system, and/or; Introducing and encouraging the purchase of the system and other additional products. This operating leverage affords the Company the 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 system will be targeted at global markets that service various businesses. As the system is a user subscription product and is web based it can be used by any business with a project driven or human resource (HR) element. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region. The Company has demonstrated the system 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 company has stated that the system is a unique solution to assist businesses in workforce planning. A third party software competitor review you commissioned and a competitor review that you have undertaken have highlighted the key differentiators of the system. The Company's competitive advantages of being first to market will be maintained through a combination of its IP protection, low user licence costs and distribution model as well as the opportunity afforded by being first to market of building and maintaining a large customer base. The Company has demonstrated the potential for the system to have competitive advantages within the HR and Project based community, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test 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 2016 until 30 June 2017 or the date when the system has been fully developed and is ready for sale, whichever occurs earlier. Conclusion The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 2016 until the earlier of 30 June 2017 or the date when the system has been fully developed and is ready for sale, whichever occurs earlier.