Private ruling: Early Stage Innovation Company eligibility.
Date of advice: 31 October 2017
Published: January 2018


Relevant facts and circumstances: Background 1. Company A is a proprietary company, limited by shares, incorporated and registered in the Australian Business Register on DDMMYY 2. The Managing Director of Company A is Z. 3. Company A is the head entity of a group consolidated for tax purposes. 4. Company A is 100% owned by Company B, trustee for Company C, which is owned by Z (75%) and Y (25%). 5. For the financial year ending XX XX 20XX, Company A has incurred and earned the following: a. Total expenses of $xx b. Total income of $yy 6. Company A’s equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country. 7. A provisional application for a patent on the technology being developed by Company B was lodged with IP Australia on XX XX 20XX. Description of Company A’s business premise 8. Company A is a technology business. 9. Company A is developing the ‘system’, a new software and hardware system for a number of clients. 10. The system’s novel platform provides diverse functionality to allow large groups of participants to interact with the system and collaborate with others in a single collaborative experience. 11. Using the system, the facilitator will be able to maintain visibility over engagement, control participation and monitor performance. 12. Commercialisation of the system will take place with the following targets: ● Company A expects to achieve a market penetration of 12% subscriptions in 10% of the market X and 5% of subscriptions in 2% of market y in Year 1 after first sales have been achieved. ● Company A expects to achieve a market penetration of 1% in market z and in the overseas sector, after a full year of commercialisation. ● Market penetration into 10 markets is targeted for the same period. 13. Company A’s system has been identified as having an international addressable market. Information provided 14. You have provided a number of documents containing detailed information in relation to Company A, including: a. Private Binding Ruling (‘PBR’) Application, dated XX XX 20XX. b. Attachment A – arguments and references relating to each element of the Early Stage test and the Principles-based Innovation test in subsection 360-40(1) of the ITAA 1997 . c. Attachment B1 – details of incorporation information used for the Early Stage test d. Attachment B2 – diagram of Group Structure e. Attachment C – details of company financial statements for the 20XX income year f. Attachment D – extracts from the draft Application Form, submitted to company’s Adviser on XX XX 20XX. g. Attachment E – an overview of Company A’s investment opportunity, including details of proposed business/revenue model for commercialisation of the system h. Numerous emails and telephone conversations with X during XX and XX 20XX 15. We have referred to the relevant information within these documents 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

Reasons for decision: Detailed Reasoning - Qualifying Early Stage Innovation Company: 16. 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’: 17. 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): 18. 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). 19. 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. 20. 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): 21. 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): 22. 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): 23. 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: 24. 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: 25. 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): 26. 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. 27. 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. 28. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are: i. the company must be genuinely focussed on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods 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: 29. 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…” 30. 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. 31. Improvements must be significant in nature to meet this requirement. Significant is defined in the online Macquarie Dictionary as “ important; of consequence .” 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. 32. 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.” 33. The company must be genuinely focussed 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. 34. For a company to qualify as an ESIC under the principles based test, the company must be “genuinely focussed on developing for commercialisation” their innovation. That is, the central activities of the company must be truly concentrated on developing their innovation for a commercial purpose. ‘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: 35. The company must be able to demonstrate that the business relating to the innovation has a high growth potential 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: 36. The company must be able to demonstrate that it has the potential to successfully scale up the business relating to the innovation. 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. | Detailed Reasoning - Broader than local market: 37. 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: 38. 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 - TEST TIME: 39. 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 XX XX 20XX, but before YY YY 20YY. | Detailed Reasoning - Current year: 40. Therefore, for the purposes of subsection 360-40(1) ITAA 1997 , the current year will be the year ending YY YY 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending YY YY 20YY, 20XX and 20ZZ, and the income year before the current year will be the year ending XX XX 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration – paragraph 360-40(1)(a) ITAA 1997: 41. Company A was incorporated on XX XX 20XX, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) are satisfied. | Detailed Reasoning - Total expenses – paragraph 360-40(1)(b) ITAA 1997: 42. In applying the requirements of paragraph 360-40(1)(b), Company A and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20XX income year, being the income year before the current year. 43. Company A incurred expenses of $xx in the 20ZZ income year. Consequently, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income – paragraph 360-40(1)(c) ITAA 1997: 44. In applying the requirements of paragraph 360-40(1)(c), Company A and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the income year before the current year. 45. Company A earned $yy assessable income in the 20ZZ income year. Consequently, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No Stock Exchange listing – paragraph 360-40(1)(d) ITAA 1997: 46. In applying the requirements of paragraph 360-40(1)(d), Company A must not be listed on any Stock Exchange in Australia or a foreign country at the test time. 47. Company A was not listed on any Stock Exchange in Australia or a foreign country at any of the test times, so paragraph 360-40(1)(d) is satisfied. | Detailed Reasoning - CONCLUSION FOR EARLY STAGE TEST: 48. Company A satisfies 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 - THE ‘100 POINT TEST’ – paragraph 360-40(1)(e) and section 360-45: 49. Company A has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending YY YY 20YY. For Company A to be a qualifying ESIC, it will need to satisfy the principles-based test. | Detailed Reasoning - Developing new or significantly improved innovations for commercialisation – subparagraph 360-40(1)(e)(i) ITAA 1997: 50. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be developing an innovation which is either new or significantly improved for an applicable addressable market. 51. Company A is currently developing a product. 52. According to Company A, the product is a platform which will allow multiple users to interact and collaborate with other users in real time. 53. Company A’s product will be the first to offer such a product in this environment. 54. An instructor will be able to maintain visibility over user engagement, control user participation and monitor their performance. 55. There is no other competitor in the Australian market, nor any observable international competitor, offering a system directly comparable to Company A’s product. 56. Such a product offering does not currently exist on the market in Australia or worldwide, so Company A is developing a product which is new, and is identified as having an international addressable market. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997 57. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company. 58. Company A’s product development commenced in ZZ 20ZZ, with initial concepts followed by a x-y month period of research and investigation of existing technologies and their associated limitations, market offerings, and the proposed architectural approach theorised to underpin design. 59. In early 20ZZ, the concept was outlined (using a mock-up) to both Company M and Company N, with a small financial contribution obtained from Company N to assist with the cost of further exploratory work. 60. Once a functional requirement was appropriately defined, a full-time developer was engaged in XX 20XX and tasked with producing detailed designs and the first prototype as a technical proof of concept. 61. A period of x months of research and design development followed to late XX 20XX. In parallel, the company sought to protect its emerging intellectual property (IP) rights via preparation and lodgement of an Innovation Patent in XX 20XX. 62. Components of the solution were first tested internally in code in ZZ 20ZZ, when a method of optimising the product and related protocols was theorised and confirmed through experimentation. 63. Further research and development (R&D) was then undertaken to further optimise performance of the product. 64. The first working prototype of a product was completed in XX 20XX, and is now to be used as the basis for the pilot implementation. 65. The first phase of research & development (R&D) of the product is complete with a working prototype now able to be demonstrated. Company A will use this ‘alpha’ version in a commercial pilot implementation. 66. The pilot, and subsequent early-stage commercialisation of the product in the Australian market is the subject of the company’s grant application currently under consideration. 67. The purpose of the commercial pilot process is to test: a. Stability b. Usability c. Functionality d. Which functions are most useful e. Popularity and suitability 68. Further development of the product to produce a final production version (Version 1.0) is required in parallel and following completion of the pilot, and throughout the remainder of the 20ZZ income year as available funds permit. 69. In addition to bug fixing of the existing product which is ongoing, there are a number of further developments. 70. On completion of these developments, together with positive outcomes from commercial pilots and other early-stage sales, Company A believe that the first full production-ready version of the product will be complete. 71. The product will be a new product compared to any system currently used in the Australian or worldwide market. Company A is genuinely focussed on developing the product, for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period ZZ ZZ 20ZZ to XX XX 20XX, or the date when the product has been fully developed, whichever occurs earliest. Once the product 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. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 72. In applying the requirements of subparagraph 360-40(1)(e)(ii), Company A must be able to demonstrate that it has the potential for high growth within a broad addressable market. 73. Company A is well geared to expand its reach immediately with funding in place to acquire new talent and execute further marketing as required. In addition, Company A’s product development team is constantly innovating and developing additional new technologies that provide further growth potential for the company. 74. Company A has a strategy that sets out the tangible steps that will be taken, or have been taken, to capitalise on the growth opportunities in the Australian market. 75. Company A has demonstrated a high growth potential for the product, so subparagraph 360-40(1)(e)(ii) is satisfied. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 76. In applying the requirements of subparagraph 360-40(1)(e)(iii), Company A must be able to demonstrate that it has the potential to successfully scale up the business. 77. Company A is the only company presenting a holistic solution which is both scalable and updatable. 78. Total revenue is projected to increase from approximately $xx million in 20ZZ to $yy million in 20VV, increasing between x% and y% each year. Total costs will increase at a lower rate, from $xx to $yy million in the same period, increasing between x% and y% each year. 79. This operating leverage means that existing revenues can be multiplied while incurring a reduced, or minimal, increase in operating costs. 80. Operating leverage can be seen to be sufficient to ensure Company A has the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 81. In applying the requirements of subparagraph 360-40(1)(e)(iv), Company A must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets. 82. The product which Company A is developing, is being designed to be used as both a national and global product. 83. Company A’s overseas markets can be targeted immediately due to their similarity to the Australian market, high growth rates and the fact that Company A already has a presence in Country H from which to base further business development activities. 84. Company A has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: 85. In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must demonstrate that it has potential to be able to have competitive advantage for that business. 86. Company A has no direct competitors in the current Australian market and therefore has first mover status which is a considerable competitive advantage in the market. 87. The value proposition of Company A’s product over all of its competitors is that it is a product that solves many issues. 88. Company A is also currently recruiting personnel and building upon already strong business relationships with both Company X & Company Y, which also provides a significant intangible asset to the company, and make it very difficult for a follower to quickly and easily enter the market with the same scale. 89. While there are competitors generally, Company A remains the only vendor to offer these capabilities. Intellectual property underpinning the system is subject to an Innovation Patent Pending, and could not be easily replicated without a similar extensive investment in experimental R&D as has been made by Company A. 90. Company A is currently in negotiations with investors and intends to raise capital which in partnership with Company X and Company Y will support an extensive product demonstration, sales and marketing campaign within Australia. This is intended to quickly create a committed customer base from which to defend against any potential new entrants. 91. Company A has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied. | Detailed Reasoning - CONCLUSION FOR PRINCIPLES BASED TEST: Company A satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing XX XX 20XX until YY YY 20YY, or the date when the product has been fully developed, whichever occurs earliest. | Detailed Reasoning - CONCLUSION: Company A meets the eligibility criteria of an ESIC under section 360-40 for the period commencing XX XX 20XX until YY YY 20YY, or the date when the product has been fully developed, whichever occurs earliest.

REASONS FOR DECISION: All legislative references are to the Income Tax Assessment Act 1997 ( ITAA 1997 ) unless otherwise stated.