Private ruling: Early Stage Innovation Company qualification
Date of advice: 13 June 2019
Published: August 2019
Ruling period: Year ending 30 June 201D
Date scheme commenced: 1 July 201C

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: 1. The company was incorporated in Australia in the 201A income year. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. The company has no subsidiaries. 3. The company has expenses totalling less than $1 million in the 201B, 201C and 201D income years. It derived income of less than $200,000 in the 201C income year. 4. In early 201A, the Managing director and CEO of the company came up with the idea for a product that could fill a gap in the Australian (and global) market. 5. The company commissioned independent research in support of the product. 6. Taking a holistic approach, the company brought a team of like-minded experts together with various skill sets who were prepared to work together to develop the product. 7. There is no product like it that currently exists in the addressable market. 8. The company has identified its ultimate market as being the international market, with its initial target being Australian markets. Commercialisation strategy 9. The company is continuing to develop the product. 10. The company is expecting to commercialise the product in 202E. 11. The company has identified and defined the target market. 12. The company will initially launch the product in the Australian market. Shortly after it will be released in the Country A market. 13. The company will promote its product through the following: · Online sites · Articles published. · contacts 14. A number of strategies will be employed including use of their website, Blogs and testimonials. 15. The revenue from the target market is forecast to rise over the next five years. Information provided 16. You have provided information in a number of documents and phone conversations in relation to the product, including: · your private ruling application · our phone conversation. 17. We have referred to the relevant information within these documents and conversations in applying the relevant tests to your circumstances. 18. You issued new shares in the company to various investors to assist in funding the continued development and commercialisation of the product.

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: The company meets the eligibility requirements of an ESIC under, subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 19. 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': 20. 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): 21. 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). 22. 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. 23. 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): 24. 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): 25. 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): 26. 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: 27. 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 - 'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (v): 28. 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. 29. 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. 30. 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: 31. 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..." 32. 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. 33. 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. 34. 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. 35. 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." 36. 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." 37. 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. 38. '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: 39. 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: 40. 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: 41. 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: 42. 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 43. 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 201D. Current year 44. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 201D (the 201D 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 201B, 201C and 201D, and the income year before the current year will be the year ending 30 June 201C (the 201C income year). | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) 45. The company was incorporated in the 201A income year, which is within the last 6 income years. The company had expenses totalling less than $1 million over the 201B, 201C and 201D income years (inclusive). Subparagraph 360-40(1)(a) (ii) is therefore satisfied. Total expenses - paragraph 360-40(1)(b) 46. As the company 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) 47. As the company's assessable income for the prior income year is less than $200,000 paragraphs 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) 48. As the company is privately owned and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(d) is satisfied. Conclusion on early stage test 49. The company will satisfy the early stage test for the entire 201D income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - Principles based test: Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) 50. The product is unique. 51. Although it will initially be targeted at the Australian market, the product has been identified as having a wider global addressable market. 52. The company will be the first to offer such a product. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) 53. The company has taken the following steps in developing the product: a. Engaging expertise. b. Bringing together a team of like-minded experts with various skill sets to work together to develop the product. c. research and development. 54. This has led to the company developing the product. 55. The company expects testing of the product in the 202E income year. 56. The product is continuing to be developed with further testing being conducted. 57. The company is expecting to commercialise the product in 202E. 58. The company will initially launch the product in the Australian market, followed by the US market. 59. The company will promote its product through the following: d. Facebook e. Articles published. f. contacts 60. A number of strategies will be employed. Conclusion on subparagraph 360-40(1)(e)(i) 61. The company is genuinely focussed on developing the product for a commercial purpose. The product will be new compared to existing products. 62. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 201C until 30 June 201D or the date when the product has been fully developed, whichever occurs earliest. Once the product 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) 63. Through its commercialisation / marketing strategy, the company hopes to foster widespread use of the product. 64. The income being generated will increase with sales. 65. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 66. There is a projected increase in sales. 67. This provides the company with 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) 68. The product will be targeted at the Australian market (but is intended for worldwide use). It will be released globally starting with the Country A market shortly after being released in the Australian market. 69. The ultimate addressable market is on a global scale and is not confined to Australia. 70. The company has demonstrated the product 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) 71. The product has differentiating features which may give it a competitive advantage: 72. Being the first of such product, the company has the first mover advantage. The company has demonstrated the potential for the product to have competitive advantages within the professional business community, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test 73. 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 201C until 30 June 201D or the date when the product has been fully developed and is ready for sale, whichever occurs earlier. Conclusion 74. The company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 201C until the earlier of 30 June 201D or the date when the product has been fully developed and is ready for sale, whichever occurs earlier.

Reasons for decision: All legislative references are to the ITAA 1997 unless otherwise indicated.