Private ruling: Early stage innovation company
Date of advice: 6 November 2020
Published: January 2021
Ruling period: 1 July 20XX to 30 June 20XX
Date scheme commenced: 1 July 20XX

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 during the financial year ended 30 June 20XX. Its equity interests are not listed for quotation on the official list of any stock exchange. The Company has no subsidiaries. The Company had expenses of $XXX or less in the previous income year (20XX year) and earned no income in the previous income year. The Company identified that within a federal government department (FGD) there is no solution which provides the comprehensive ability to plan, brief, execute, capture data, analyse and report on both training and operational activities. To fill this gap and to assist with the training and operational activities the Company is developing the XX - an enterprise level software for the FGD. XX will give the FGD the ability to gather and deploy information to support agile decision making. XX enhances decision making by delivering real time situational awareness to leaders of the FGD. XX will deliver a medical capability that is not yet available in the FDG. The software will: capture and analyse data, identify trends and highlight medical risks. A prototype of XX has been constructed to demonstrate the planning, briefing, activity conduct and data capture capability. The prototype also demonstrates the reporting capability of the product. In addition, XX will mobilise data to provide key insights on things such as: operational activities, personnel experience, qualification data, competencies and frequency of training. It is expected that use of the software will result in: extensive monetary savings, improved efficiency, time savings, reallocation of funds; and better safety. XX will use a Software-as-a-Service (SAAS) model. Initially, the system will require significant human input during the development stages, however once the baseline solution is complete, the amount of human interaction required will reduce to the level needed to provide support and updates to the product. Many thousands of people in Australia can potentially use XX. The Company will consider adapting XX to the FGD and other organisations worldwide starting with the USA, Canada, UK and NZ. If successful, it could potentially service over XXXX people. XX is protected by a provisional patent and a full patent is in the process of being lodged. The Company has secured a software trial with the FGD which will take place in 20XX. Before this trial, the Company has identified that it will need to complete a full-scale development of the XX solution which should take two to three months. Once the trial is complete, XX will expand to include additional applications. A state government department has requested a demonstration of XX. The Company plans to invite representatives from both domestic and international agencies to a demonstration of XX. It is likely that further trials will occur subsequent to this demonstration. The Company has consolidated its list of key suppliers and has worked closely with Microsoft to deliver a secure environment for the trial. The Company is taking part in a university program to assist with the commercialisation of early innovation ideas. The Company is developing the XX by itself. Its revenue will be made by charging fees for use of the software provided to the FGD and other organisations. The cost of the XX will be $xx per month per user. Clients will gain access to the XX portal, including its data model, workflow tool and complete reporting capability. Each additional application will be licensed at $x per month per user. As part of the XX, the Company will provide hardware, advanced sensor technology to integrate with the software, IT support services, ongoing system updates and training during the implementation and roll out phases for each client. The Company's addressable market is any organisation that would benefit from a comprehensive planning and reporting tool, to better manage their workforce and to assist in better decision making. The Company proposes to issue new shares to various investors to assist in funding the continued development and commercialisation of the XX.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-40 | Income Tax Assessment Act 1997 subsection 360-40(1) | Income Tax Assessment Act 1997 paragraph 360-40(1)(a) | Income Tax Assessment Act 1997 paragraph 360-40(1)(b) | Income Tax Assessment Act 1997 paragraph 360-40(1)(c) | Income Tax Assessment Act 1997 paragraph 360-40(1)(d) | Income Tax Assessment Act 1997 paragraph 360-40(1)(e) | Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(i) | Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(ii) | Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(iii) | Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(iv) | Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(v) | Income Tax Assessment Act 1997 section 360-45

Reasons for decision: Summary: The Company is an Early Stage Innovation Company (ESIC) for the year ending 30 June 20XX, having met the eligibility requirements under subsection 360-40(1). | Detailed Reasoning - Detailed reasoning: Subsection 360-40(1) outlines the criteria for a company to qualify as an ESIC at a particular time in an income year. The criteria are based on a series of tests to identify if the company is at an early stage of its development and is developing new or significantly improved innovations to generate an economic return. A company qualifies as an ESIC if it satisfies the early stage test and one of two 'innovation' tests which are the 100-point innovation test or the principles-based innovation test. | Detailed Reasoning - 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. | Detailed Reasoning - Current year: For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX. For clarity, for the 20XX income year, the last three income years will include the years ending 30 June 20XX, 20XX and 20XX, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a): The early stage test requirements are specified in paragraphs 360-40(1)(a) to (d) and are outlined below. 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: • 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 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, it must also satisfy one of two innovation tests being: 1. The objective (100 point) test; or 2. The principles based test. The Company has stated that it seeks this Ruling in relation to the principles based test. | Detailed Reasoning - 'Principles based test' - paragraph 360-40(1)(e): To satisfy the principles based test, the company must meet the 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 in subparagraphs 360-40(1)(e)(i) to (v) 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. The five requirements in paragraph 360-40(1)(e) are outlined below. | Detailed Reasoning - (i) 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 identified by making a realistic and objective assessment of the company's intended market for its innovation. It includes identification of the immediately accessible market to which the innovation will initially be introduced, or a new market which may be created by the innovation. Factors in identifying the addressable market may include the location of the company's potential customers, the type of industry to be served and the geographical area it will serve. The addressable market must be objective and realistic. A 'new' innovation means novel or introduced to the addressable market for the first time. It must be compared to the products, services, processes or methods that may or may not exist in the intended market for the innovation. 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, changes to pricing strategies or changes to goods resulting from seasonal change are examples of improvements that would not be considered significant. The OECD Oslo Manual (paragraphs 124 and 151) 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. The company must be genuinely focused on developing the 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. This requirement draws the distinction between simply having an idea and commercialising an idea. The EM does not define the meaning of the term 'genuinely focussed' within the context of subparagraph 360-40(1)(e)(i). 'Genuine' is defined in the online Macquarie Dictionary as "Being truly such; real; authentic." 'Focus' is defined as "3. a central point, as of attraction, attention, or activity. ... 8. to concentrate; to focus one's attention." In essence, the phrase 'genuinely focussed' is looking to what the company is truly concentrating and focussing their attention on or, put another way, what is the real central point of the company's activities. That is, the central activities of the company must be truly concentrated on developing their innovation for a commercial purpose. Developing an innovation for commercialisation in relation to a new innovation refers to the process of creating that innovation, and it includes a range of activities such as proof of concept activities, market research, prototyping, pilots and user testing, and other activities to prepare for the launch of the new innovation. | Detailed Reasoning - (ii) 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 - (iii) 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. | Detailed Reasoning - (iv) 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 - (v) 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 - 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. | Detailed Reasoning - Current year: For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2021 (the 2021 income year). For clarity, in relation to particular requirements within subsection 360-40(1), for the 20XX income year the last three years will include the years ending 30 June 20XX, 20XX and 20XX. The income year before the current year will be the year ending 30 June 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a): The Company was incorporated within the last three income years, therefore paragraph 360-40(1)(a) is satisfied. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b): The Company was incorporated in the 2019 income year and does not have any subsidiaries. The Company incurred expenses of less than $1 million ($4,728) in the prior income year (i.e. the 20XX income year). Paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c): The Company was incorporated in the 20XX income year and had assessable income of less than $XXX ($0) in the prior income year (i.e. the 20XX income year). It has no subsidiaries. Paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No stock exchange listing - paragraph 360-40(1)(d): The Company is a privately owned company and is not listed on any stock exchange in Australia or in a foreign country, therefore paragraph 360-40(1)(d) is satisfied. | Detailed Reasoning - Conclusion on early stage test: The Company satisfies the early stage test for the 20XX income year as each of the requirements in paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100-point test: The Company has not provided evidence of satisfying the 100-point test under section 360-45 for the year ending 30 June 20XX. For it to be a qualifying ESIC, it will therefore need to satisfy the principles based test. | Detailed Reasoning - Principles based test: To satisfy the principles-based test, the Company must meet the five requirements in paragraph 360-40(1)(e). Each of these is discussed below. | Detailed Reasoning - Genuinely focussed on developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i): Through research, the Company found that the FGD was aware of the information gaps and that there was little capacity to develop a solution for the issue. The Company's founders have an intimate knowledge of these issues and used this knowledge, together with interview responses to build a working prototype which included a comprehensive reporting tool. As a result of its prototype of XX, the Company has secured a software trial with the FGD which will take place in 20XX. The prototype has been constructed to demonstrate the planning, briefing, activity conduct and data capture capability. A state government department has requested a demonstration of XX. The Company plans to invite representatives from both domestic and international agencies to a demonstration of XX. It is likely further trials will occur subsequent to this demonstration. The Company has consolidated its list of key suppliers and has worked closely with Microsoft to deliver a secure environment for the trial. The Company is taking part in a university program designed specifically to assist with the commercialisation of early innovative ideas. Conclusion on subparagraph 360-40(1)(e)(i) The Company is genuinely focussed on developing the XX for a commercial purpose. The XX will be a new or a significantly improved innovation. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii): There are many thousands of people in Australia who could potentially use XX. XX could also be adapted to other organisations within Australia. The Company could consider adapting XX to other organisations worldwide starting with USA, Canada, UK and NZ. This could mean that over X million people could be using XX. XX could be used to provide engineering, construction and mining companies with a comprehensive tool to plan and undertake activities, conduct risk assessments and report on previously inaccessible data. The Company has been able to demonstrate that it has potential for high growth within a broad addressable market. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii): The business model provided by the Company illustrates the anticipated demand for XX. XX will use a Software-as-a-Service (SAAS) model. Initially, the system will require significant human input during the development stages, however once the baseline solution is complete, the amount of human interaction required will reduce to only the level needed to provide support and updates to the product. Due to security requirements, all hosting for the FGD will be undertaken on FGD networks and therefore XX will not incur the burden of cost for hosting activities. The Company's strategy for the use of XX will be able to generate increased revenue through targeted sales. The Company plans to invite representatives from both domestic and international organisations to a demonstration of XX. It is likely further trials will occur subsequent to this demonstration. Also once XX's underlying structure is finalised it will operate with reduced manual input (adjusting the rules for each client) thus increasing its commercial viability. This operating leverage affords the Company the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. | Detailed Reasoning - Broader than local market: The Company's addressable market is any organisation which will benefit from a comprehensive planning and reporting tool, to better manage their workforce and to assist in better decision making. The Company will direct its immediate focus onto the FGD and other organisations. Once the Company has established itself as the only solution in this space, it will commit resources to securing customers in the engineering, mining and construction sectors. The Company plans to initiate conversations with other domestic customers concurrent to the trial. They also believe there is an immediate opportunity to move into foreign markets within the next twelve to twenty-four months. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region. The Company has many activities planned to help grow the take up of XX. The Company has demonstrated that XX 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) XX's unique concept and design means that it has no directly comparable competitors. The Company has identified key points of differentiation for XX which include: • End to end tool for planning, risk assessments, briefing, activity conduct, data capture, trend analysis and reporting • Online/offline syncing capability optimised for remote operating environments • Road-map with capability to assist with high level mission planning and assessment of human performance in high stress environments • Intimate knowledge of the pain points and how to address them • Likely long-term Commonwealth contract will be a barrier for other vendors • Existing understanding and relationship with the client. Like most software, XX is able to be imitated, however with a much higher level of complexity than usual software products. The processes which are streamlined by XX are unique and therefore would not be common knowledge to the general public. XX is a proprietary software with provisional patent protection. These provisional patents will transition to standard or innovation patents at the end of the provisional period. The Company has demonstrated the potential for Buddy Suite to have competitive advantages, satisfying subparagraph 360-40(1)(e)(v). | Detailed Reasoning - 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 20XX until 30 June 20XX. | Detailed Reasoning - Conclusion: The Company meets the eligibility criteria of an ESIC under section 360-40(1) for the period commencing 1 July 20XX until 30 June 20XX.