Private ruling: Early Stage Innovation Company
Date of advice: 17 August 2017
Published: December 2017
Ruling period: Year ending 30 June 201E
Date scheme commenced: 1 July 201D

Ruling: Q1: Does Company meet the criteria of an 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 Early 201A. Its equity interests are not listed for quotation in the official list of any stock exchange. ● The company has no subsidiaries and has expenses of less than $1 million across the previous three income years, i.e. from 1 July 201B to 30 June 201E. ● The company’s assessable income in the 201D income year is less than $200,000. ● The company is developing innovative financial product that allow for capital investments across various sectors of the Australian agriculture industry. ● The company’s business model is to target businesses with high quality management and operations, particularly those that require investments to maximise production and operations but lack of opportunities. ● The company is developing a number of prototypes of the innovative product and is in the process of trialling one of the prototypes. ● The company is currently looking to raise early capital investment to continue to fully develop the new product. Market position ● The company is claiming to have an early mover advantage in developing the innovation. Current market dynamics have created an ideal opportunity for the company to bring this innovation to the Australian market. Commercialisation strategy ● The company is currently looking to raise early capital investment to continue to fully develop and commercialise the innovation. ● The company have identified key distribution channels through which the company will establish channel partners with operators that will have the innovation as part of their product offerings. ● The company has access to industry networks and potential deal flow that will put in a position to deploy capital efficiently and strategically without any major marketing initiatives. ● Net cash flow generated will initially be reinvested with future growth to be funded organically and/or through additional capital raisings. As part of its funding strategy the company will also look to apply for a listing of its securities in the future.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-40

Reasons for decision: Detailed Reasoning - Qualifying Early Stage Innovation Company: 1. 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’: 2. 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): 3. 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). 4. 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. 5. 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): 6. 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): 7. 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): 8. 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: 9. 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 (iv): 10. 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. 11. 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. 12. 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: 13. 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…” 14. 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. 15. 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. 16. 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. 17. 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.” 18. 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.” 19. 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. 20. '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: 21. 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: 22. 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: 23. 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: 24. 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 25. 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 201E. Current year 26. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 201E (the 201E 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 201E, 201D and 201C, and the income year before the current year will be the year ending 30 June 201D (the 201D income year). | Detailed Reasoning - Early stage test: Incorporation or Registration – paragraph 360-40(1)(a) 27. As the company was incorporated on 3 February 2014, which is within the last 6 income years and across the last 3 of those income years it had incurred total expenses of less than $1 million. Therefore, subparagraph 360-40(1)(a)(ii) is satisfied. Total expenses – paragraph 360-40(1)(b) 28. As the company’s total expenses in the prior year is also less than $1 million, paragraph 360-40(1)(b) is satisfied. Assessable income – paragraph 360-40(1)(c) 29. As the company’s 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) 30. 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 31. The company will satisfy the early stage test for the entire 201E 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) 32. The company is an early mover in developing an innovative financial product that allow for capital investments across various sectors of the Australian agriculture industry. 33. The company’s innovation has its origin in an industry which has been redesigned and adapted for application in the Australian agricultural business. 34. Through the innovation, the company offering Australian businesses an innovative option to capitalised their operation and build growth without relying on traditional products. 35. The company’s innovation, once fully developed has the potential to significantly impact the Australian agricultural market. The innovation presents a number of opportunities and advantages to investors as well as the business operators. 36. In Australia, the company has plans to expand the application of the innovation across a wide range of sectors in the agriculture industry as its business continues to grow in the future. 37. The company had spent the last 12 months testing the innovation to ensure it is suitable to be applied in Australian agricultural market. Genuinely focussed on developing for commercialisation – subparagraph 360-40(1)(e)(i) 38. The company has taken the following steps in developing the innovation: ● Researching global markets and demand for in the goods and services of the relevant industry. ● Researching of other similar products currently and traditionally available to the industry operators. ● Researching the use of the innovation in the industry as well as other industries around the world. ● Researching of market conditions and opportunities and determine an ideal timing to introduce the innovation to the Australian market. ● Developing the Australian model and prototype that incorporate the risks and drivers specific to the Australian industry and which support the company’s business model as well as meeting the funding need businesses. ● Developed and executed the first prototype from which the company is generating significant and valuable learnings that are used to improve the innovation for commercialisation. ● Developing further prototypes that can be applied across other sectors in the industry. ● Working on gaining access to industry networks contacts and developing strategic partnership to position the company to efficiently undertake commercialisation of its product. 39. The company’s business model is to target businesses with high quality management and operations, particularly those that require investments to maximise production and operations but lack of opportunities. 40. Through the company’s network, there is a list of quality, high performing as well as award winning businesses, some of whom would be excellent advocates for the company’s innovation. 41. According to the company, there is a current initial uptake of the innovation that is potentially worth $20 million without any major marketing initiatives. 42. With the first prototype now in place, the company is seeking to raise early capital investment to continue fully developing the innovation as well as funding additional prototypes for other products across other sector in the industry. Conclusion on subparagraph 360-40(1)(e)(i) 43. The company is genuinely focussed on developing the innovation for a commercial purpose. The innovation is considered to be a new for in the Australian market. Following the successful implementation of the prototypes to trial the innovation, it is considered that the company has fully developed the innovation for the Australian market. 44. Subparagraph 360-40(1)(e)(i) will therefore be satisfied for the time period from 1 July 201D until 30 June 201E or the date when the innovation has been fully developed, whichever occurs earliest. Once innovation has been fully developed, the company will no longer be considered '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) 45. The company shows its high growth potential through the disruptive advantages of the innovation over traditional products currently available in the market and by positioning itself to play a role in the Australian market. 46. According to the company, there are approximately 140,000 operators in the target industry in Australia, including around 30,000 in the initial prototype target group. 47. Through its commercialisation strategy, the company hopes to foster widespread use of innovation through its distribution channel partners (insurance companies, accountants and financial advisers and industry specialists). By aligning with partners of natural fit, the company benefits will include increasing growth potential and profitability. 48. If the commercialisation strategy is successful, this may give the company the ability to increase business through channel partner referrals and industry network. 49. The innovation being developed has demonstrated the potential to generate high growth for the company. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability – subparagraph 360-40(1)(e)(iii) 50. Based on financial modelling, the ability of the company to scale up the business is underpin by the amount of initial capital investment it can successfully to deploy additional prototypes and developed the innovation to be ready for commercialisation. 51. The innovation that the company is developing is flexible and can be applied across a range of industry sectors. Once proven, the company will be able to scale up the innovation to other sectors and build a business that delivers highly reliable and well diversified revenue streams with minimal cost increase. According to the company, over time as the business grows in scale and market share, ongoing corporate costs are expected to reduce. The company will be able to spread the cost over a wider operating base to maintain a positive cash flow position, allowing it to organically grow by reinvesting earnings into new business opportunities. 52. The company’s business strategy also provides for opportunities to scale up the business through other avenues. For example, through supply chain participation the company has the ability to take advantage of short-term price volatility and demand drivers thereby generating more value without having to own capital intensive infrastructure or supply chain infrastructure. 53. These operating leverages afford 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) 54. The innovation has recently been successfully applied in X through another company. 55. Having been originally developed in other industries followed by its application in agriculture, the innovation has shown a potential for application in other industries in Australia as well as globally in markets where similar products has not been developed. Thus, the ultimate addressable market is on a global scale and is not strictly confined to the Australian market solely. 56. The company has demonstrated that the innovation 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) 57. The company is claiming to have an early mover advantage in bringing the innovation to the Australian industry as an alternative and proven product. The innovative product that the company is developing is flexible and can be applied across a range of industry sector. It also has the following differentiating features which may give it a competitive advantage: ● It has built in mechanism that will provide extra cash flow to cover ongoing costs faced by the business owner during product implementation. ● The business owner has the opportunity to share in any value added through price & margin upsides as well as the opportunity to participate in all sections of the supply chain where more value are created from the goods and services through vertical integration. ● For the company, the innovative product locks in a pre-determined price for the goods and services which will allow the company to generate high value and returns where market prices are higher. ● For the company’s investor, there is no requirement to pay for operating and capital expenditure overruns that would usually come with direct investments in the business. The investors are therefore, able to obtain direct exposure to a particular market without all of the risks and costs of owning and operating capital-intensive infrastructure. 58. The company is well supported by a team of executives with significant experience and access to the right network, influential industry operators and other affiliates which can be leveraged without large scale marketing. 59. Being the first company to develop the innovation in Australia, the company has demonstrated the potential for innovative product to have competitive advantages within the Australian market, thereby satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test 60. 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 201D until 30 June 201E or the date when the innovation has been fully developed, whichever occurs earliest. Conclusion The company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 201D until 30 June 201E or the date when the innovation has been fully developed, whichever occurs earliest.