Private ruling: Early stage innovation company qualification
Date of advice: 21 September 2022
Published: December 2022
Ruling period: Year ending 30 June 20SS

Ruling: Q1: Does Company A satisfy conditions to be an early stage innovation company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 ? | A1: Yes

Relevant facts and circumstances: Company A was incorporated in Australia in 20WW. It was also registered in the Australian Business Register in that year. 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. Company A has no subsidiaries. In respect of the income year ended 30 June 20WW, Company A derived no income and incurred expenses of $X. In respect of the income year ended 30 June 20XX, Company A derived no income and incurred expenses of $X. In respect of the income year ended 30 June 20YY, Company A recorded no assessable income and incurred expenses of $X. In respect of the income year ended 30 June 20ZZ (i.e. the income year previous to the current income year), Company A recorded assessable income of $X and incurred expenses of $X. The Product is a new online platform created by Company A targeted at prospective property downsizers. Company A plans to raise capital via the issue of ordinary shares in the year ended 30 June 20SS. Company A's initial target market is Australia, before expanding overseas in specific markets that have particular common characteristics with Australia, including large, growing populations over 55. Company A has identified that three key innovations are required in respect of its platform. These involve process innovation, product innovation and technology innovation. Company A has established that the Product is unique and novel and there is no comparable offering in the marketplace, Company A has taken steps to commercialise the platform and has provided its commercialisation strategy and timeline. Company A sees a huge market that is ripe for their offering. Company A's initial business model is based on four key revenue streams.

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 subparagraph 360-40(1)(a)(ii) | 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 paragraph 360-40(1)(f) | Corporations Act 2001 section 9

Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated. Company A meets the eligibility requirements of an ESIC under subsection 360-40(1). | Detailed Reasoning - Qualifying ESIC: Subsection 360-40(1) outlines the criteria for a company to qualify as an 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 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: 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 (if any) 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 (if any) must have derived total assessable income of $200,000 or less in the income year before the current year. | Detailed Reasoning - 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 - Principles-based test - subparagraphs 360-40(1)(e)(i) to (v): 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: | 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 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 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. '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, whereby it increases its market share or enters into new markets, and 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 - Foreign company test - paragraph 360-40(1)(f): To meet the requirement at paragraph 360-40(1)(f), the company must not be a foreign company within the meaning of the Corporations Act 2001 at the test time . The dictionary in section 9 of the Corporations Act 2001 defines a foreign company to mean: (a) a body corporate that is incorporated in an external Territory, or outside Australia and the external Territories, and is not: (i) a corporation sole; or (ii) an exempt public authority; or (b) an unincorporated body that: (i) is formed in an external Territory or outside Australia and the external Territories; and (ii) under the law of its place of formation, may sue or be sued, or may hold property in the name of its secretary or of an officer of the body duly appointed for that purpose; and (iii) does not have its head office or principal place of business in Australia. | Detailed Reasoning - Application to your circumstances: Test time For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be upon the issue of qualifying shares on a particular date or dates during the income year ending 30 June 20SS (the 20SS income year). Company A plans to raise capital by issue of ordinary shares during the 20SS income year. Current year For the purposes of subsection 360-40(1), the current year will be the 20SS income year. | Detailed Reasoning - Early stage test: Incorporation or registration - paragraph 360-40(1)(a) Company A was incorporated in 20WW, within the last six income years, and therefore subparagraph 360-40(1)(a)(ii) will be satisfied if the total expenses Company A incurred across the previous three income years before the current year is $1 million or less. As Company A incurred total expenses of $X across the previous three income years (20XX, 20YY, 20ZZ) before the current year (20SS), subparagraph 360-40(1)(a)(ii) is satisfied. Total expenses - paragraph 360-40(1)(b) As Company A incurred expenses of $X (and therefore less than $1 million) in the prior income year (20ZZ), paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) As Company A had total assessable income of $X (and therefore less than $200,000) in the prior income year (20ZZ), paragraph 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) As Company A's equity interests are not listed on any stock exchange in Australia or a foreign country, paragraph 360-40(1)(d) is satisfied. Conclusion on early stage test For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be upon the issue of qualifying shares on a particular date or dates during the 20SS income year. Therefore, upon any issue of shares during the 20SS income year, Company A will satisfy the early-stage test for the entire 20SS 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) According to Company A, the Product will be the first of its kind available in its selected market and will include 3 key innovations. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) Company A is genuinely focussed on developing the Product for commercialisation. Commercialisation has been initially based on a business-to-business model, where Company A will seek to gain revenue from various income streams. The steps Company A has undertaken to commercialise the platform in accordance with its commercialisation strategy have been provided. Conclusion on subparagraph 360-40(1)(e)(i) Company A is genuinely focussed on developing its platform for a commercial purpose. The Product will be an innovative online platform for the property sector compared to the existing online platforms. Therefore subparagraph 360-40(1)(e)(i) will be satisfied from the period beginning 1 July 20ZZ until 30 June 20SS or until such date as the platform has been fully developed, if that occurs before 30 June 20SS. Once the platform 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. High growth potential - subparagraph 360-40(1)(e)(ii) Company A believes that the platform will have high growth potential. The market is considered ripe for Company A's offering and the business plan shows an intended roll-out across the nation by January 20SS. There is also scope to take the platform to overseas markets that share common factors. Therefore, subparagraph 360-40(1)(e)(ii) is satisfied. Scalability - subparagraph 360-40(1)(e)(iii) Company A submits that its business model is based on four key revenue streams which is forecast to scale up quickly with circa 100% turnover growth year on year. This growth is supported by transitioning rapidly from the original 'minimum viable product' phase to the second phase and then to the third phase. Company A anticipates that: Therefore, subparagraph 360-40(1)(e)(iii) is satisfied. Broader than local market - subparagraph 360-40(1)(e)(iv) The Product will initially be targeted at the Australian market but is intended for worldwide use. Company A has demonstrated that the platform has the potential to address a broader market than just the local market, including international markets. Therefore, subparagraph 360-40(1)(e)(iv) is satisfied. Competitive advantages - subparagraph 360-40(1)(e)(v) The Product has demonstrated the potential for the platform to have competitive advantages within the 'addressable market', thus satisfying subparagraph 360-40(1)(e)(v). Conclusion for the principles-based test The Product satisfies the principles-based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the 20SS income year, unless the platform is fully developed before 30 June 20SS in which case Company A only satisfies the principles-based test from 1 July 20ZZ to the date the platform is fully developed. | Detailed Reasoning - Foreign company test: As Company A was incorporated in Australia, it is not a foreign company and paragraph 360-40(1)(f) is satisfied. | Detailed Reasoning - Conclusion: Company A meets the eligibility criteria of an ESIC under section 360-40 for the period 1 July 20ZZ to 30 June 20SS, unless the platform is fully developed before 30 June 20SS in which case Company A only satisfies the criteria of an ESIC from 1 July 20ZZ to the date the platform is fully developed.

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 before the current year the company and its 100% subsidiaries (if any) 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 income year). | 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 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. | as the offering grows and more parties become involved and gain comfort over the operating model, the potential scale up to new markets is high; | being a digital platform there is clear economies of scale for growing market share and expanding the offering over time; and | the proposed expansion to overseas markets also will allow Company A to scale its revenue.