Private ruling: Early stage innovation company - principles-based test
Date of advice: 23 March 2021
Published: June 2021
Ruling period: Date in income year to 30 June 20XX | 1 July 20XX to a date in the income year
Date scheme commenced: Date 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 on XX. Its equity interests are not listed for quotation in the official list of any stock exchange. The Company has a single director who is also the founder. The founder's personal interests lead the founder to develop the Innovation. For the income year ending 30 June 20XX the Company had no subsidiaries and as it was incorporated in the same income year it had no expenses and no assessable income in the previous income year. For the income year ending 30 June 20XX the Company had no subsidiaries and had expenses of less than $1 million in the previous income year, i.e. the year ended 20 June 20XX. Its assessable income in the year ending 30 June 20XX was less than $200,000. The Company's goal is to provide the Innovation. The Company has identified its ultimate market as being the global market, with its initial target being Australian markets. The Company's Innovation makes the Innovation accessible to the everyday user. The Innovation effectively introduces the Innovation to retail customers who previously did not have access to this form of technology due to the resources required and the significant costs associated. To undertake the development of the Innovation, the Company sought initial funds by way of convertible notes. The convertible notes were converted into ordinary shares during the ruling period. The Company owns all intellectual property related to internal and contracted development of the Innovation. The Company has received legal advice to ensure external development of Intellectual Property (IP) has been appropriately assigned to the Company. Further, all employees, as part of their employment, sign the appropriate documentation assigning IP to the Company during and after their employment with the Company. When the Innovation was in the development and testing phase of the product life-cycle, a number of early adopters were using and trialling the Innovation. This phase ceased on XX 20XX when the full Innovation Product was launched. For completeness, the Company provided a timeline of the Innovation's development. The Company has provided information on the key differentiators in their Innovation to products that were already available in the market. The Company has identified its addressable market to include global markets. Commercialisation strategy The Company's commercialisation strategy starts from the development stage where the company completed a trialling phase with users testing the Innovation for their own purposes and providing feedback to the Company. The next steps involved the Innovation being developed for integration with a professional market The Company has engaged with various professionals, who have expressed their interest in the Innovation. The Company is initially targeting the Australian markets. In the short-term Australian users have been identified as the initial addressable market for the Innovation. The Company intends on releasing its Innovation to international users over the next 2 years, as these markets are significantly larger than the Australian market. The long-term addressable markets are global and not confined to a local city, area or region.

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: 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': 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): 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: ii. incorporated in Australia within the last 6 income years (the latest being the current year), and across the last 3 of those income years before the current year it and its *100% subsidiaries (if any) 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). 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, 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): 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: 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: 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..." [1] 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. [2] 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 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. '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, 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: 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): At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001. 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 - 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 years ending 30 June 20XX and 20XX. | Detailed Reasoning - Current year: For the purposes of subsection 360-40(1), the current year: • for the income year ending 30 June 20XX will be the year ending 30 June 20XX (the 20XX income year) • for the income year ending 30 June 20XX will be the year ending 30 June 20XX (the 20XX income year) | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a): As the Company was incorporated on Date 20XX, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) for the 20XX and 20XX income years is satisfied. For the 20XX and 20XX income years, the Company's expenditure in each of the income years ending 30 June 20XX and 30 June 20XX was $1 million or less and subparagraph 360-40(1)(a)(ii) is satisfied. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b): As the Company had expenses of $1 million or less in the prior income years (the 20XX and 20XX income years) paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c): As the Company's assessable income in the prior income years (the 20XX and 20XX income years) was $200,000 or less paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No stock exchange listing - paragraph 360-40(1)(d): 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. | Detailed Reasoning - Conclusion on early stage test: The Company will satisfy the early stage test for the 20XX and 20XX income years, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100 point test: The Company has not provided any evidence of satisfying the 100 point test under section 360-45 for the years ending 30 June 20XX and 30 June 20XX. For the Company 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): According to the Company, the Innovation is the first holistic product that will enable everyday users to access the Product. This is due to the significant resources and costs involved. Although it will initially be targeted at the Australian market, the Innovation has been identified as having a wider global addressable market. The Innovation will be the first to offer such a product. | Detailed Reasoning - Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i): The Company has taken the following steps in developing the Innovation: • market research • design completion • partnerships formed • engineering office established via a contractor agreement. • customer testing of product This has led to the Company developing the Innovation. The timeline provides that the Company completed testing in late 20XX, with a product launch of the Innovation for general release in 20XX. | Detailed Reasoning - Conclusion on subparagraph 360-40(1)(e)(i): The Company was genuinely focussed on developing the Innovation for a commercial purpose. The Innovation is a significantly improved product compared to existing products. Therefore subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 20XX until 20XX when the Innovation was fully developed and launched. Therefore, as the Innovation 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 from a date in 20XX onwards. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii): The Company expects the Innovation to appeal to a wide range of users. This aids decision making and is particularly useful when assessing product or service viability in particular markets. With the appropriate investment capital, the Company has developed its Innovation to be fully functional across a variety of global markets. The Company will continue to connect with professionals who align with their requirements. The Company is looking to expand its operations internationally which has a significantly larger future addressable market. The Company has the potential to rapidly expand its customer base across the Australian and global markets. The Company has developed the Innovation themselves. They will make their revenue through sales of its Product. If the commercialisation strategy is successful, this may give the Company the ability to increase sales through referrals and online. Therefore subparagraph 360-40(1)(e)(ii) will be satisfied. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii): The Innovation's projections and business model provided illustrates the increase in projected sales. Given that the Innovation will be available globally, it is expected that the Innovation has the potential to successfully scale up its business. The Company's strategy for the use of the Innovation will be able to generate increased revenue with increased online sales both in Australia and globally. Unlike many other products, the Company's Innovation is designed specifically for people without prior knowledge of the Product. 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- subparagraph 360-40(1)(e)(iv): The Company's Innovation will initially be targeted at the Australian markets but is intended for worldwide use. It will be released globally once it gains traction in the initial targeted markets. The Innovation can be used worldwide by any individual or business. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region. The Company has demonstrated 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. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v): The Innovation has a number of differentiating features which may give it a competitive advantage.. Being the first of such an Innovation, the Company has the first mover advantage. The Company has demonstrated the potential for the Innovation to have competitive advantages within the 'addressable market' 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 a date in 20XX until a date in 20XX when the Innovation was fully developed and ready for sale. | Detailed Reasoning - Foreign Company Test: As the Company was incorporated in Australia, it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied. | Detailed Reasoning - Conclusion: The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing a date in 20XX until a date in 20XX when the Innovation was fully developed and when the full Innovation Product was launched. [1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76. [2] OECD Oslo Manual, paragraph 124 and paragraph 151.

incorporated in Australia within the last three income years (the latest being the current year); or | the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation