Private ruling: Qualification as an early stage innovation company
Date of advice: 20 June 2018
Published: August 2018
Ruling period: Year ended 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: For the year ending 30 June 2018 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 registered on the Australian Business Register in the 2015 income year. 2. The Company has no subsidiaries and is not listed on any stock exchange. 3. The Company’s total expenses for the years ended 30 June 201X, 201X and 201X are below $X million. Its assessable income for the year ended 30 June 201X is below $XXX. 4. The Company has created a product designed to manage lost property utilising technology. 5. The Company has a patent in Australia and has lodged patents internationally. 6. The Company has begun its journey rolling out its technology into the Australian market. 7. The Company has entered into a licensing deal with a supplier in Australia, with several Memoranda of Understanding and Letters of Intent signed with various suppliers. 8. Due to the nature of the business model, whereby unit costs are kept low for the consumer, it is affordable to use the product. 9. The Company believes that its product has a global application and it has no competition globally. 10. As such the Company has been emboldened to embrace a global mindset and is now ready to roll out its product in the Country A market, which has similar characteristics to the Australian. 11. The Company’s immediate focus is to exploit its first mover advantage to capture a large percentage of the Country A market. 12. By working in partnership with strategic partners, the Company believes it has the potential to achieve $XXm+ annual revenues within two years in the Country A alone. In the Country B market, the company believes it can achieve $XXm+ annual revenues within three years by executing a similar channel to market strategy. 13. The Company has no direct competitor in the local Australian market and minimal competition abroad.

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 Summary | 14. The Company meets the eligibility requirements of an ESIC under subsection 360-40(1) for the year ended 30 June 201X. | Detailed reasoning | Qualifying Early Stage Innovation Company | 15. 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. | ‘The early stage test’ | 16. The early stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d). | Incorporation or Registration – paragraph 360-40(1)(a) | 17. 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: | 18. incorporated in Australia within the last three income years (the latest being the current year); or | 19. 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 | 20. registered in the Australian Business Register (ABR) within the last three income years (the latest being the current year). | 21. 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. | 22. A company that does not meet any of these conditions will not qualify as an ESIC. | Total expenses - paragraph 360-40(1)(b) | 23. 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. | Assessable income - paragraph 360-40(1)(c) | 24. 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. | No stock exchange listing - paragraph 360-40(1)(d) | 25. 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. | Innovation tests | 26. 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. The Company has applied for this ruling on the basis that it meets the principles-based test. | ‘Principles-based test’ – subparagraphs 360-40(1)(e)(i) to (iv) | 27. 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. | 28. 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. | 29. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are: | 30. the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation | 31. the business relating to that innovation must have a high growth potential | 32. the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation | 33. 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 | 34. the company must demonstrate that it has the potential to be able to have competitive advantages for that business. | Developing new or significantly improved innovations for commercialisation | 35. 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: | i. “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 | 36. 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. | 37. 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, pricing strategies or seasonal changes are examples of improvements that would not be considered significant. | 38. 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. | 39. 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. | 40. For a company to qualify as an ESIC under the principles based test, the company must be “genuinely focussed on developing for commercialisation” their innovation. That is, the central activities of the company must be truly concentrated on developing their 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. | 41. ‘Commercialisation’ is discussed further at paragraph 1.81 in the EM which states: | b. Commercialisation encompasses a spectrum of activities including those leading to the sale of new or significantly improved product, process or service as well as activities involving the implementation of a new, or significantly improved, process or method, where the process or method directly leads to the generation of economic value for the company. | 42. The pre-commercialisation stage may involve a range of activities such as market research, developing a proof of concept, prototyping, user testing, setting up manufacturing and marketing processes, and other business development activities to prepare for the launch of a product or service. | 43. To be developing an innovation for commercialisation, the company must be at a stage before the innovation has been successfully commercialised. If the company has achieved a number of commercial sales or it is otherwise generating significant revenue from the business relating to the innovation, it is likely that the innovation is no longer being developed for commercialisation. | High growth potential | 44. The company must be able to demonstrate that the business relating to the innovation has a high growth potential 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. | Scalability | 45. The company must be able to demonstrate that it has the potential to successfully scale up the business relating to the innovation. 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. | Broader than local market | 46. 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. | Competitive advantages | 47. 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. | Application to your circumstances | Early stage test | 48. For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC will be a particular date on or after 1 July 201X, but before 30 June 201X. | 49. Therefore, for the purposes of subsection 360-40(1), the current year will be the year ending 30 June 201X (201X income year). For clarity, in relation to the requirement in subparagraph 360-40(1)(a)(ii), | 50. the last 3 income years will include the years ending 30 June 201X, 201X and 201X | 51. the last 6 income years will include the years ending 30 June 201X, 201X, 201X, 201X, 201X and 201X. | Incorporation or Registration – paragraph 360-40(1)(a) | 52. The Company was registered on the Australian Business Register in the year ended 30 June 201X. | 53. Therefore, the Company does not satisfy subparagraphs 360-40(1)(a)(i) or (iii) as it was not incorporated in Australia or registered on the ABR within the last 3 income years. | 54. The Company will need to satisfy the element in subparagraph 360-40(1)(a)(ii). This element is made up of 2 parts, being time of incorporation and expenses incurred across 3 years by the company and its 100% subsidiaries. | 55. The Company satisfies the first requirement of subparagraph 360-40(1)(a)(ii), as it was incorporated in Australia within the last 6 income years. | 56. The second requirement of subparagraph 360-40(1)(a)(ii) is that the Company and its 100% subsidiaries must have incurred total expenses of $1 million or less across the last 3 income years. The relevant 3 income years in your circumstance are the years ending 30 June 201X, 201X and 201X. These three years include the current year. | 57. The Company does not have any subsidiaries. | 58. To satisfy subparagraph 360-40(1)(a)(ii), the total expenses incurred by the Company for the 201X, 201X and 201X income years must not exceed $1 million. | 59. The total expenses incurred by the Company for the 201X, 201X and 201X income years totals less than $X million. Therefore subparagraph 360-40(1)(a)(ii) is satisfied. | Total expenses – paragraph 360-40(1)(b) | 60. As the Company had expenses less than $X million in the income years ended 30 June 201X, paragraph 360-40(1)(b) is satisfied. | Assessable income – paragraph 360-40(1)(c) | 61. As the Company’s assessable income for the income year ended 30 June 201X is less than $XXX paragraphs 360-40(1)(c) is satisfied. | No stock exchange listing – paragraph 360-40(1)(d) | 62. As the Company is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(a)(d) is satisfied. | Conclusion on early stage test | 63. The Company will satisfy the early stage test for the 201X income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Principles based test | Genuinely focussed on developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) | 64. The Company has created a product designed to manage lost property | 65. The Company is genuinely focussed on developing its product for a commercial purpose. The product is new to the marketplace and is a starting point for further innovations to leverage off. | 66. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the year ending 30 June 201X. | High growth potential – subparagraph 360-40(1)(e)(ii) | 67. The Company has several Memoranda of Understanding with suppliers as well as its licensing deal with a supplier. | 68. Initially the Company will be replicating its Australian strategy in the Country A market, where it believes it has the potential to achieve over $XXm in annual revenues within two years. | 69. A patent has been granted in Australia while patents are pending in other jurisdictions. | 70. Clearly the Company has a growth strategy that involves international operations. The potential for high growth exists. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. | Scalability – subparagraph 360-40(1)(e)(iii) | 71. Due to the channel to market strategy, which involves partnering with manufacturers and retailers, the Company is able to achieve scale and rapid market penetration. With increasing scale, it benefits from reduce unit costs. The costs with increasing economies of scale. | 72. The Company can demonstrate 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) | 73. The Company has already commenced operations in the Australian market and is making moves to expand into Country A. | 74. The Company has demonstrated it has the potential to address a broader market than Australia. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. | Competitive advantages – subparagraph 360-40(1)(e)(v) | 75. The Company has no direct competitor in the local Australian market and minimal competition abroad. | 76. A patent has been granted in Australia and patents are pending in foreign jurisdictions. | 77. The Company has a first-mover advantage which it will be able to maintain via a patent already granted in Australia and patents pending in foreign jurisdictions. | 78. In short the Company has demonstrated the potential for its product to have competitive advantages within its market, satisfying subparagraph 360-40(1)(e)(v). | Conclusion on principles test | 79. For the year ending 30 June 201X the Company satisfies the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for this period. | Conclusion | 80. The Company meets the eligibility criteria of an ESIC under section 360-40 for the year ending 30 June 201X.