Private ruling: Early stage innovation company - qualification
Date of advice: 29 June 2018
Published: September 2018
Ruling period: Year ending 30 June 20XX
Date scheme commenced: XX February 20XX

Ruling: Q1: Does Company A (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: Overview 1. In 20XX, the Company was incorporated in Australia. It is an unlisted public company because its equity interests are not listed for quotation in the official list of any stock exchange. 2. The Company has a wholly owned subsidiary, Company B (the Subsidiary). The Subsidiary is the Company’s operating entity. 3. In 20XX, the Company and Subsidiary formed a tax consolidated group for income tax purposes. 4. For the income year ended 30 June 20YY: (a) the Company had no expenses or assessable income, and (b) the Subsidiary had expenses of less than $1m and assessable income of less than $200,000. 5. The Company is developing a software system (the Products) to provide a solution and automate processes for the relevant industry. 6. The Subsidiary originally spent four years developing and prototyping the Products, but the intellectual property and intangible assets associated with the Products were transferred or assigned from the Subsidiary to the Company, including relevant domain names. 7. The Company has applied for a registration of its trademark. Information provided 8. You have provided the following information in relation to the Company’s Products: (a) Your Private Binding Ruling application, (b) The Company’s Marketing Plan, (c) The Company’s Fee structure, (d) The Subsidiary’s Balance sheet as at 30 June 20YY, (e) The Subsidiary’s Profit and Loss statement for 30 June 20YY, and, (f) The Company’s Business Plan. 9. We have referred to the relevant information within these documents and conversations in applying the relevant tests to your circumstances. 10. You propose to issue new shares in the Company to investors to assist in funding the continued development and commercialisation of the Company’s Products.

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

Reasons for decision: Detailed Reasoning - Overview of ESIC qualifying criteria: 1. Subsection 360-40(1) of the ITAA 1997 provides the criteria that a company must satisfy in order to qualify as an Early Stage Innovation Company (ESIC) at a particular time (the test time) in an income tax year (the current year). 2. ‘Current year’ is defined in subsection 360-40(1) of the ITAA 1997 as being the income year in which the company issues shares to the investor. 3. These criteria test the company to determine whether it is at an early stage of its development and is developing new or significantly improved innovations to generate an economic return. | Detailed Reasoning - Early stage test: 4. The early stage test requirements are outlined in paragraphs 360-40(1)(a) to (d) of the ITAA 1997. 5. Paragraph 360-40(1)(a) of the ITAA 1997 requires that, at the test time in the current year, a company must have been either: (i) incorporated in Australia within the last 3 income years (the latest being the current year); or (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 it and its 100% subsidiaries (if any) incurred total expenses of $1 million or less; or (iii) registered in the Australian Business Register within the last 3 income years (the latest being the current year). 6. Paragraph 360-40(1)(b) of the ITAA 1997 requires that: the company and its 100% subsidiaries (if any) incurred total expenses of $1 million or less in the income year before the current year. 7. Paragraph 360-40(1)(c) of the ITAA 1997 requires that: the company and its 100% subsidiaries (if any) had a total assessable income of $200,000 or less in the income year before the current year. 8. Paragraph 360-40(1)(d) of the ITAA 1997 requires that: at the test time, none of the company’s equity interests are listed for quotation in the official list of any stock exchange in Australia or a foreign country. 9. A company that does not meet these criteria will not qualify as an ESIC. | Detailed Reasoning - Innovation tests: 10. Where a company satisfies the early stage test, the company will also need to satisfy one or two innovation tests: (a) 100 point (objective) test, or (b) Principles-based test. Principles-based test 11. The principles-based test is contained in subparagraphs 360-40(1)(e)(i) to (v) of the ITAA 1997. At a time immediately after the relevant new shares are issued to investors, it is required that: (i) the company is genuinely focussed on developing for commercialisation one or more new, significantly improved, products, processes, services or marketing or organisational methods; and, (ii) the business relating to those products, processes, services or methods has a high growth potential; and, (iii) the company can demonstrate that it has the potential to be able to successfully scale that business; and, (iv) the company can 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 can demonstrate that it has the potential to be able to have competitive advantages for that business. Developing new or significantly improved innovations for commercialisation 12. At paragraph 1.76 of the Explanatory Memorandum to the Tax Laws (Tax Incentives for Innovation) Bill 2016 (the EM), ‘innovation’ is defined for the purposes of Subdivision 360-A of the ITAA 1997: 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… 13. The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. 14. The company’s addressable market is the revenue opportunity or market demand arising from the innovation or the related business. This 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. 17. 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. 18. Paragraph 111 of the OECD Oslo Manual discusses services innovation activity: 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. 19. Further, at paragraph 161, the OECD Oslo Manual defines ‘innovative services’: …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. 20. 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. 21. ‘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. High growth potential 22. 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. Scalability 23. 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. Broader than local market 24. 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. 25. 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 26. 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 27. Here, the test time for determining whether the Company is a qualifying ESIC will be a particular date during the income tax year ending 30 June 20XX. Current year 28. Pursuant to subsection 360-40(1) of the ITAA 1997, the current year will be the income tax year ending 30 June 20XX. For clarity: (a) The last three income years are the 20ZZ, 20YY and 20XX income years. (b) The income year before the current year is the 20YY income year. | Detailed Reasoning - Early stage test: Paragraph 360-40(1)(a): incorporation or registration 29. The Company was incorporated on XX February 20XX. As this date falls within the last three income years of the current year, the Company satisfies this criterion. Paragraph 360-40(1)(b): total expenses 30. The Company and Subsidiary have combined expenses of less than $1m for the 20YY income tax year. As a result, the Company satisfies this criterion. Paragraph 360-40(1)(c): assessable income 31. The Company and Subsidiary have combined assessable income of less than $200,000 for the 20YY income tax year. As a result, the Company satisfies this criterion. Paragraph 360-40(1)(d): no stock exchange listing 32. The Company is an unlisted public company and its equity interests are not listed on any stock exchange in Australia or foreign country. As a result, the Company satisfies this criterion. Conclusion 33. The Company satisfies the early stage test under paragraphs 360-40(1)(a) to (d) of the ITAA 1997 for the entire 20YY income tax year. | Detailed Reasoning - Principles-based test: Subparagraph 360-40(1)(e)(i): developing new or significantly improved innovations for commercialisation 34. The Company is developing Products to provide a solution and automate processes for the relevant industry. 35. The information you provided outlines in detail how the Products are intended to work. 36. The Company has identified its addressable market as a specific Australian market sector. 37. The Company will target individuals and businesses within and across various segments of the Australian market sector. The information you provided outlines in detail the key sectors and industries targeted. 38. You also provided details of the existing systems that customers currently use in the Australian market sector. 39. You have indicated that no other company in the Australian market currently offers solutions similar to your Products. You have provided details regarding how your Product is unique when compared to other existing systems and services. 40. You are in the process of registering a trademark with respect to your Products. 41. The Company has taken the following steps in developing the Products: (a) Market analysis, including market opportunity needs; (b) Securing capital contributions from some investors and seeking to raise further capital; (c) Applying for registration of its trademark (pending confirmation); (d) Prototyping the Products; (e) Preliminary budgeting and business plan preparation; and, (f) Implementing a corporate structure to support growth and commercial operations. 42. The Company has received interest from a range of potential clients, which you have detailed in the information you provided. 43. The Company intends to develop these potential customers as paying customers, which would give rise to direct sales. 44. The Company expects to have its Products ready for sale at or around the end of the 20XX calendar year or early in the 20AA calendar year. 45. As highlighted above, the Company is genuinely focussed on developing the Products for a commercial purpose; and, the Products will be a significantly improved product compared to existing products. 46. As a result, the subparagraph 360-40(1)(e)(i) of the ITAA 1997 will be satisfied for time period being the earliest of either: (a) The period commencing 1 July 20YY until 30 June 20XX; or, (b) The date when the Products are fully developed. 47. Once the Products have been fully ‘developed’, the Company will no longer satisfy the requirements under subparagraph 360-40(1)(e)(i) of the ITAA 1997. Subparagraph 360-40(1)(e)(ii): high growth potential 48. The Company expects that the Products will appeal to a wide range of businesses for the following reasons: (a) Simplification, efficiency and accuracy; (b) Cost and time savings; and, (c) Sophistication and uniqueness. 49. Through its commercialisation and market strategy, the Company hopes to foster widespread use of its product by: (a) Direct marketing and sale of the Products, and (b) Subscription-based services. 50. The Company is developing the Products themselves and has both a marketing and business plan. The Company intends to generate income through the sale of products and services offered by the Company, and as a result of the Company’s Products. 51. If the commercialisation strategy is successful, this may allow the Company to increase sales through repeat users, referrals and expansion throughout regions in Australia or overseas. 52. As a result, subparagraph 360-40(1)(e)(ii) of the ITAA 1997 will be satisfied. Subparagraph 360-40(1)(e)(iii): scalability 53. The information you provided shows a detailed revenue model. You have also outlined the projected sales and the Company’s ability to increase sales. 54. The information you provided also outlines the Company’s first mover advantage because your Products are uniquely placed in the market with no known competition. 55. It is expected that the Company has the potential to scale up its business in light of the above facts, coupled with: (a) the availability of the Products to be rolled out across Australia, (b) the potential for the Products to be used internationally, and (c) the unique offering to consumers in the target industries. 56. As a result, the operating leverage affords the Company the potential to successfully scale up its business. 57. Therefore, subparagraph 360-40(1)(e)(iii) of the ITAA 1997 will be satisfied. Subparagraph 360-40(1)(e)(iv): broader than local market 58. The Company’s Products will be initially targeted at the Australian market, but the Products are suitable for use in other overseas locations. 59. As the Products can be used locally, domestically, or worldwide by any business, the ultimate addressable market for the Products is on an Australia and global scale. 60. As a result, subparagraph 360-40(1)(e)(iv) of the ITAA 1997 will be satisfied as the Company has demonstrated that the Products have the potential to address a broader market than just the local market. Subparagraph 360-40(1)(e)(v): competitive advantages 61. The Products have the following differentiating features that may give it a competitive advantage: (a) Simplification, efficiency and accuracy; (b) Cost and time savings to users; (c) Sophistication and uniqueness, such that the Product is difficult to replicate; and, (d) Not offered by any other competitors. 62. As a result, the Company has first mover advantage. 63. Subparagraph 360-40(1)(e)(v) of the ITAA 1997 will be satisfied as the Company has demonstrated the potential for the Products to have competitive advantage within the Australian market. Conclusion 64. The Company satisfies the principles-based test under subparagraphs 65. 360-40(1)(e)(i) to (v) of the ITAA 1997 for the period commencing 1 July 20YY and ceasing on the earlier of: (a) 30 June 20XX; or, (b) The date when the Products are fully developed. | Detailed Reasoning - Conclusion: 66. The Company qualifies as an Early Stage Innovation Company under section 360-40 of the ITAA 1997 for the period commencing 1 July 20YY and ceasing on the earlier of: (a) 30 June 20XX; or, (b) The date when the Products are fully developed.