Private ruling: Early stage innovation company
Date of advice: 26 April 2018
Published: July 2018
Ruling period: 1 XX 20XX to 30 YY 20YY
Date scheme commenced: 1 XX 20ZZ

Ruling: Q1: Does Company E satisfy the criteria of an Early Stage Innovation Company (ESIC) pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 (‘ ITAA 1997 ’)? | A1: Yes

Relevant facts and circumstances: 1. Company E is a proprietary company incorporated on XX XX 20XX and registered in the Australian Business Register on YY YY 20ZZ. 2. Company E’s Directors are Taxpayer M and Taxpayer N. 3. Company E lodged a company income tax return for the year ending XX XX 20XX, and declared the following: a. total expenses at item 6 of $xyz b. total income at item 6 of $zyx 4. Company E’s equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country. 5. Company E is developing a secure and reliable digital system known as ‘The S Product’. The S product will enable taxpayers and corporations to interact securely, reliably and easily from anywhere on the planet. The S product will deliver trusted and transparent results instantly for a fraction of the cost. 6. The S product is a digital system, which is fully end-to-end verifiable and immune to the normal methods of technical fraud. 7. The S product aims to eliminate traditional difficulties with digital systems, such as: a. Speed – traditional methods are slow, tedious and manual in process b. Manipulability – Interactions can be manipulated easily c. Expense – Modern interactions can costs taxpayers and corporations up to $15 per interaction d. Error-Prone – Both human and technical errors are possible at many points in the system 8. Once fully developed, the S product will be totally transparent and will support peer to peer interactions using a world first, patent-pending algorithm called CCC . 9. The S product’s innovative technology will be: a. Secure – interactions cannot be manipulated by attackers b. Decentralised – verifying systems can be hosted by anyone, ensuring that all stakeholders can validate the results c. Cost Effective – up to 15 times cheaper than existing solutions d. Scalable – the patent-pending CCC algorithm allows end-to-end anonymization at extremely low computational costs e. Flexible Core Platform – the core platform can be easily applied across a vast array of business and government uses. 10. Company E is continuing to develop the S product. Company E predicts that there is still approximately 6 – 8 months of development left to be completed before the S product is fully developed and ready for general release, however this is dependent on developer resources. 11. Company E’s S product has been identified as having an international addressable market. Information provided 12. You have provided a number of documents containing detailed information in relation to Company E’s S product, including: a. Private Binding Ruling (‘PBR’) Application, dated X XX 20ZZ b. Company Tax Return 20XX c. A summary table of ESIC eligibility tests d. A copy of Company E’s investor program e. Responses to further information as requested by the ATO f. Responses to numerous emails 13. We have referred to the relevant information within these documents in applying the relevant tests to your circumstances. 14. You propose to issue new shares in Company E to various investors to assist in funding the continued development and commercialisation of the S product.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-15 | Income Tax Assessment Act 1997 section 360-40 | Income Tax Assessment Act 1997 section 360-45

Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 (‘ ITAA 1997 ’) unless otherwise stated. Company E meets the eligibility requirements of an ESIC pursuant to subsection 360-40(1). | 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. | Detailed Reasoning - ‘The early stage test’: 16. 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): 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: 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). 18. 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. 19. 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): 20. 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): 21. 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): 22. 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: 23. 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 - ‘100 point test’ – paragraph 360-40(1)(e) and section 360-45: 24. To satisfy the 100 point test the company must obtain at least 100 points by meeting the innovation criteria in the table within section 360-45. The criteria are tested at a time immediately after the relevant shares are issued. If a company satisfies this test it does not need to satisfy the principles-based test. | Detailed Reasoning - ‘Principles-based test’ – subparagraphs 360-40(1)(e)(i) to (iv): 25. 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. 26. 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. 27. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are: i. the company must be genuinely focussed on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods 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: 28. 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…” 29. The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. 1 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. 30. 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. 31. 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.” 32. 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. 33. 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. | Detailed Reasoning - High growth potential: 34. 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. | Detailed Reasoning - Scalability: 35. 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. | Detailed Reasoning - Broader than local market: 36. 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: 37. 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 - TEST TIME: 38. For the purposes of this ruling, the ‘test time’ for determining if Company E is a qualifying ESIC, will be upon the issue of qualifying shares on a particular date or dates after 1 XX 20XX, and on or before 30 YY 20YY. | Detailed Reasoning - Current year – shares issued in 20YY income year: 39. Therefore, for the purposes of subsection 360-40(1) ITAA 1997 , the current year will be the year ending 30 XX 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending 30 XX 20YY, 20XX and 20ZZ, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration – paragraph 360-40(1)(a) ITAA 1997: 40. Company E was incorporated on X XX 20ZZ, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) are satisfied. | Detailed Reasoning - Total expenses – paragraph 360-40(1)(b) ITAA 1997: 41. In applying the requirements of paragraph 360-40(1)(b), Company E and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the income year before the current year. 42. Company E incurred expenses of $xyz in the 20XX income year. Consequently, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income – paragraph 360-40(1)(c) ITAA 1997: 43. In applying the requirements of paragraph 360-40(1)(c), Company E and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the income year before the current year. 44. Company E earned $zyx assessable income in the 20XX income year. Consequently, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No Stock Exchange listing – paragraph 360-40(1)(d) ITAA 1997: 45. In applying the requirements of paragraph 360-40(1)(d), Company E must not be listed on any Stock Exchange in Australia or a foreign country at the test time. 46. Company E is not listed on any Stock Exchange in Australia or a foreign country at the test time, so paragraph 360-40(1)(d) is satisfied. | Detailed Reasoning - CONCLUSION FOR EARLY STAGE TEST: 47. Company E satisfies the early stage test for the 20YY income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - THE ‘100 POINT TEST’ – paragraph 360-40(1)(e) and section 360-45: 48. Company E has indicated that they would satisfy the 100 point test under section 360-45 for the year ending 30 YY 20YY. They are however, electing to seek eligibility by satisfying the Principles based Innovation test under section 360-40(1)(e)(i)-(v), in order to be issued with a Private Binding Ruling. | Detailed Reasoning - Developing new or significantly improved innovation– subparagraph 360-40(1)(e)(i) ITAA 1997: 49. In applying the requirements of subparagraph 360-40(1)(e)(i), Company E must be developing an innovation which is either new or significantly improved for an applicable addressable market. 50. Company E is currently developing a secure and reliable digital system known as the S product. 51. The S product is a digital system, which is fully end-to-end verifiable and immune to the normal methods of fraud. 52. The S product will enable taxpayers and corporations to interact securely, reliably and easily from anywhere on the planet. 53. The S product will deliver trusted and transparent results instantly for a fraction of the cost. 54. The S product is new product within the addressable market, as there does not currently exist a highly secure, scalable, and reliable internet based digital solution. 55. Costs associated with facilitating typical interactions vary between $x and $y each, depending on the country. The S product is able to facilitate the same process for less than $z each. 56. The S product platform solves almost all of the associated problems, such as: a. Speed – Interactions are slow, tedious and manual in process b. Manipulability – Can be manipulated easily c. Expense – Can costs taxpayers and corporations up to $xx each d. Error-Prone – Both human and technical errors are possible at many points in the system 57. The S product has an international addressable market. As a digital product, it is easily distributed and has immediate application for organisations globally. 58. The S product’s first client is based in X, in addition to other countries. In addition to these markets, the S product will be used by the digital industry. 59. Company E has already completed much work in the development phase of the S product, which is still continuing. Prototyping work has been undertaken between XX 20XX and YY 20YY. 60. Company E is genuinely focussed on developing the S product, a new and innovative digital system, for an applicable addressable market. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997 61. In applying the requirements of subparagraph 360-40(1)(e)(i), Company E must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company. 62. Commercialising their product will allow Company E to generate monthly recurring income and exposes the product to its first target market whilst the full product is developed. 63. There are a number of steps which are required to be completed into the future, before the S product is considered to be fully developed for commercialisation: i. Testing for Prototype 2; building out digital architecture and integrating with existing databases; optimisation for server/apps; set up servers to extend product. ii. Continue development of index; User Interface for multiple users. 64. Company E is genuinely focussed on developing the S product, a digital system, for a commercial purpose. Subparagraph 360-40(1)(e)(i) is satisfied for the period 1 XX 20XX to 30 YY 20YY or the date when the S product has been fully developed, whichever occurs earliest. Once the S product has been fully developed, Company E will no longer be ‘developing’ the product for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 65. In applying the requirements of subparagraph 360-40(1)(e)(ii), Company E must be able to demonstrate that it has the potential for high growth within a broad addressable market. 66. Company E has a go-to-market strategy primarily focused on fast growth. By taking advantage of the need in the emerging industry for early revenue, the company will be well positioned to grow its development team, delivering improvements faster to the platform. 67. Company E will also be undertaking several more rounds of capital raising to accelerate their growth. The first round will be embarked upon in the coming weeks, with another round of capital raising slated for the end of 20YY, off the back of initial market traction. 68. For traditional markets, Company E is in discussions with potential international channel partners in a number of countries. By leveraging these partnerships, Company E can rapidly distribute its digital product to clients globally, without the overhead of managing each sales process and relationship. 69. Company E has demonstrated a high growth potential for the S product, a digital system, so subparagraph 360-40(1)(e)(ii) is satisfied for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 70. In applying the requirements of subparagraph 360-40(1)(e)(iii), Company E must be able to demonstrate that it has the potential to successfully scale up the business. 71. The S product’s technology is highly scalable thanks to one of their key innovations, and has demonstrated that it can handle millions of interactions per minute. For the roll out of their product, Company E will enable electronic delivery via an easy to use web application, while more significant implementations can be done remotely, and reuse an existing code base. 72. The S product is highly cost effective to operate. As with most digital products, the bulk of expenditure exists in the initial development phase. Once development is completed, the platform requires minimal ongoing maintenance to support. 73. As there is currently no other service on offer in this market segment, Company E expects to capture as much as 10% of the market within the first 12 months of product roll out. 74. With more than 500 potential clients in this market segment, Company E forecast this would generate monthly recurring revenue of -$xx. Company E’s revenue model and digital product allows their customers to easily on-board and use their solution, generating recurring revenue that will result in a high and consistent gross profit margin. 75. Company E will invest all revenue back into R&D and into growing its market share across the industry, as well as establishing the necessary teams required to compete for tenders and move into the public sector market. 76. This leverage ensures that Company E has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 77. In applying the requirements of subparagraph 360-40(1)(e)(iv), Company E must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets. 78. Company E have already demonstrated global reach by working on a large implementation with an overseas firm. As a digital company, their customers can easily access their platform online, and work on large projects can be done remotely. 79. Company E is not hindered by national borders, and they expect most early revenue to be generated abroad. 80. Company E has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: 81. In applying the requirements of subparagraph 360-40(1)(e)(v), Company E must demonstrate that it has potential to be able to have competitive advantage for that business. 82. Company E has identified 3 key competitive advantages over its competitor: i. Their patent pending (Australia and International) algorithm named CCC . ii. Their digital architecture allows them to conduct transactions at a tremendous scale and a very low cost. iii. Their go-to-market strategy leverages the rapidly growing industry to achieve early recurring revenue. By contrast, their competitors are focusing on addressing the larger but much slower to act public sector. 83. Company E has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period 1 July 20XX to 30 June 20YY. | Detailed Reasoning - CONCLUSION FOR PRINCIPLES BASED TEST: Company E satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period 1 July 20XX to 30 June 20YY or the date when the S product has been fully developed, whichever occurs earliest. | Detailed Reasoning - CONCLUSION: Company E meets the eligibility criteria of an ESIC under section 360-40 for the period 1 July 20XX to 30 June 20YY or the date when the S product has been fully developed, whichever occurs earliest.