Private ruling: Income Tax: Tax Incentive for Early Stage Investors
Date of advice: 22 August 2017
Published: December 2017
Ruling period: Year ending 30 June 2017
Date scheme commenced: During year ending 30 June 2017.

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: 1. The Company was incorporated and registered in the Australian Business Register (ABR) during the year ending 30 June 2017. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. The Company has no subsidiaries and started business in the current income year (ie the year ending 30 June 2017), and did not incur any expenses or have any assessable income in the previous income year, ie the year ending 30 June 2016. 3. The Company is developing a service (’the Service’), which aims to offer an internet based fitness and health monitoring platform and support services for a specific sector of the health care market. 4. The Company’s goal is to provide a service which allows its customers/users to track their own fitness and health data, collect and storage the data, and permit distribution of data/information to various individuals. 5. The Company has three founders (individuals ‘X, ‘Y’ and ‘Z’). All founders hold shares in the Company, either directly, or via a family trust. X holds the largest interests in the company and is the CEO of the Company. 6. X has senior management experience. 7. Y is an experienced professional and business consultant. 8. Z is an experienced accountant, who has a background in a diverse range of industries. 9. The Company have not yet decided on a comprehensive patent and trademark strategy. Their current intention (and priority) is to develop and validate their business model. After this proof of concept stage they plan to develop an IP, patent and trademark strategy. The Company plans to protect their IP by following a lean start up model to achieve speed and cost advantages. They have stated that they have implemented the following IP protection actions: a. Created a universal branding and trademark for the business. b. Registered a global web address. c. Created sticky enterprise features to match the needs of care provider partners. 10. The Company has highlighted the key differentiators and competitive advantages of their service to alternate services, as being the Service will provide: a. its services to its users/customers as a complete ‘end-to-end’, supported, ready to use package/bundle b. an affordable leasing package vs more expensive services/bundles which require customers to purchase expensive hardware and user interfaces c. a platform which is compatible with third party health and medical sensors d. data/information accessible by authorised third parties e. features that are designed specifically to meet the needs of its target sector f. design features enabling remote carer support g. a service designed specifically for its target sector, with input from health care and medical professionals h. local support services i. a service with the capability of managing a range of health related data. 11. The Company has identified its addressable market as being both the domestic and international/global market, with its initial target to be the Australian market. Commercialisation strategy 12. The Company has undertaken extensive market research, and prepared a comprehensive development and commercialisation business plan. 13. The Company has identified the market size of its potential customers in Australia and its initial international target market in its business plan 14. The Company describes its current progress, and short term development and commercialisation plan as follows: a. software architecture, functional features and user interfaces have been defined b. software/systems development to commence on securing funds c. first pilot program to commence in conjunction with a health care provider organisation d. develop system and local support services to be to be operational e. complete initial pilot program f. volume rollout to commence on completion of initial pilot program. 15. The Company is planning to offer a bundle service for a monthly fee at its pilot stage, which includes the following services: ● Devices rental and insurance ● Delivery and installation cost ● Setup of devices and online services ● User training ● Telephone support ● Devices repair and swap ● Video guides 16. The Company plans to target health care providers within a specific sector of the health care market and their clients as their initial target market. 17. The Company has determined that its initial business orientation will be strategy based on partnership with health care providers within its specific target sector of the health care market. It has engaged a health care industry executive to provide them with advice and facilitate its commercialisation activities. 18. The Company is initially targeting the Australian market, and plan to pursue product sales through targeted direct sales to health care providers and individuals within their target segment. 19. The Company plans to generate its revenue from recurring subscription fees. They have projected, based on their financial modelling calculations, that they will be generating significant annual profits by the year ending 30 June 2020. 20. The Company has engaged with a health care provider organisation who have confirmed their intention to run a pilot project of the Service in conjunction with The Company. The health care provider organisation have also formally expressed interest in becoming the Company’s distributor and investing in their start up. The target schedule for the first pilot trial is June 2017. 21. The Company have also been introduced to a second health care provider organisation, and has received an informal expression of interest from them in exploring and trialling the Service. 22. The Company is planning to register with AusIndustry and claim R&D tax offsets in relation to some of the advanced research it plans to undertake in collaboration with universities and CSIRO – commencing in the future. 23. The Company have lodged a ‘Preliminary Assessment Form’ for a Government Grants Application. 24. The Company have set up a page on their website to market their ‘pilot service bundle’. Information provided 25. You have provided information in a number of documents and phone conversations in relation to the Service, including: ● your private ruling application ● copy of a ‘Preliminary Assessment Form’ for a Government Grants Application lodged on behalf of the Company ● phone conversation with X ● your response to request for further information 26. We have referred to the relevant information within these documents and conversation/s in applying the relevant tests to your circumstances. 27. You propose to issue new shares in the Company to various investors to assist in funding the continued development and commercialisation of the Service.

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 Further issues for you to consider | All legislative references are to the ITAA 1997 unless otherwise indicated. | Question 1: | Summary | The Company meets the eligibility requirements of an ESIC under subsection 360-40(1). | Detailed reasoning | Qualifying Early Stage Innovation Company | 1. 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’ | 2. 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) | 3. 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). | 4. 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. | 5. A company that does not meet any of these conditions will not qualify as an ESIC. | Total expenses - paragraph 360-40(1)(b) | 6. 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) | 7. 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) | 8. 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 | 9. 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. | ‘100 point test’ – paragraph 360-40(1)(e) and section 360-45 | 10. 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. | ‘Principles-based test’ – subparagraphs 360-40(1)(e)(i) to (iv) | 11. 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. | 12. 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. | 13. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are: | i. the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation | 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. | Developing new or significantly improved innovations for commercialisation | 14. 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…” | 15. 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. | 16. 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. | 17. 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. | 18. 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.” | 19. 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.” | 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. 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 | 25. 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 | Test time | 26. 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 year ending 30 June 2017. | Current year | 27. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2017 (the 2017 income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years will include the years ending 30 June 2017, 2016 and 2015, and the income year before the current year will be the year ending 30 June 2016 (the 2016 income year). | Early stage test | Incorporation or Registration – paragraph 360-40(1)(a) | 28. As the Company was incorporated and registered in the ABR within the last 3 income years, subparagraph 360-40(1)(a)(iii) is satisfied. | Total expenses – paragraph 360-40(1)(b) | 29. As the Company had no subsidiaries and did not incur expenses in the prior income year, paragraph 360-40(1)(b) is satisfied. | Assessable income – paragraph 360-40(1)(c) | 30. As the Company had no subsidiaries and did not have assessable income in the prior income year, paragraph 360-40(1)(c) is satisfied. | No stock exchange listing – paragraph 360-40(1)(d) | 31. As the Company is privately owned and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(d) is satisfied. | Conclusion on early stage test | 32. The Company will satisfy the early stage test for the period from the date of its incorporation and registration in the ABR to 30 June 2017, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | 100 point test | 33. The Company has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 2017. For the Company to be a qualifying ESIC it will need to satisfy the principles-based test. | Principles based test | Developing new or significantly improved innovations for commercialisation – subparagraph 360-40(1)(e)(i) | 34. According to the Company, the Service is the first ‘end-to-end’ supported service, targeted at the specific health care sector, which allows customers/users to use electronic devices to allow its customers to track their own fitness and health data, facilitate the collection and storage of health data utilizing the internet, and permit distribution of data/information to family, carers and physicians. | 35. Although it will initially be targeted at the Australian market, the Service has been identified as having a wider international/global addressable market. | 36. The Company’s research indicates that it will be the first company/entity to offer such a product/service. | New, or significantly improved, products, processes, services or marketing or organisational methods – | subparagraph 360-40(1)(e)(i) | 37. The Company has highlighted the key differentiators and competitive advantages of their service to alternate services, as being the Service will provide: | a. its services to its users/customers as a complete ‘end-to-end’, supported, ready to use package/bundle | b. an affordable leasing package vs more expensive services/bundles which require customers to purchase expensive hardware and user interfaces | c. a platform which is compatible with third party health and medical sensors | d. data/information accessible by authorised third parties - including family, carers and medical services providers | e. features that are designed specifically to meet the needs of its target sector | f. design features enabling remote carer support | g. a service designed specifically for its target sector, with input from health care and medical professionals | h. local support services | i. a service with the capability of managing a range of health related data. | Genuinely focussed on developing for commercialisation – | subparagraph 360-40(1)(e)(i) | 38. The Company has taken the following steps in developing the Service, including: | a. undertaken extensive market research | b. prepared a comprehensive development and commercialisation plan | c. engaged a health care industry executive to provide them with advice and facilitate its commercialisation activities – ‘open doors’ for them | d. set up a page on their website to market the ‘pilot service bundle’ | e. lodged a ‘Preliminary Assessment Form’ for a Government Grants Application. | 39. The Company describes its current progress, and short term development and commercialisation plan as follows: | a. software architecture, functional features and user interfaces have been defined | b. software/systems development to commence on securing seed funds from angel investors | c. first pilot program to commence in conjunction with a health care provider organisation | d. develop system and local support services to be to be operational | e. complete initial pilot program | f. volume rollout to commence on completion of initial pilot program. | 40. The Company plans to target health care providers and their clients as their initial target market. | 41. The Company has determined that its initial business orientation will be strategy based on partnership with health care providers. | 42. The Company plans to generate its revenue from recurring subscription fees. | 43. The Company has engaged with a health care provider organisation who have confirmed their intention to run a pilot project of the Service in conjunction with the Company. The health care provider organisation have also formally expressed interest in becoming the Company’s distributor and investing in their start up. The target schedule for the commencement of the first pilot trial is during the year ending 30 June 2017. | 44. The Company have been introduced to a second health care provider organisation and has received an informal expression of interest from them in exploring and trialling the Service. | 45. The Company expects that when their initial pilot program/s are completed, it will have developed a version ready for general release / volume rollout. | 46. The Company is initially targeting the Australian market, and initially plans to pursue product sales through targeted direct sales to health care providers, and individuals within their target segment. | Conclusion on subparagraph 360-40(1)(e)(i) | 47. The Company is genuinely focussed on developing the Service for a commercial purpose. The Service will be a significantly improved product/service compared to existing products available to the health care market. | 48. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from the date of its registration until 30 June 2017 or the date when the Service has been fully developed, whichever occurs earliest. Once the Service 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. | High growth potential – subparagraph 360-40(1)(e)(ii) | 49. The Company expects the Service to have wide appeal within its specific target sector of the health care market sector as an affordable proactive health management service. Its research indicates that its target market is rapidly increasing within Australia and globally, and that this will provide it with increasing potential opportunities to expand. | 50. Through its initial commercialisation/marketing strategy, the Company hopes to foster widespread use of its product by partnering with health care institutions/providers. | 51. The Company is developing the Service in successive stages. It plans to develop the initial version of its product/service by running pilot projects of the service in partnership with a number of health care providers. | 52. Once The Company has developed the initial version of its service, it intends to proceed to ‘roll out’ the service primarily as a ‘white label service,’ via health care providers, health funds and apps stores. | 53. The Company plans to generate its revenue from recurring subscription fees. | 54. If The Company’s commercialisation strategy is successful, its market analysis indicates that it will be able to rapidly expand its activities / generation of revenue first within the Australian market, and then within international/global markets. | 55. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. | Scalability – subparagraph 360-40(1)(e)(iii) | 56. The Company’s projections illustrate an increase in projected sales. They have projected, based on their financial modelling calculations, that they will be able to be generating significant annual profits by the year ending 30 June 2020. | 57. Given that that the Service is internet based, and The Company’s research indicates that the service will have application within both domestic and global markets, it is expected that the Company has the potential to successfully scale up its business. | 58. The Company’s service is centered around an ‘internet based market platform’, which they believe can be scaled up to support millions of users. The Company projects that it will be able to generate increased revenue with a less than direct proportionate increase in operating costs. This operating leverage affords the Company the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. | 59. Broader than local market- subparagraph 360-40(1)(e)(iv) | 60. The Company will initially target its marketing of the Service at the Australian market. However, the Company has identified its ultimate market as being both the Australian and international/global markets. Its longer term marketing plan will be dominated by efforts to establish distribution partnerships through health care providers, health funds, and app stores (to self-service users). | 61. The Service has the potential for application worldwide within the health care industry. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region. | 62. The Company has demonstrated the Service 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. | Competitive advantages – subparagraph 360-40(1)(e)(v) | 63. The Company has highlighted the key differentiators and competitive advantages of their service to alternate services, as being the Service will provide: | a. its services to its users/customers as a complete ‘end-to-end’, supported, ready to use package/bundle | b. an affordable leasing package vs more expensive services/bundles which require customers to purchase expensive hardware and user interfaces | c. a platform which is compatible with third party health and medical sensors | d. data/information accessible by authorised third parties | e. features that are designed specifically to meet the needs of its target sector | f. design features enabling remote carer support | g. a service designed specifically for its target sector, with input from various professionals | h. local support services | i. a service with the capability of managing a range of health related data. | 64. Therefore, as the Service is the first service with these differentiating features, the Company has the first mover advantage. The Company has demonstrated the potential for the Service to have competitive advantages within the health care industry, and in particular the specific sector of the health care industry that it is targeting, satisfying subparagraph 360-40(1)(e)(v). | Conclusion on principles test | 65. 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 from the date of its incorporation and registration in the ABR until 30 June 2017, or the date when the Service has been fully developed and is ready for sale, whichever occurs earlier. | Conclusion | 66. The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing from the date of its incorporation and registration in the ABR until the earlier of 30 June 2017, or the date when the Service has been fully developed and is ready for sale, whichever occurs earlier.