Private ruling: Early Stage Innovation Company
Date of advice: 28 June 2017
Published: October 2017
Ruling period: 01 July 20A3 to 30 June 20A4
Date scheme commenced: 01 July 20A3

Ruling: Q1: Does Company A 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. Company A was incorporated in Australia in a prior income year. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. Company A commenced product design in a prior year and has been commercially active, more recently with fully operational clients using the prototype. 3. Company A has no subsidiaries and has expenses of less than 1 million in the previous income year, i.e. the year ended 30 June 20A3. It has not yet generated any revenue therefore its assessable income is less than $200,000. 4. It is submitted that Company A provides the most comprehensive platform. 5. Company A has identified its ultimate market as being the global market. 6. Company A has submitted that it will ultimately take market share from a specified market place targeting particular industries where there is demand for 'the platform’. 7. It is submitted that there will be fast growing demand for ’the platform’. Commercialisation strategy 8. Company A currently has businesses in Australia trialling the product. 9. Company A is currently: a. Offering trials b. Undergoing early stage prototype trials 10. The next steps involve: ● Rolling the product out across all states. ● Grow to a critical mass of clients within Australia. ● Drive the business internationally. Currently Company A is in preliminary discussions with industry alliances. ● Producing a business model that is appropriate for global expansion. 11. Businesses are currently using 'the platform’. Company A is now in conversation with some of those businesses about rolling out 'the platform’ to other outlets within the groups. 12. Company A has already signed up multiyear alliances. These are exclusive deals spanning years. 13. Company A is targeting large multinational groups to use the product, starting with multiple store trials. 14. Company A has now launched the developed platform in the last few weeks as per the timeline, with the following proposed: ● Pilot phase ● 20A5 income year – the product will become fully commercial 15. Company A is initially targeting the Australian market. They will pursue product sales through: a. Current clients b. Strategic partnerships. c. Referral programs. d. Social media launch e. Strong marketing, PR, social media (including Facebook), LinkedIn f. Forming alliances with peak bodies and compliment service providers. 16. Company A is currently piloting the program with select large client organisations to test the success and efficiency of 'the platform’. 17. Company A will charge for the services provided. 18. Projected future revenue forecasts show revenue to increase exponentially. Information provided 19. You have provided information in a number of documents and phone conversations in relation to 'the platform’, including: a. your private ruling application b. our phone conversations c. supplementary information provided 20. We have referred to the relevant information within these documents and conversations in applying the relevant tests to your circumstances. 21. You issued a number of new shares in Company A in the 20A4 income year to assist in funding the continued development and commercialisation of 'the platform’.

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

Reasons for decision: Summary: The Company’ meets the eligibility requirements of, an ESIC under, subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 22. 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’: 23. 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): 24. 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). 25. 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. 26. 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): 27. 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): 29. 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): 30. 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: 31. 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): 32. 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. 33. 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. 34. 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. | Detailed Reasoning - 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: “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…” 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. 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 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. 39. 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.” 40. 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.” 41. 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. 42. '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: 43. 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: 44. 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. | Detailed Reasoning - Broader than local market: 45. 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: 46. 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 47. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date during the income year ending 30 June 20A4. Current year 48. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20A4 (the 20A4 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 20A4, 20A3 and 20A2, and the income year before the current year will be the year ending 30 June 20A3 (the 20A3 income year). | Detailed Reasoning - Early stage test: Incorporation or Registration – paragraph 360-40(1)(a) 49. As Company A was incorporated in the 20A1 income year which is within the last 6 income years, and in the last three of those income years the company and its 100% subsidiaries incurred total expenses of $1 million or less, subparagraph 360-40(1)(a)(i)/(ii)/(iii) is satisfied. Total expenses – paragraph 360-40(1)(b) 50. As Company A had expenses less than $1 million in the prior income year, paragraph 360-40(1)(b) is satisfied. Assessable income – paragraph 360-40(1)(c) 51. As Company A’s assessable income for the prior income year is less than $200,000, paragraphs 360-40(1)(c) is satisfied. No stock exchange listing – paragraph 360-40(1)(d) 52. As Company A 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 53. Company A satisfy the early stage test for the entire 20A4 income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - Principles based test: Developing new or significantly improved innovations for commercialisation – subparagraph 360-40(1)(e)(i) 54. At the point in time when the relevant shares were issued, the platform was in the early stages of development. 55. The developed platform was launched in the 20A4 income year and is currently at the piloting phase. 56. Although it will initially be targeted at the Australian market, 'the platform’ has been identified as having a wider International addressable market. 57. 'The platform’ will be fully commercialised in the 20A5 income year. 58. 'The platform’ will be the first of such a product. Genuinely focussed on developing for commercialisation –subparagraph 360-40(1)(e)(i) 59. Company A has taken the following steps in developing 'the platform’: ● Market research and analysis ● Multiple store trials/ prototype testing 60. This has led to Company A developing 'the platform’. 61. The timeline provides that from its early development stage within the 20A4 income year, 'The platform’ has been launched with the following planned for the next few months: ● June / July – Pilot phase ● August – the product will be fully commercialised 62. Company A has formed strategic partnerships with businesses using 'the platform’ since mid to late 20A3. Company A is now in conversation with the businesses about rolling out 'the platform’ to other outlets within the groups. 63. Company A aims to form alliances with peak bodies and compliment service providers. 64. Company A is currently piloting the program with select large client organisations. Current clients will allow Company A to expand into those markets. Conclusion on subparagraph 360-40(1)(e)(i) 65. Company A is genuinely focussed on developing 'the platform’ for a commercial purpose which will be a significantly improved product compared to existing products. 66. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20A3 until 30 June 20A4 or the date when 'the platform’ has been fully developed, whichever occurs earliest. Once 'the platform’ has been fully developed, Company A 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) 67. 'The platform’ will appeal to relevant businesses requiring use of 'the platform’. 68. There will be increasingly high demand for 'the platform’. 69. 'The platform’ will ultimately take market share from its competitors. 70. The target sector is amongst the fastest growing in the market place. 71. Company A has demonstrated that the market has a high growth potential and therefore subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability – subparagraph 360-40(1)(e)(iii) 72. Company As growth plan provided illustrates the increase in projected sales and revenue. 73. Company A platform is application software and delivered to customers via the internet. By nature, this means it will easily scale with customers utilising 'the platform’ on a user-pays subscription basis. The software code base and internet based distribution model means the application is developed one and then can be distributed many times in response to customer demand with minimal increases in costs per unit. 74. Company A is continuing to expand its strategic partnerships and alliances to provide further geographical reach for 'the platform’. It currently trialling the app. 75. As an internet delivered product in a high growth market Company A has demonstrated the potential to successfully scale up its business. Broader than local market- subparagraph 360-40(1)(e)(iv) 76. 'The platform’ will initially be targeted at the Australian market, but is intended for worldwide use). 77. ''The platform' can be used worldwide by any business. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region. 78. Company A has demonstrated 'the platform’ 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) 79. Being the first of such ’the platform’ Company A has the first mover advantage. Company A has demonstrated the potential for 'the platform’ to have competitive advantages within the professional business community, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test 80. Company A satisfies the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i)to (v) for the period commencing 1 July 20A3 until 30 June 20A4 or the date when 'the platform has been fully developed and is ready for sale, whichever occurs earlier. Conclusion 81. Company A meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20A3 until the earlier of 30 June 20A4 or the date when 'the platform has been fully developed and is ready for sale, whichever occurs earlier.