Private ruling: Early stage innovation company
Date of advice: 5 March 2019
Published: May 2019
Ruling period: XX 20XX to YY 20YY
Date scheme commenced: 1 xx 20XX

Ruling: Q1: Does Company A 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 A is a proprietary company incorporated on WW 20WW. 2. Company A was registered in the Australian Business Register (ABR) on XX 20XX. 3. Since incorporation Company A has incurred and earned the following: Total expenses of less than $1 million Total income of less than $200,000. 4. Company A’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 A has no subsidiaries. 6. Company A is developing a software application (‘the Application’) to teach business acumen within the corporate sector. It utilises gamification in order to coach business concept thinking. 7. The Application is being developed to address a market need for a solution to teach business acumen in a safe environment that is no real world impact. 8. Company A acquired the Company A business, IP and related assets from Company X. 9. The key innovation of the Application is the incorporation of a number of elements into a single gamified real-world simulation. 10. Company A has productised their technology to address a number of discrete markets and is continuing to develop the Application. Company A anticipates that the current programme of development will be completed in the 20ZZ financial year. 11. Company A’s Application 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 A’s ‘Product’, including: a. Private Binding Ruling (‘PBR’) Application, dated YY 20XY b. Additional details in Appendices A to G 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 A to various investors to assist in funding the continued development and commercialisation of the Application.

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 A 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. 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 A is a qualifying ESIC, will be upon the issue of qualifying shares on a particular date or dates on or after XX 20XX, and on or before YY 20YY. | Detailed Reasoning - Current year: 39. Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending YY 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years will include the years ending YY 20YY, 20XX and 20WW, and the income year before the current year will be the year ending YY 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration – paragraph 360-40(1)(a) ITAA 1997: 40. Company A was registered in the Australian Business Register (ABR) on XX 20XX, which is within the three income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(iii) 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 A and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20XX income year, being the income year before the current year. 42. Company A incurred less than $1 million in expenses 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 A and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20XX income year, being the income year before the current year. 44. Company A did not earn any 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 A must not be listed on any Stock Exchange in Australia or a foreign country at the test time. 46. Company A 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 A 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 A are 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 innovations for applicable addressable market – subparagraph 360-40(1)(e)(i) ITAA 1997: 49. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be developing an innovation which is either new or significantly improved for an applicable addressable market. 50. Company A is developing a software application (the Application) which aims to teach business acumen in a simulated environment. 51. The key innovation of the Product is the integration of a number of elements into a single gamified simulation. The integration of the various elements makes this a significant improvement over existing products in the addressable market. 52. The market need that Company A addresses is the need to be able to effectively educate employees in management skills within the professional practice market segment. 53. Company A is genuinely focussed on developing the Application, for an applicable addressable market. | Detailed Reasoning - Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997: 54. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company. 55. The product is currently in its design phase. Preliminary steps have been taken towards commercialisation. 56. The work done to date has resulted in a demonstration product that is available to show potential investors and to obtain initial customer feedback. 57. The product will be commercialised and ready for sale in the third quarter of the 2019 calendar year. 58. There are a number of steps which are required to be completed into the future, before the Application is considered to be fully developed for commercialisation. The required steps have been identified and a detailed plan to commercialisation has been developed. 59. Company A is genuinely focussed on developing the Application for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 2018 to 30 June 2019. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 60. In applying the requirements of subparagraph 360-40(1)(e)(ii), Company A must be able to demonstrate that it has the potential for high growth within a broad addressable market. 61. Company A has high growth potential as the Application is easily scalable to a global audience. 62. Being a Software-as-a-Service (SaaS) available on the cloud, there is a real potential for Company A to expand customers both within the Australian and New Zealand domestic markets and also in other international markets. 63. Gamified training is a growing industry that is predicted to grow substantially into the future. 64. Company A has demonstrated a high growth potential for their business, so subparagraph 360-40(1)(e)(ii) is satisfied for the period XX 20XX to YY 20YY. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 65. In applying the requirements of subparagraph 360-40(1)(e)(iii), Company A must be able to demonstrate that it has the potential to successfully scale up the business. 66. A key feature for Company A for scaling the business is the development a subscription based SaaS that will be hosted on the Cloud. This enables them to quickly and easily accommodate a growing clientele within domestic and global markets. 67. This SaaS model allows them to keep costs down while expanding the business. Once the product is developed, the software based application will require only support staff to support the adoption and use of the Application. 68. It is evident that Company A has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period XX 20XX to YY 20YY. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 69. In applying the requirements of subparagraph 360-40(1)(e)(iv), Company A must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets. 70. Being a Cloud based SaaS, the Application may be adopted anywhere in the world and can thus be considered geographically agnostic. However, the Application will be initially launched in English. As such the initial targets for global expansion will be those markets that have a substantial representation of English speakers. 71. Businesses worldwide aim to develop leadership skills in their employees and, from the information provided, it is apparent that gamified learning for such a purpose is a growing market internationally. Thus, products such as the Application have global appeal. 72. Company A 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 XX 20XX to YY 20YY. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: 73. In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must demonstrate that it has potential to be able to have competitive advantage for that business. 74. The competitive advantage of the Application lies in the differences from their competitors. As discussed above, this is the incorporation of a number of elements into a single product. 75. With these features, Company A hopes to secure a first mover advantage as a market participant offering this particular mix of features in the Application. 76. They aim to maintain this advantage via an ongoing and concentrated investment in new technology and additions to the Application. 77. Thus, Company A has shown that the Application has the potential to be able to have competitive advantages for that business and so satisfies subparagraph 360-40(1)(e)(v) for the period 1 July 2018 to 30 June 2019. | Detailed Reasoning - CONCLUSION FOR PRINCIPLES BASED TEST: 78. Company A satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period XX 20XX to YY 20YY. | Detailed Reasoning - CONCLUSION: 79. Company A meets the eligibility criteria of an ESIC under section 360-40 for the period XX 20XX to YY 20YY.