Private ruling: Early Stage Innovation Company
Published: August 2017
Ruling period: Year ended 30 June 20ZZ
Date scheme commenced: 1 July 20YY

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 on Date A. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. Company A has no subsidiaries and as it is in its first year of existence it has no expenses or income in the previous income year, i.e. the year ended 30 June 20YY. 3. Company A is developing a range of machines which they will offer to customers in a 'full' service arrangement in which both machines and operating person will be provided under a contract. 4. Company A has identified its ultimate market as being a global market, however will begin operations in Australia. 5. In looking at the existing market Company A has not been able to identify any commercial operator that is offering a similar service using machines similar to theirs. Commercialisation strategy 6. A copy of Company A's commercialisation has been provided. Information provided 7. The applicant provided information in a number of documents and phone conversations in relation to the application; we referred to the relevant information within these documents and conversations in applying the relevant tests.

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: 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 under, subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 8. 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': 9. 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): 10. 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). 11. 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. 12. 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): 13. 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): 14. 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): 15. 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: 16. 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: 17. 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): 18. 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. 19. 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. 20. 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: 21. 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…” 22. 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. 23. 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. 24. 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. 25. 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.” 26. 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.” 27. 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. 28. '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: 29. 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: 30. 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: 31. 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: 32. 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 33. 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 20ZZ. Current year 34. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20ZZ (the 20ZZ 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 20ZZ, 20YY and 20XX, and the income year before the current year will be the year ending 30 June 20YY (the 20YY income year). | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) 35. As Company A was incorporated on Date A, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. Total expenses - paragraph 360-40(1)(b) 36. As Company A is in its first year it had no had expenses in the prior income year and paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) 37. As Company A is in its first year it had no assessable income for the prior income year and paragraphs 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) 38. As Company A is an unlisted public company which is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(a)(d) is satisfied. Conclusion on early stage test 39. Company A will satisfy the early stage test for the entire 20ZZ income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100 point test: 40. 'Company A has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20ZZ. For it to be a qualifying ESIC it will need to satisfy the principles-based test. | Detailed Reasoning - Principles based test: Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) 41. Company A is developing a range of machines use in its target industry. Although it will initially be targeted at the Australian market the machines could be operated anywhere in the world. 42. Company A is of the view that they will be will be the first in the market to offer these machines. 43. In looking at the innovations being developed by Company A, there are two distinct innovations being developed. The first is the Machines themselves and the second is using the machines on behalf of their customers. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) 44. Company A has provided the steps already undertaken in developing their machines. 45. Company A has also provided details of how close the machines are to being commercialised and what is still needed to be done before they can be used to produce income. Conclusion on subparagraph 360-40(1)(e)(i) 46. Company A is genuinely focussed on developing their machines for a commercial purpose. The machines themselves will be a significantly improved when compared with existing machines currently used in the target markets. In addition each model in development improves upon the previous model. 47. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20YY until 30 June 20ZZ or the date when all of the machines in development have been fully developed, whichever occurs earliest. Once the last of the machines have been fully developed and in operation, Company A will no longer be developing them for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. High growth potential - subparagraph 360-40(1)(e)(ii) 48. Company A has provided a prediction for the growth potential within their market. We undertook some additional research which confirmed this information. 49. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 50. Under Company A's business model they intend to operate as a service business. 51. The ability to successfully scale up a service business is limited as need for employees to run their machines add to the variable costs of running the business. 52. In looking at the machines themselves, as the manufacturer Company A can leverage the cost of building and operating their construction facility into the production costs of the Machines. Over time as Company A produces more machines it should result in a lower cost per unit. In addition the business would become increasing more scalable if at some point in the future Company A started suppling their Machines to other service providers 53. Company A as a manufacturer has a far greater potential to scale their business than a non-manufacturing operator could. The fact that they will be a manufacturer of the machines they will use indicates that Company A has the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) 54. Company A will initially be targeted at the Australian market but intends to expand outside of Australia once the use of their machines gains traction in Australia. 55. Company A 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) 56. Company A states that they are unable to identity and of the machines they have available in the market nor is there any other company currently developing similar machines. As a result once their machines are developed they will be the first mover in the market. 57. The application detailed the steps Company A would take to maintain their first mover advantage. 58. As first mover, Company A has demonstrated the potential for their business to have competitive advantages over any competitor wishing to use similar machines in their market and they satisfy subparagraph 360-40(1)(e)(v). Conclusion on principles test 59. As Company A will be the first to manufacture their type of machines for commercial operations they can satisfy the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20YY until 30 June 20ZZ or the date when the machines have been fully developed and are ready for use, whichever occurs earlier. Conclusion 60. Company A meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20YY until the earlier of 30 June 20ZZ or the date when the machines has been fully developed and is ready for sale, whichever occurs earlier.