Private ruling: Early Stage Innovation Company qualification
Date of advice: 13 December 2018
Published: April 2019
Ruling period: Year ending 30 June 2019
Date scheme commenced: 1 July 2018

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: No.

Relevant facts and circumstances: 1. Company A was incorporated in Australia during the year ended 30 June 2017. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. 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 2018. It has not yet generated any revenue. 3. Company A.’s goal is to provide the innovation offering a service. Company A has identified its ultimate market as being the global market, with its initial target being Australian domestic markets. 4. There are currently no other service providers in the market offering this service. 5. Company A is developing software. Company A will own the Intellectual Property rights. 6. The Company has identified its addressable market as the Australian market. Commercialisation strategy 7. The innovation’s commercialisation is targeted for the end of the 2019 financial year. The minimum viable product is in progress and then further testing will begin. 8. The commercialisation strategy starts from the development stage where the software is built into a platform. 9. The innovation is initially targeting the domestic Australian market. 10. Within the domestic Australian market, the innovation has identified specific potential customers. Information provided 11. You have provided information in a number of documents and phone conversations in relation to innovation, including: a. the private ruling application b. our phone conversations c. supplementary information provided. 12. We have referred to the relevant information within these documents and conversations in applying the relevant tests to your circumstances. 13. You propose to issue new shares in Company A to various investors to assist in funding the continued development and commercialisation of the innovation.

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

Reasons for decision: Summary: Company A does not meet 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. | Detailed Reasoning - ‘The early stage test’: 2. 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): 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. | Detailed Reasoning - 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. | Detailed Reasoning - 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. | Detailed Reasoning - 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. | Detailed Reasoning - 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. | Detailed Reasoning - ‘Principles-based test’ – subparagraphs 360-40(1)(e)(i) to (v): 10. 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. 11. 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. 12. 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: 13. 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…” 1 14. 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. 15. 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. 16. 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. 2 17. 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.” 18. 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.” 19. 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. 20. ‘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: 21. 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: 22. 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: 23. 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: 24. 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 25. 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 2019. Current year 26. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2019 (the 2019 income year). | Detailed Reasoning - Early stage test: Incorporation or Registration – paragraph 360-40(1)(a) 27. As Company A was incorporated during the year ended 30 June 2017, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. Total expenses – paragraph 360-40(1)(b) 28. 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) 29. As Company A.’s assessable income for the prior income year is less than $200,000 paragraph 360-40(1)(c) is satisfied. No stock exchange listing – paragraph 360-40(1)(d) 30. As Company A is privately owned and is not listed on any stock exchange in Australia or a foreign country paragraph 360-40(1)(d) is satisfied. Conclusion on early stage test 31. Company A will satisfy the early stage test for the entire 2019 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) 32. According to Company A, the innovation is the first holistic product and service of its kind. 33. Company A is developing an IT platform. 34. There is no evidence Company A’s innovation provides a new product or service compared to those already available in the market. Genuinely focussed on developing for commercialisation – subparagraph 360-40(1)(e)(i) 35. Company A has taken steps in developing the innovation. 36. The timeline provides that Company A expects to develop the Minimum Viable Product and conduct further testing, with a version ready for general release by the end of the 2019 financial year. 37. Company A will develop potential customers to increase revenue. Conclusion on subparagraph 360-40(1)(e)(i) 38. Company A is genuinely focussed on developing the innovation for a commercial purpose. However Company A has not established their product is significantly improved compared to existing products 39. Therefore, subparagraph 360-40(1)(e)(i) will not be satisfied for the time period from 1 July 2018 until 30 June 2019. High growth potential – subparagraph 360-40(1)(e)(ii) 40. Company A expects the innovation to appeal to a wide range of businesses. This aids decision making and is particularly useful when assessing product or service viability in the market. 41. Through its commercialisation strategy, Company A hopes to foster widespread use of its product through marketing. 42. Company A is developing the Innovation themselves and by contracting stages of the development to IT professionals. 43. If the commercialisation strategy is successful this may give Company A the ability to increase customers. 44. Therefore subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability – subparagraph 360-40(1)(e)(iii) 45. Company A’s projections provided illustrate the increase in projected sales. 46. Company A’s strategy for the use of the innovation has potential to scale up its business. 47. Therefore subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) 48. Company A’s innovation will initially be targeted in the Australian market. 49. The innovation can be used domestically by any business. Thus, the ultimate addressable market is on an Australian scale and is not confined to a local city, area or region. 50. Company A’s innovation may not have the potential to address a broader market. 51. Therefore subparagraph 360-40(1)(e)(iv) may not be satisfied. Competitive advantages – subparagraph 360-40(1)(e)(v) 52. The innovation has features which we consider do not give Company A a competitive advantage. 53. The innovation has not established their product has differentiating features that are new or offer competitive functions that are not already available in the market. 54. Company A does not have the first mover advantage to provide the product. There are several comparable competitors already established in this particular market. 55. Company A has not established a differential advantage to competitors established in the market. The potential for the innovation to have competitive advantages within the market does not satisfy subparagraph 360-40(1)(e)(v). Conclusion on principles test 56. To meet the principles based innovation test, Company A must meet each of the five conditions. If one or more of the conditions is not satisfied by Company A it will not qualify as an ESIC. 57. Company A does not satisfy all of the principles based test criteria within subparagraphs 360-40(1)(e)(i) for the period commencing 1 July 2018 until 30 June 2019. Conclusion 58. Company A does not meet the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 2018.