Private ruling: Early Stage Innovation Company
Date of advice: 29 May 2017
Published: October 2017
Ruling period: Year ending 30 June 2017
Date scheme commenced: 1 July 2016

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 in Australia in 2016. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. The Company has no subsidiaries and has expenses less than $1 million in the previous income year, and assessable income less than $200,000. 3. The Company owns the intellectual property of a device whose software offers strong encryption and secure storage. 4. A decision was made to incorporate the Company in Australia and transfer the intellectual property related to the Company with a view to raise funding and further develop the product and market potential. 5. The Company is developing product lines to complement its hardware device. 6. The Company has entered into Reseller Agreements internationally. Information provided 7. The Company provided the further information explaining the innovation’s key features, growth and scalability potential, a commercialisation timeline and competitor analysis.

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: 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. 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. 24. The OECD Oslo Manual defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. 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. The EM does not define the meaning of the term 'genuinely focussed’ within the context of subparagraph 360-40(1)(e)(i). Genuine is defined in the online Macquarie Dictionary as “ Being truly such; real; authentic .” Focus is defined as “ 3. a central point, as of attraction, attention, or activity. … 8. to concentrate; to focus one's attention. ” In essence, the phrase “genuinely focussed” is looking to what the company is truly concentrating and focussing their attention on or, put another way, what is the real central point of the company’s activities. 29. 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. 30. 'Commercialisation’ is discussed further at paragraph 1.81 in the EM which states “Commercialisation encompasses a spectrum of activities including those leading to the sale of new or significantly improved product, process or service as well as activities involving the implementation of a new, or significantly improved, process or method, where the process or method directly leads to the generation of economic value for the company.” | Detailed Reasoning - High growth potential: 31. 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: 32. 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: 33. 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: 34. 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: 35. 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. | Detailed Reasoning - Current year: 36. 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). | Detailed Reasoning - Incorporation or Registration – paragraph 360-40(1)(a): 37. As The Company was incorporated in May 2016 which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. | Detailed Reasoning - Total expenses – paragraph 360-40(1)(b): 38. As The Company had expenses less than $1 million in the prior income year, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income – paragraph 360-40(1)(c): 39. As The Company’s assessable income for the prior income year is less than $200,000 paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No stock exchange listing – paragraph 360-40(1)(d): 40. As The Company is privately owned and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(a)(d) is satisfied. | Detailed Reasoning - Conclusion on early stage test: 41. The Company will satisfy the early stage test for the entire 2017 income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - Developing new or significantly improved innovations for commercialisation – subparagraph 360-40(1)(e)(i): 42. According to The Company they are innovative in the sense that they give previously unheard of control of security and data to users. 43. The OECD Oslo Manual specifically excludes as innovations, minor changes or improvements, routine upgrades, customisation for a single client, or design changes that do not alter function of a good or service. The Company on the other hand produces new products, despite utilising existing hardware and software. In the case of one product it is not a routine upgrade as the new product is significantly improved. 44. Further, the application products are design changes that alter its function. The existing products in the market do not allow for the security of these proposed products. | Detailed Reasoning - Genuinely focussed on developing for commercialisation – subparagraph 360-40(1)(e)(i): 45. According to the timeline provided, The Company is in the stage of developing and testing its new products, with releases still expected in the future. | Detailed Reasoning - Conclusion on subparagraph 360-40(1)(e)(i): 46. The Company is genuinely focussed on developing its applications for a commercial purpose. The products represent more than routine upgrades and will be significantly improved products compared to existing products. 47. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 2016 until 30 June 2017 or the date when all innovations haves been fully developed, whichever occurs earliest. Once the innovations have been fully developed, The Company will no longer be 'developing’ the applications for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. | Detailed Reasoning - High growth potential – subparagraph 360-40(1)(e)(ii): 48. The Company has demonstrated that it has achieved traction in the marketplace to date. For instance it has entered into Reseller Agreements internationally. 49. In addition, The Company is operating in a global market that is experiencing strong growth. 50. These factors indicate a high growth potential. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. | Detailed Reasoning - Scalability – subparagraph 360-40(1)(e)(iii): 51. The business model of The Company involves adding applications as they are developed. The cost of adding further applications diminishes incrementally over time, thus demonstrating scalability. 52. Given that the innovations in question will be available internationally, it is expected that the innovations have the potential to successfully scale up the business. 53. In short, The Company can demonstrate the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. | Detailed Reasoning - Broader than local market- subparagraph 360-40(1)(e)(iv): 54. The Company applications can be used domestically and 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. 55. The Company has demonstrated its innovations have 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. | Detailed Reasoning - Competitive advantages – subparagraph 360-40(1)(e)(v): 56. The key differences offered via The Company’s applications include privacy and security being controlled by users. This is a major change to other products on the market currently. 57. Being the first of such, The Company has the first mover advantage. The Company has demonstrated the potential for its applications to have competitive advantages its industry, satisfying subparagraph 360-40(1)(e)(v). | Detailed Reasoning - Conclusion on principles test: 58. 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 1 July 2016 until 30 June 2017 or the date when its innovations have been fully developed and ready for sale, whichever occurs earlier. | Detailed Reasoning - Conclusion: 59. The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 2016 until the earlier of 30 June 2017 or the date when its innovations have been fully developed and ready for sale, whichever occurs earlier.