Private ruling: Early Stage Innovation Company
Date of advice: 21 September 2018
Published: November 2018
Ruling period: Year ended 30 June 20XX
Date scheme commenced: 1 July 20XX

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 during the 20XX income year. 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 $200,000 in the year ended 30 June 20XX. It has not yet generated any assessable income. 3. Company A will focus on the Australian market for the first three years. In the long term, Company A will be providing this product to the global market. 4. Company A is negotiating the terms of the Intellectual Property License Agreement with a Country AB based company for using the one of the specified technologies in Australia, New Zealand and South Asia. 5. Company A is developing the other specified technology with its co-developers. Once this technology is developed, Company A will co-own the intellectual property rights. Negotiation is still ongoing in respect of the terms of the intellectual property license agreement. Commercialisation strategy 6. Company A has completed part of the development and targeted to have both technologies fully developed within the next two to three years. 7. Company A is initially targeting the Australian markets. They will pursue product sales through: a. engagement with both local and foreign governments/councils b. targeted direct sales locally 8. Company A has identified specific potential customers and has engaged with several business owners and regional councils in Australia and overseas. Information provided 9. You have provided information in a number of documents and an email in relation to developing your sustainable agriculture system, including: a. your private ruling application b. supplementary information. 10. We have referred to the relevant information within these documents and conversations in applying the relevant tests to your circumstances. 11. You propose to issue new shares in Company A to various investors to assist in funding the continued development and commercialisation of the Product.

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

Reasons for decision: Summary: All legislative references are to the ITAA 1997 unless otherwise indicated. Company A meets 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 (iv): 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…” 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. 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 - 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 20XX. | Detailed Reasoning - Current year: 26. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX (the 20XX 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 20XX, 20XX and 20XX, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration – paragraph 360-40(1)(a): 27. As Company A was registered on during the 20XX income year, which is within the last 6 income years, subparagraph 360-40(1)(a)(ii) is satisfied. | Detailed Reasoning - Total expenses – paragraph 360-40(1)(b): 28. As Company A incurred total expenses of $1 million or less in the income year before the current year, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - 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. | Detailed Reasoning - 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, subparagraph 360-40(1)(d) is satisfied. | Detailed Reasoning - Conclusion on early stage test: 31. Company A will satisfy the early stage test for the entire 20XX 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): 32. According to Company A, the Product is the first holistic product that will be positioned in the Australian market. The Product has been identified as having an international addressable market. | Detailed Reasoning - Genuinely focussed on developing for commercialisation –subparagraph 360-40(1)(e)(i): 33. Company A has taken the following steps in developing the Product: a. conducted market research in Australia b. partnered with local councils and university and oversea co-developers to further develop the Product to suit Australian market needs c. engaged a commercialization adviser 34. The timeline provides that Company A expects the research site to be set up within the first year with a version ready for commercialization in two to three years. 35. Company A will develop potential customers to increase direct sales. | Detailed Reasoning - Conclusion on subparagraph 360-40(1)(e)(i): 36. Company A is genuinely focussed on developing the Product for a commercial purpose. The Product will be a significantly improved Product compared to existing products. 37. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XX until 30 June 20XX or the date when the Product has been fully developed, whichever occurs earliest. Once the Product 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. | Detailed Reasoning - High growth potential – subparagraph 360-40(1)(e)(ii): 38. Company A expects the Product to appeal to a wide range of businesses. This aids decision making and is particularly useful when assessing product viability in particular markets. 39. Company A is developing the Product in Australia and overseas. They will make their revenue through sales of fresh produce for the first three years. However, Company A will pursue selling the Product and charging support fees to generate greater income in the long term. 40. If the commercialisation strategy is successful, this may give Company A the ability to increase sales through engagement with local government councils and direct sales. 41. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. | Detailed Reasoning - Scalability – subparagraph 360-40(1)(e)(iii): 42. The Product’s business model provided illustrates the increase in projected sales. 43. The initial costs for developing the Product are estimated to be very high, however, given that the Product will be available globally, it is expected that the Product has the potential to successfully scale up its business by passing these costs through each individual sale. 44. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. | Detailed Reasoning - Broader than local market- subparagraph 360-40(1)(e)(iv): 45. Company A’s Product will initially be targeted at the Australian markets but is intended for worldwide use. It will be released globally once it gains traction in the initial targeted markets. 46. Company A has demonstrated the Product 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. | Detailed Reasoning - Competitive advantages – subparagraph 360-40(1)(e)(v): 47. The Product has differentiating features which may give it a competitive advantage. 48. Although Company A is licensing one of the technologies, it will co-own the intellectual property rights to the other technology once it is fully developed. Company A will be the first to offer a Product using both technologies; therefore, it has the first mover advantage. Company A has demonstrated the potential for the Product to have competitive advantages within its targeted market, satisfying subparagraph 360-40(1)(e)(v). | Detailed Reasoning - Conclusion on principles test: 49. 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 20XX until 30 June 20XX or the date when the Product has been fully developed and is ready for sale, whichever occurs earlier. | Detailed Reasoning - Conclusion: 50. Company A meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until the earlier of 30 June 20XX or the date when the Product has been fully developed and is ready for sale, whichever occurs earlier.