Private ruling: Early Stage Innovation Company eligibility
Date of advice: 7 September 2016
Published: November 2016
Ruling period: Year ending 30 June 20ZZ

Ruling: Q1: Does Company A meet the criteria of an Early Stage Innovation Company under subsection 360-40(1) of the Income Tax Assessment Act 1997 ? | A1: Yes

Relevant facts and circumstances: 1. Company A was incorporated and registered in the Australian Business Register in 20XX. The director of Company A is Taxpayer A. 2. Company A is developing a software system ('the system'). The system provides a solution and method particularly suited for a variety of customers. 3. Company A is the company currently undertaking the development of the system. 20YY income year 4. Company A lodged their company income tax return and research and development (R&D) schedule for the year ending 30 June 20YY and declared the following: a. total income at item 6 of $L b. total expenses at item 6 of $M, and c. accounting expenditure in item 6 subject to R&D tax incentive of $N added-back at item 7 in the reconciliation statement. 5. The Company A audited financial statements for the year ending 30 June 20YY report the following: a. total income of $L in the profit and loss statement b. total accounting expenses of $M, and c. non-current intangible assets totalling $P at 30 June 20YY. 6. You state the income of $L relates to the 20YY R&D tax incentive refund received by Company A. This refund was received in the 20ZZ income year; however, the income has been included in the 20YY financial year profit and loss to match the incentive income with the year in which the R&D expenditure occurred. 7. Company A did not receive any other income during the 20YY income year. 8. Company A own the intellectual property related to the system software. The Company A 20YY financial statements show intangible assets of $P as at 30 June 20YY, relating to software development. 9. You state that all expenditure directly relating to the development of the software is capitalised in the financial accounts of Company A. 10. During the 20YY income year Company A capitalised expenses totalling $Q primarily relating to software development. 11. You state all of the workers for Company A are engaged as contractors. The expenses to pay these contractors, along with Taxpayer A's salary, have been capitalised and included within the software development intangible asset value. 12. Taxpayer A contributes funds to Company A as required to fund the company. These funds are represented in the Company A balance sheet as a non-current liability which totalled $R at 30 June 20YY. Current structure 13. Company A has one ordinary share on issue, which is owned by Company B. Taxpayer A holds 100% of the issued shares in, and is the sole director of, Company B. 14. Company A does not own shares in any subsidiary companies. 15. Company A holds a provisional patent relating to the system. Company A holds all trademarks associated with the system. Proposed structure 16. You state that prior to the issue of new shares in Company A, the company ownership will be updated such that: a. Company B will dispose of their share in Company A to Taxpayer A's Family Trust, and b. Company B will be deregistered. 17. Company A will remain the company responsible for developing the system. Information provided 18. You have provided a number of documents containing detailed information in relation to the system, including: a. Company A Information Memorandum b. Company A audited financial statements for the year ending 30 June 20YY c. Company A overview d. Detailed reports, including back end system documentation and front end assessment e. System integration documentation f. Provisional patent g. Copy of the draft Shareholders Deed and Share Subscription Agreement h. Financial Model 2 Year forecast, and i. Narrative explanations in response to additional Tax Office questions, including supporting diagrams and workflows. 19. We have referred to the relevant information within these documents in applying the relevant tests to your circumstances. 20. You propose to issue new shares in Company A to various investors to assist in funding the continued development and commercialisation of the system.

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

Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated. | Detailed Reasoning - Qualifying early stage innovation company: 21. Subdivision 360-A sets out the main requirements for an investor to be eligible for the early stage investor tax offset and the modified capital gains tax (CGT) treatment on eligible equity interests. 22. Subsection 360-15(1) outlines the requirements for an investor to assess entitlement to the tax offset. Relevantly, one of those requirements is that a company issues shares to the investor and, immediately after the time that those shares are issued, the company meets the requirements to be an Early Stage Innovation Company (ESIC). 23. Subsection 360-40(1) outlines the criteria required for a company to qualify as an 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': 24. The early stage test determines if the company is at an early stage in its development. In short, the company must satisfy the following requirements at a particular time in an income year: • Recent incorporation or registration in the Australian Business Register • Total expenses of $1 million or less • Assessable income of $200,000 or less, and • Not listed on a stock exchange. 25. These requirements are outlined in detail within paragraphs 360-40(1)(a) to (d). Incorporation or Registration - paragraph 360-40(1)(a) 26. 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). 27. 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. 28. It is considered that a company will satisfy the incorporation test in subparagraph 360-40(1)(a)(i) where, immediately after the issue of shares to the investor, the company had been incorporated in either: • that part of the current year which precedes the issue of shares; or • one of the two income years prior to that year. 29. A company that does not meet any of these conditions will not qualify as an ESIC. Total expenses - paragraph 360-40(1)(b) 30. 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. Assessable income - paragraph 360-40(1)(c) 31. 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. 32. Subsection 360-40(2) provides that in determining the company's assessable income, any amount of Accelerating Commercialisation Grant that the company received in that year can be disregarded. No stock exchange listing - paragraph 360-40(1)(d) 33. 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: 34. 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. These tests determine whether the company is developing new or significantly improved innovations to generate an economic return. 35. For the purposes of Subdivision 360-A, an innovation is considered to be a development of a new or significantly improved product, process, service, marketing or organisational method. 'Principles-based test' - paragraph 360-40(1)(e) 36. 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. 37. 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. 38. 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. Developing new or significantly improved innovations for commercialisation 39. 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. 40. 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. 41. 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. 42. '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. High growth potential 43. 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. Scalability 44. 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. Broader than local market 45. 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. Competitive advantages 46. 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 47. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date on or after 1 July 20YY, but before 30 June 20ZZ. 48. Therefore, for the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20ZZ (the 20ZZ income year). The relevant period for the purposes of this ruling will include the 2 income years prior to the 20ZZ income year. 49. For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending 30 June 20ZZ, 20YY and 20XX. | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) 50. Company A was incorporated in 20XX, which is within the last 3 income years outlined above, therefore subparagraph 360-40(1)(a)(i) is satisfied. Total expenses - paragraph 360-40(1)(b) 51. To meet the requirement in paragraph 360-40(1)(b), Company A must have incurred total expenses of $1 million or less in the 20YY income year, being the income year before the current year. Company A did not own any 100% subsidiaries during the 20YY income year. 52. Company A lodged their company tax return for the year ending 30 June 20YY, reporting total expenses of $M at item 6. This amount corresponds to the total accounting expenses incurred by Company A per the audited financial statements provided for the year ending 30 June 20YY. 53. During the 20YY income year Company A also capitalised expenses totalling $Q relating to the development of the system. 54. As the incurred total expenses for Company A during the 20YY financial year is less than $1 million, paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) 55. To meet the requirement in paragraph 360-40(1)(c), Company A must have derived total assessable income of $200,000 or less in the 20YY income year. Company A did not own any 100% subsidiaries during the 20YY income year. 56. Company A lodged their company tax return for the year ending 30 June 20YY, reporting total income of $L at item 6. 57. As Company A did not receive any other income during the 20YY financial year, the total assessable income derived by Company A in the 20YY financial year is less than $200,000. Therefore, paragraph 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) 58. Company A is privately owned and is not listed on any stock exchange in Australia or a foreign country. Therefore, paragraph 360-40(1)(d) is satisfied. Conclusion on early stage test 59. 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 - Principles based test: Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) 60. Company A is developing a software system. The system provides a solution and method and is particularly suited for a variety of customers. 61. The information you provided outlines in detail how the design of the system. 62. Company A has identified its addressable market as a specific Australian market sector ('Australian market'). 63. Company A will target businesses within and across the various segments within this Australian market. The information you provided outlines in detail the key sectors and industries within this Australian market. 64. You have provided an example of a business utilising the system as a solution across each various market segment. 65. You have provided details of the systems customers currently use in the Australian market. 66. There are only a few companies in the Australian market that currently offer solutions similar to your system. You have provided extensive details comparing features and outlining why your system will be a unique system compared to other available systems. 67. You state there is no other competitor in the Australian market which offers a system comparable to your system. 68. The unique features of the system are patented features which add significant complexity and novelty to the system. Company A holds the provisional patent for the core feature of the system. 69. You state there are new concepts currently being drafted by your patent attorney which will further add to the functionality of system's existing capabilities. Genuinely focussed on developing for commercialisation 70. Company A has taken the following steps in developing the system: a. Planning - including developing the initial concept, validating the model and quantifying potential cost savings b. Design - writing technical specification documentation for software design and engaging a software design specialist agency c. Technology & Infrastructure Preparation - design architecture of system, framework and selecting appropriate programming languages d. Validation - engagement with third party independent consulting company, and e. Staffing - Company A has a team of contractors who have been working together to build the system. 71. Company A is currently at the stage of internally testing the system. Following completion of the internal testing, the team has arranged with a customer to test the system in a real environment. 72. To continue developing the system for commercialisation, the information you provided has identified a number of steps requiring completion. 73. The system will be fully developed when all design and testing has been completed. After this time, the system will be ready for sale to customers. Company A will generate revenue via charging a software licensing subscription fee to customers. 74. You do not expect the system to be fully developed before 30 June 20ZZ. However, this date is subject to change following end-to-end testing along with finishing additional software designs. 75. The above facts demonstrate that Company A has taken tangible steps to lead to the sale of its products, which demonstrate a genuine focus on developing the system for commercial sale. 76. Company A has prepared and supplied an Information Memorandum that outlines the system, target markets, revenue model and forecast value of the company. Conclusion on subparagraph 360-40(1)(e)(i) 77. Company A is genuinely focussed on developing the system for a commercial purpose. The system will be a new or significantly improved product compared to the systems currently used in the Australian market. 78. 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 the system has been fully developed, whichever occurs earliest. The Commissioner considers that once the system has been fully developed, Company A will no longer be 'developing' the system for commercialisation and subparagraph 360-40(1)(e)(i) will no longer be satisfied. High growth potential - subparagraph 360-40(1)(e)(ii) 79. The system will appeal to customers within the Australian market, based upon the following facts: a. Demand - The system will provide a comprehensive unified system to address customer requirements. There is demand within the Australian market for such a system, as it will be easier and quicker to use than current systems. b. Cost savings - Compared to traditional providers, the system expects to provide increased efficiencies and cost savings for customers. 80. Company A are planning to market the system via resellers, as well as directly to customers. The reseller sales model has the potential to provide immediate scale in the Australian market by utilising the footprint of existing resellers within the market. 81. Company A have begun to develop relationships with resellers within the market. 82. The business relating to the system has the potential to rapidly expand its customer base across the Australian market, both via the reseller model as well as direct sales to customers. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 83. The core of the system is the software and technology framework to provide a system and method for customers. The cost of designing and developing this software is a major expense for Company A. Once this underlying technology has been fully designed and tested, Company A will be able to market and increase sales to customers. 84. You state that as Company A expands its sales, it will be able to generate increased revenue with only a minimal increase in its operating costs, due to the software system already being completed. 85. This operating leverage ensures 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) 86. The software based system has been designed to be used as a global system. It has the capacity to service customers immediately in multiple markets. You state that only minor software modifications would be needed to use the system outside the Australian market. This makes Company A well placed to internationalise the system. 87. You state there is a definite intention to expand from the Australian market to International markets. 88. Company A has demonstrated the system has the potential to address a broader market than just the Australian market, including international markets. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. Competitive advantages - subparagraph 360-40(1)(e)(v) 89. Company A have identified a number of differential advantages the system will have over its competitors, as outlined in the information provided. 90. Company A have invested a significant amount of time and expertise into developing the system. There is a high barrier to entry for a competitor to replicate the technological advances within the system. 91. Given the provisional patent registered over the system, you state it would be easier and cheaper for a competitor to licence the system from you for their use, rather than build an entire system. 92. You state Company A have a first mover advantage within the Australian market given the new level of efficiency their product can provide to customers, along with the high barrier to entry for competitors. 93. Company A have demonstrated the potential for the system to have competitive advantages for customers within the Australian market, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test 94. 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 commencing 1 July 20YY until 30 June 20ZZ or the date when the system has been fully developed and is ready for sale, whichever occurs earlier. Conclusion 95. 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 system has been fully developed and is ready for sale, whichever occurs earlier.