Private ruling: Early stage innovation company
Date of advice: 21 September 2018
Published: October 2018
Ruling period: Year ended 30 June 2018
Date scheme commenced: 1 July 2017

Ruling: Q1: Is Company A eligible for the Early Stage Innovation Company (ESIC) status per section 360-40 of the Income Tax Assessment Act 1997 (ITAA 1997) for the 2018 financial year? | A1: Yes

Relevant facts and circumstances: 1. Company A is a private company incorporated in Australia in mid-2014. None of its equity interests are listed on any stock exchange. The director and secretary of the company is Taxpayer A. 2. Shares in Company A were issued in late 2017. A total of over 1,000 Ordinary Shares were issued at a cost of over $200,000. In particular, shares were issued to new investors in late 2017. 3. The majority of shares were purchased by Company B, which is the ultimate holding company of Company A. 4. Company A has developed a software platform to provide a 24/7 online marketplace for both customers and suppliers, by significantly simplifying the ordering process and improve the way businesses are able to source a larger range of wholesalers, products and prices than any stand-alone wholesaler. 5. Company A is considered to be a marketplace operator acting as a limited payment collection agent. Company A is positioned between customers and sellers. Marketplace customers purchase from the sellers directly on the web platform paying via company A utilizing their credit cards. 6. Sellers process the orders and ensure delivery of items. Company A runs a weekly reconciliation of daily bank receipts against confirmed orders from their E-Commerce Platform. 7. An excel spreadsheet is used to check all payments made to suppliers are in line with Company A’s reporting system which generates a distributed Tax Invoice to sellers at the end of each week (Monday to Sunday). A fee of 7% plus GST is deducted from total value of the seller’s delivery dockets/invoices. 8. Bank transfers are made from Company A to sellers for all of the previous weeks payments collected on their behalf. 9. Activities conducted by Company A to develop the software platform at the time of the share issue include: ● Setting up the Relevant Web Services infrastructure for the new version of the Company A shop, ● Fixing major and minor bugs in the existing shop’s codebase, ● Setting up local infrastructure and start building the new version of the shop, and ● Narrowing down “must-have” features as well as outlining the new project. Assumptions

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: Detailed Reasoning - Qualifying Early Stage Innovation Company: 10. Subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997) 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 ‘test time’ for determining whether an entity is a qualifying ESIC is the time immediately after the relevant ESIC shares are issued. 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’: 11. The early stage test requirements are outlined in paragraphs 360-40(1)(a) to (d). | Detailed Reasoning - Incorporation or Registration – paragraph 360-40(1)(a): 12. 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). 13. 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. 14. 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 1 of shares; or ● one of the two income years prior to that year 15. 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): 16. 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): 17. 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): 18. 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: 19. 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: 20. 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. Company A is not applying the 100 point test under section 360-45 for the year ending 30 June 2018. For Company A to be a qualifying ESIC it will need to satisfy the principles-based test. | Detailed Reasoning - ‘Principles-based test’ – subparagraphs 360-40(1)(e)(i) to (v): 21. 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. 22. 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. 23. 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: 24. For the purposes of Subdivision 360-A, an innovation is considered to be a new or significantly improved product, process, service, marketing or organisational method. 2 25. 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. 26. 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. 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 in late 2017, when shares were issued to members of the public, but before 30 June 2018. 34. For the purposes of subsection 360-40(1) of the ITAA 1997, the current year will be the year ended 30 June 2018 (the 2018 income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years includes the years ended 30 June 2016 to 30 June 2018. The income year before the current year is the year ended 30 June 2017 (the 2017 income year). | Detailed Reasoning - Paragraph 360-40(1)(a)(i): 35. To satisfy this paragraph, the company needs to be incorporated within the last three income years (the latest being the current year). 36. The current year is the year ended 30 June 2018. The last three income years are the years ended 30 June 2016, 2017 and 2018. Company A was incorporated in mid- 2014. This is in the year ended 30 June 2015, which is outside the last three income years. Therefore, Company A does not satisfy paragraph 360-40(1)(a)(i) of the ITAA 1997. | Detailed Reasoning - Paragraph 360-40(1)(a)(ii): 37. To satisfy this paragraph, the company needs to satisfy both criteria, namely, to be incorporated within the last six income years (the latest being the current year), and it and its 100% subsidiaries incurred total expenses of $1 million or less across the last three of those income years. 38. Company A was incorporated in mid-2014, and was therefore incorporated within the last six income years. 39. Company A’s total expenses need to be $1 million or less across the current year, the year ended 30 June 2018, and the previous two years, the years ended 30 June 2016 and 2017. 40. Company A is considered to be a marketplace operator which connects wholesalers and retailers. It collects the full payment from the retailer and forwards the payment to the wholesaler, and receives a commission of 7.7%. The full payment collected and banked does not form part of Company A’s assessable income; only the commission received is Company A’s assessable income. Payment forwarded to the wholesalers is not an expense, but merely forwarding payment to the wholesalers. 41. The profit and loss statements for Company A for the years ended 30 June 2016 and 2017 have been revised on this basis. 42. The total expenses incurred in the two income years ended 30 June 2016 and 2017 were: Year ended 30 June Total annual expenses 2016 a 2017 b Total expenses c 43. The share issue was in late 2017. It is accepted that Company A incurred total expenses in the years ended 30 June 2016 and 2017, and up to the share issue in late 2017, less than $1 million. Therefore, Company A does satisfy paragraph 360-40(1)(a)(ii) of the ITAA 1997. | Detailed Reasoning - Paragraph 360-40(1)(a)(iii): 44. To satisfy this paragraph, the company needs to register in the Australian Business Register within the last three income years (the latest being the current year). 45. Company A has not registered in the Australian Business Register within the last three income years. Therefore, Company A does not satisfy paragraph 360-40(1)(a)(iii) of the ITAA 1997. | Detailed Reasoning - Conclusion: 46. Company A satisfies paragraph 360-40(1)(a)(ii) of the ITAA 1997. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b): 47. Company A incurred expenses of $1 million or less in the income year before the current year, and satisfies paragraph 360-40(1)(b) of the ITAA 1997. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c): 48. Company A had total assessable income of $200,000 or less in the income year before the current year, and satisfies paragraph 360-40(1)(c) of the ITAA 1997. | Detailed Reasoning - No stock exchange listing - paragraph 360-40(1)(d): 49. None of Company A’s interests are listed on a stock exchange in Australia or a foreign country. Company A therefore satisfies paragraph 360-40(1)(d) of the ITAA 1997. | Detailed Reasoning - Conclusion on early stage test.: Company A satisfied the early stage test for the 2018 income year, as each of the requirements within subparagraph 360-40(1)(a) to (d) were satisfied | Detailed Reasoning - ‘Principles-based test’: Developing new or significantly improved innovations for commercialisation – subparagraph 360-40(1)(e)(i) 50. Subparagraph 360-40(1)(e)(i) requires two main elements to be present for the provision to be satisfied, being that the company is ‘genuinely focussed’ and is ‘developing new or significantly improved innovations for commercialisation’. 51. Company A is genuinely focussed in providing a 24/7 online marketplace for both customers and suppliers. This will provide customers with a significantly improved solution to obtain the best industry process and products on offer, saving a great deal on costs, time and stress. 52. A new or significantly improved innovation is that Company A offers customers a free to use solution for all their purchasing needs. No similar online ordering programs have a marketplace or the features of Company A. Other platforms require wholesalers to find and invite their customers to use them, which limits the number of customers it attracts. 53. Company A, through its software platform has significantly simplified the ordering process and improved the way retailers are able to source a larger range of wholesalers, products and prices than any stand-alone wholesaler, saving them more time and money. 54. Significant improvements from similar products and notable features within the Company A software platform include: ● search prices, products, minimum orders and delivery times from a large range of suppliers; ● one platform with which to order all a customer’s products; ● wholesalers will no longer compete on trading terms; instead they will be judged on price, quality and service as in almost every other industry; ● receive reporting on purchase made; ● receive reward points and occasional specials on purchases; ● owners no longer need to spend hours every week sorting through invoices to pay multiple suppliers as all payments are made to Company A and then disbursed to their suppliers; ● Company A manages tendering, ordering and payments; ● Credit cards and bad debts will be a thing of the past, with Company A customers never needing to have their accounts managed; ● All payments will be received by credit card before leaving suppliers, reducing the need for sales representatives and improving networking capability; and ● Packaging slips produced at a click of a button. 55. Activities conducted by Company A to develop the software platform at the time of the share issue include: ● Setting up the Relevant Web Services infrastructure for the new version of the Company A shop, ● Fixing major and minor bugs in the existing shop’s codebase, ● Setting up local infrastructure and start building the new version of the shop, and ● Narrowing down “must-have” features as well as outlining the new project. Conclusion on subparagraph 360-40(1)(e)(i) 56. Subparagraph 360-40(1)(e)(i) requires two main elements to be present for the provision to be satisfied, being that the company is ‘genuinely focussed’ and is ‘developing new or significantly improved innovations for commercialisation’. Company A is genuinely focussed in providing an improved online marketplace for both customers and suppliers, and will provide a platform with several significantly improved innovations compared to current products, which will attract new customers resulting in a commercial purpose. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied. High growth potential - subparagraph 360-40(1)(e)(ii) 57. It is estimated that there are more than 40,000 relevant retailers across Australia, with demand for the best industry prices increases every day. The Company A marketplace allows retailers, suppliers and customers to compare and source a larger range of wholesalers, products and prices on one website. 58. The increasing demand for the product and the best industry prices has led to growth in Company A’s target user base, with current growth estimated at 18% month on month. 59. Company A offers both retailers and wholesalers massive savings in time and money by obtaining quality suppliers, new products and competitive prices. Retailers save time by paying only Company A rather than multiple suppliers, while employees save time making orders only to Company A rather than different suppliers. 60. Company A is planning to allow suppliers custom prices for their individual customers. Wholesalers have suggested that with this functionality, they would send many of their customers to Company A. 61. Company A have commenced offering three to four suppliers that offer industry best prices and service for improved cash flow in every industry. 62. Company A has a high growth potential in providing their services to retailers. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 63. Company A’s shareholders have already committed a significantly amount of funds to the research and development phase of the project, and will continue to fund their share of expenses in the commercialisation phase of the project. 64. Gross revenue is expected to increase six-fold from the 2017 income year to the 2020 income year by the time of the Australia wide launch, and over ten-fold by the time of the international launch in 2021. 65. Forecast operating costs are expected to fall below gross margin revenue within four years largely due to the primary overhead of software developer costs reducing proportionally as the platform scales in popularity. 66. 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) 67. Company A has launched its product within Australia by recruiting at least 25 wholesalers from an array of industries. 68. There was an initial beta testing period, where a select group of retailers were invited to trial the platform. Throughout this period, Company A monitored any issues in order to see whether the site clearly conveys its purpose and functionality and that users are able to navigate the site easily. Wholesalers were also assisted during this period to ensure they too understand the process of receiving and filling orders. 69. With these learnings, Company A will be able to automate much of the onboarding process, allowing it to scale with ease. Possible mediums to market Company A within Australia and internationally include: ● Industry magazines and trade shows ● The possible use of call centres ● Cold calling by their team ● Social Media / Linked-in ● Flyers ● Public Relations ● Referral programs ● Word of mouth 70 Company A has plans to scope out Country A marketplace, and plan to launch in Country A in 2021. 71. Company A has the potential to offer its product beyond the local market in Australia, to Country A in 2021. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. Competitive advantages - subparagraph 360-40(1)(e)(v) 72. Company A has exceeded competitors, which have created online ordering programs targeted at the relevant industry, by creating the only marketplace, giving it a clear competitive advantage over competitors. 73. On competitor’s platforms, wholesalers must find and invite their own existing customers to use them, limiting the number of customers they attract, giving Company A a clear competitive advantage. 74. One competing platform, purely targets one group who are willing to buy in large volumes. The system is a type of auction where suppliers must offer a bid and see if their offer is taken up. 75. Another competitor is an ordering platform without the freedom of choice of several suppliers and merely streamlines the ordering process with set buyers. 76. In contrast, Company A has designed its platform to significantly streamline the ordering process for customers and suppliers. There are currently no platforms on the market today, like Company A, that offers customers a free-market solution for all their product purchasing needs. 77. Company A aims to attract customers through offering a unique, convenient service that is free to use, offers rewards programs and also offers a 5% discount on spending in their first month, for customers that have registered. This will help ensure its prices are below industry best prices for the first 30 days and matching best prices thereafter. 78. Company A has demonstrated the potential for its platform to have competitive advantages in the online ordering industry. Therefore, subparagraph 360-40(1)(e)(v) will be satisfied. Conclusion on principles-based test 79. Company A satisfies the principles-based test as it satisfies all of the requirements within subparagraphs 360-40(1)(e)(i) to (v) of the ITAA 1997 for the period ended 30 June 2018. Conclusion 80. Company A meets the eligibility criteria of an ESIC under subsection 360-40(1) for the period ended 30 June 2018. In particular, Company A met the eligibility criteria at the ‘test time’ immediately after the issue of shares to new investors in late 2017. 1 Note that this test is separately applied on each subsequent issue of shares. 2 See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76.