Private ruling: Early stage innovation company qualification
Date of advice: 18 January 2019
Published: May 2019
Ruling period: Year ended 30 June 20YY
Date scheme commenced: 1 July 20XX

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: Background 1. According to the records from the Australian Securities and Investments Commission (‘ ASIC ’), Company A Pty Ltd (‘ Company A ’) was incorporated in Australia during the 20YY income year. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. Company A is currently jointly owned by A Pty Ltd, B Pty Ltd and C Pty Ltd. It does not have any subsidiaries.

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: 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 - ‘100 point test’ – paragraph 360-40(1)(e) and section 360-45: 10. 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): 11. 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. 12. 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. 13. 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: 14. 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…” 15. The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. Significant is defined in the online Macquarie Dictionary as “ important; of consequence .” 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. 16. 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. 17. 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. 18. 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. 19. 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. 20. 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. 21. ‘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: 22. 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: 23. 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. | Detailed Reasoning - Broader than local market: 24. 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: 25. 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: 26. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be at various dates during the income year ending 30 June 20YY. | Detailed Reasoning - Current year: 27. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20YY (the 20YY 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 20YY, 20XX and 20WW, 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): 28. As Company A was incorporated in Australia during the 20YY income year, 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): 29. As Company A was incorporated in Australia during the 20YY income year, paragraph 360-40(1)(b) is not applicable, as it did not have expenses in the prior year that could breach the threshold provided in subsections 360-40(1)(b). | Detailed Reasoning - Assessable income – paragraph 360-40(1)(c): 30. As Company A was incorporated in Australia during the 20YY income year, paragraph 360-40(1)(c) is not applicable, as it did not have assessable income in the prior year that could breach the threshold provided in subsections 360-40(1)(c). | Detailed Reasoning - No stock exchange listing – paragraph 360-40(1)(d): 31. 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. | Detailed Reasoning - Conclusion on early stage test: 32. Company A will satisfy the early stage test for the entire 20YY income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - 100 point test: 33. Company A has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20YY. For Company A to be a qualifying ESIC it will need to satisfy the principles-based test. | Detailed Reasoning - Genuinely focussed on developing new or significantly improved innovations for commercialisation – subparagraph 360-40(1)(e)(i): 34. Company A is developing an innovative product. It has demonstrated that it has taken tangible steps to identify a gap in the market, create an innovative product to fill the gap in the market and commercialise the product to generate revenue. 35. In addition, Company A is genuinely focussed on developing its product for a commercial purpose. Such product will be a significantly improved product compared to existing products. 36. Therefore, subparagraph 360-40(1)(e)(i) is satisfied for the time period from 1 July 20XX until 30 June 20YY. | Detailed Reasoning - High growth potential – subparagraph 360-40(1)(e)(ii): 37. Company A expects its product to appeal to a wide range of businesses. To this end, Company A has identified a specific addressable market in which it will sell its products. It has undertaken the necessary market and product research to bring its products to the market. 38. The financial projections demonstrate Company A’s high growth potential. The financial projections clearly demonstrate Company A’s potential for high financial growth. 39. There is a demand for the products created by Company A. The information provided shows that there is already a significant market for products, and that the potential growth in the market is sizeable. 40. For these reasons, Company A can demonstrate that it is able to rapidly expand, and subparagraph 360-40(1)(e)(ii) will be satisfied. | Detailed Reasoning - Scalability – subparagraph 360-40(1)(e)(iii): 41. Company A’s plan to increase the scale of its business is detailed in the financial projections. 42. It is noted that Company A’s profit margin increases significantly during the period 20ZZ to 20AA. That is, during this time, its revenue is projected to increase at a faster rate than its expenses. The product can be scaled (both within Australia and internationally) without significant cost. 43. On this basis, Company A can demonstrate that it is able to successfully scale its business with increased revenue and minimal increases to operating costs. 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 is developing its products with a view to expanding into the global market. 46. Company A intends to market its products globally, via online and social media. The Software will be available globally, and the products will be available to users from around the world. 47. Company A’s partnership with other overseas companies will allow it to expand into global markets by using their global networks and experience. 48. Therefore, it is clear that Company A is capable of addressing a market broader than a local market, and that its business can be adapted to a national, multinational, and global scale in the future. 49. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. | Detailed Reasoning - Competitive advantages – subparagraph 360-40(1)(e)(v): 50. Company A provided information as to how its product has the differentiating feature which may give it a competitive advantage. 51. The above differential advantages, together with its first mover advantage have demonstrated the potential for your product to have competitive advantages within the professional business community, satisfying subparagraph 360-40(1)(e)(v). | Detailed Reasoning - Conclusion on principles based test: 52. Company A satisfies the principles based test within paragraph 360-40(1)(e) for the period commencing 1 July 20XX until 30 June 20YY. | Detailed Reasoning - Conclusion: Company A meets the eligibility criteria of an ESIC under subsection 360-40(1) for the period commencing 1 July 20XX until 30 June 20YY.