Private ruling: Early stage innovation company (ESIC)
Date of advice: 17 December 2018
Published: April 2019
Ruling period: XX 20XX to YY 20YY
Date scheme commenced: 1 xx 20XX

Ruling: Q1: Does Company A satisfy the criteria of an Early Stage Innovation Company (ESIC) pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 (‘ ITAA 1997 ’)? | A1: Yes

Relevant facts and circumstances: 1. Company A is a proprietary company incorporated on x WW 20WW. 2. Company A was registered in the Australian Business Register (ABR) on x XX 20XX. 3. Company A’s directors are Taxpayer A and Taxpayer B. 4. Company A has been dormant since incorporation, so for the financial year ending xx XX 20XX, Company A has incurred and earned the following: ● Total expenses of $0.00 ● Total income of $0.00 5. Company A’s equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country. 6. Company A is developing a computer technology (‘the Product’) which will significantly improve computer processes. 7. The Product is being developed to address a market need for a solution to computer processes. Company A acquired the Company A business, IP and related assets from Company X. The continuing evolution and innovation of the capability of the Product means that this patent protection no longer meets the needs of Company A and the company is preparing a new application for protection of the new capabilities that are now in development. 8. The key innovation of the Product is the capability to convert and enrich computer processes and content. 9. Company A has productised their technology to address a number of discrete markets and is continuing to develop the Product. Company A anticipates that the current programme of development will be completed in the 20ZZ financial year. 10. Company A’s Product has been identified as having an international addressable market. Information provided 11. You have provided a number of documents containing detailed information in relation to Company A’s ‘Product’, including: a. Private Binding Ruling (‘PBR’) Application, dated YY 20XY b. Additional details in Appendices A to G 12. We have referred to the relevant information within these documents in applying the relevant tests to your circumstances. 13. 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 360-15 | Income Tax Assessment Act 1997 section 360-40 | Income Tax Assessment Act 1997 section 360-45

Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 (‘ITAA 1997’) unless otherwise stated. Company A meets the eligibility requirements of an ESIC pursuant to subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 14. 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’: 15. 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): 16. 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). 17. 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. 18. 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): 19. 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): 20. 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): 21. 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: 22. 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: 23. 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): 24. 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. 25. 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. 26. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are: i. the company must be genuinely focussed on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods 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: 27. 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…” 28. The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. 1 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. 29. 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. 30. 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.” 31. The company must be genuinely focussed 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. 32. 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. | Detailed Reasoning - High growth potential: 33. 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: 34. 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: 35. 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: 36. 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: 37. For the purposes of this ruling, the ‘test time’ for determining if Company A is a qualifying ESIC, will be upon the issue of qualifying shares on a particular date or dates on or after x XX 20XX, and on or before yy YY 20YY. | Detailed Reasoning - Current year: 38. Therefore, for the purposes of subsection 360-40(1) ITAA 1997 , the current year will be the year ending yy YY 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending yy YY 20YY, 20XX and 20WW, and the income year before the current year will be the year ending yy YY 20XX (the 20XX income year). | Detailed Reasoning - Incorporation or Registration – paragraph 360-40(1)(a) ITAA 1997: 39. Company A was registered in the Australian Business Register (ABR) on x XX 20XX, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(iii) are satisfied. | Detailed Reasoning - Total expenses – paragraph 360-40(1)(b) ITAA 1997: 40. In applying the requirements of paragraph 360-40(1)(b), Company A and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20XX income year, being the income year before the current year. 41. Company A did not incur any expenses in the 20XX income year. Consequently, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income – paragraph 360-40(1)(c) ITAA 1997: 42. In applying the requirements of paragraph 360-40(1)(c), Company A and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20XX income year, being the income year before the current year. 43. Company A did not earn any assessable income in the 20XX income year. Consequently, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No Stock Exchange listing – paragraph 360-40(1)(d) ITAA 1997: 44. In applying the requirements of paragraph 360-40(1)(d), Company A must not be listed on any Stock Exchange in Australia or a foreign country at the test time. 45. Company A is not listed on any Stock Exchange in Australia or a foreign country at the test time, so paragraph 360-40(1)(d) is satisfied. | Detailed Reasoning - CONCLUSION FOR EARLY STAGE TEST: 46. Company A satisfies the early stage test for the 20YY income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - THE ‘100 POINT TEST’ – PARAGRAPH 360-40(1)(E) AND SECTION 360-45: 47. Company A are electing to seek eligibility by satisfying the Principles based Innovation test under section 360-40(1)(e)(i)-(v), in order to be issued with a Private Binding Ruling. | Detailed Reasoning - Developing new or significantly improved innovations for applicable addressable market – subparagraph 360-40(1)(e)(i) ITAA 1997: 48. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be developing an innovation which is either new or significantly improved for an applicable addressable market. 49. Company A is developing a computer technology (‘the Product’) which will significantly improve computer processes. 50. The key innovation of the Product is the capability to convert and enrich computer processes and content. 51. The market need that Company A addresses is the imperative for organisations to quickly and accurately convert their existing computer content, and new content being created every day – into digital format for their employees and customers. Company A is mobile optimised as standard. 52. Company A is developing their technology to address a number of discrete markets and is continuing to develop several solutions. 53. Company A’s technology incorporates several capabilities. 54. Company A is genuinely focussed on developing the Product, for an applicable addressable market, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 20YY. | Detailed Reasoning - Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997: 55. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company. 56. There are a number of steps which are required to be completed into the future, before the Product is considered to be fully developed for commercialisation: a. Further evolve the enrichment of the processes b. The further extension of AI will allow Company A to infer which items are more precise c. Develop the various solutions to the point where they can operate as Software as a Service. At its current stage of development, the product requires Company A, or an experienced systems integrator, to deliver the service. Once development of the product is finalised, clients will be able to use the product as a stand-alone application and will not require manual intervention or services from Company A’s staff. d. Expand both downstream – Capabilities to create an end to end digital process solution 57. Company A anticipates that the current programme of development will be completed in the 20ZZ financial year. 58. Company A is genuinely focussed on developing their Product, for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 20YY. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 59. In applying the requirements of subparagraph 360-40(1)(e)(ii), Company A must be able to demonstrate that it has the potential for high growth within a broad addressable market. 60. Company A has extremely high growth potential as the Product is easily and infinitely scalable to a global audience. 61. There is a real potential for Company A to expand customers both within the Australian domestic market and also in international markets. Company A’s technical capability is the ability to effectively and efficiently convert computer processes. 62. There were 1.6 Trillion new processes created in 20XX and more than 7 Trillion in existence at 20ZZ. Company A delivers a highly cost effective and efficient means of converting and enriching computer processes from the pre-web formats. 63. The factor driving growth is the imperative of digital transformation in organisations – of which digital documentation is a critical component. While the unit cost of storage is falling at a rate of between 10-12% per annum, the volume of processes is increasing at between 80-90% per annum. There is an imperative for organisations to reduce storage costs and make information more easily accessible to their customers, employees and other stakeholders. 64. Added to this driver in Company A’s key market of financial services is the increasing scrutiny of financial institutions by regulatory bodies. All indications are that these businesses will be required to not only demonstrate compliance in a more dynamic fashion – but also to transform their customer communication to be more transparent and accessible. 65. The capability that Company A has developed has strong market potential across multiple industries. Company A has selected to focus on market services and others at this stage of the company’s growth due to the wealth of opportunities in these sectors. With the current versions of the product Company A are currently working with Company B, Company C, Company D, Company E and Company F. 66. The fully developed product has very strong market potential in other sectors. The product does not have any industry specific limiting factors – therefore, once the product is finalised there will be minimum barriers to entry into subsequent industries. There currently does not exist another competitor which has a solution. Company A will provide a solution that can be implemented to any industry. 67. Company A is seeking ESIC status in order to execute a capital raise that will allow an expansion of: a. Business Development and Pre-Sales Tech resources to increase market penetration, develop channel sales and offer a white label version of the technology b. Technical Development resources to continue to innovate and evolve the product to enable the company to scale quickly c. Intellectual Property Protection 68. The organisational demand globally for computer processes will continue to grow exponentially, driven by changes in the regulatory environment and an overall drive for better governance in the operations of both corporate and government agencies. 69. Company A has demonstrated a high growth potential for their Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period x XX 20XX to y YY 20YY. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 70. In applying the requirements of subparagraph 360-40(1)(e)(iii), Company A must be able to demonstrate that it has the potential to successfully scale up the business. 71. The reasoning behind Company A’s desire to secure ESIC status is to be able to raise capital that will enable the scale up of Company A’s business. Capital will be applied to both growing the business development capacity and investing in product development. 72. A key requirement for Company A for scaling the business is the development of a SaaS version of the Product. The current version of Company A’s Conversion and Enrichment technology requires engagement of Company A services for implementation. 73. Once relevant SaaS versions have been integrated and funded for, Company A will be able to maintain operational costs on a low as the required head count for process staff is not required. The Product will be self-sufficient and for all tried and tested industries, the Product will be automated, thus only requiring support staff on the rare occasion customers may have questions or require assistance. 74. This leverage ensures that Company A has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period x XX 20XX to y YY 20YY. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 75. In applying the requirements of subparagraph 360-40(1)(e)(iv), Company A must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets. 76. The nature of Company A’s Product is that it is geographically market agnostic. 77. Company A’s Product has been developed to be platform agnostic so that it will easily integrate with any number of organisational management systems. 78. Company A’s Product aims to solve a global issue surrounding conversion of computer processes to value driving knowledgeable technology. 79. Company A already has customers that are seeking to apply the product beyond Australia and are in discussion with potential customers in the Country A, Country B, Country C and Country D. Further capital will enable Company A to accelerate their entry into offshore markets. 80. Company A has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied for the period x XX 20XX to y YY 20YY. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: 81. In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must demonstrate that it has potential to be able to have competitive advantage for that business. 82. Company A currently has a first mover advantage in a huge market that is frustrated with the current limited functionality of computer processes. Company A’s technology is the only solution on the market currently that enables transformation and enrichment of computer processes at scale. 83. Company A has a significant cost advantage over alternate manual or technical methods – costing less than 10% of these approaches. 84. This first mover advantage will not remain forever and as a result Company A continues to innovate and evolve to stay ahead of any potential competitor / new entrant (although one has not been identified to date). 85. The differentiation of the Company A offering is built around the capability of the product to quickly, accurately and cost effectively convert computer processes This can only now be done via a very labour intensive and error prone alternatives. 86. Substitute products are not available in the Australian or, to the best of Company A’s knowledge, international markets. 87. Company A is continuing to develop the Product to suit the needs of the market. For example, Company A is developing regulatory compliance loops to allow visibility to computer processes. 88. Company A is anticipating future user needs beyond the current core function of the Product. 89. There is no real competitor offering in the market today. 90. The Company A Product in effect competes against manual processes. The approach that Company A has adopted from a strategy development point of view is that they have assumed market entrants will materialise. As a result, they are in the process of developing the base functionality into various products that meet the needs of various market segments and decision makers. 91. Company A will continue to develop products that will ensure that the Company A capability meets the needs of various potential customers that face challenges that are unique to their market segment. With a core technology that does not exist anywhere else in the market, Company A is able to leverage its first mover advantage by adding capabilities to address specific needs of a market segment. 92. Company A had IP protection in place in the form of a patent. Company A acquired the Company A business, IP and related assets from Company X on yy YY 20XX. Company X was a related entity to Company A, sharing common shareholders and directors. The IP was sold to Company A as there was a business relationship breakdown between various shareholders and the sale of the business provided a resolution to the situation which enabled the IP to be further developed and commercialised. The continuing evolution and innovation of the capability of the Product means that this patent protection no longer meets the needs of Company A and the company is preparing a new application for protection of the new capabilities that are now in development. 93. Company A has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period x XX 20XX to y YY 20YY. | Detailed Reasoning - CONCLUSION FOR PRINCIPLES BASED TEST: 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 x XX 20XX to y YY 20YY. | Detailed Reasoning - CONCLUSION: Company A meets the eligibility criteria of an ESIC under section 360-40 for the period x XX 20XX to y YY 20YY.