Private ruling: Early stage innovation company eligibility
Date of advice: 28 June 2018
Published: September 2018
Ruling period: 1 July 20XX to 30 June 20YY
Date scheme commenced: 1 July 20XX

Ruling: Q1: Does Company A qualify as 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: Background 1. Company A (the “Company”) is a proprietary company, limited by shares, incorporated in Australia on XX XX 20XX. 2. The Company directors are Mr Apple and Mr Orange. 3. The Company has a 100% owned subsidiary, Company B (the “Subsidiary”). 4. The Company and its Subsidiary are tax consolidated. 5. For the financial year ending 30 June 2017, the Company and its Subsidiary have incurred and earned the following: a. Total expenses of $XX.XX b. Total income of $XX.XX 6. The Company’s equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country. 7. The Subsidiary has acquired a combination of copyright and intellectual property rights. The Subsidiary owns the rights, title and interest to any new intellectual property it develops. The Company is carrying out all the other activities in relation to developing and commercialising the product. The Subsidiary has made an assignment of intellectual property rights to the Company. Description of the Company’s business premise 8. The Company is a business within an industry. 9. The Company is developing a family of products for use in a number of markets. 10. The Company intends to design, assemble, distribute, and fully support the next generation of products in these markets. 11. The Company will not manufacture components. This function will be outsourced. 12. The initial addressable market is Location A. Information provided 13. You have provided a number of documents containing detailed information in relation to the Company, including: a. Private Ruling Application (the “Application”), dated XX XX 20XX. b. The Company Business Plan 20XX/20XX. 14. We have referred to the relevant information within these documents in applying the relevant tests to your circumstances.

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. | Summary: Company A meets the eligibility requirements of an ESIC under subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 15. 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’: 16. 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): 17. 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). 18. 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. 19. 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): 20. 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): 21. 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): 22. 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: 23. 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: 24. 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): 25. 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. 26. 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. 27. 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: 28. 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… ” 29. 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. 30. 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. 31. 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.” 32. 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. 33. 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: 34. 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: 35. 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: 36. 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: 37. 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: 38. For the purposes of this ruling, the ‘test time’ for determining if the Company is a qualifying ESIC will be a particular date during the income year ending 30 June 20XX. | Detailed Reasoning - Current year: 39. Therefore, for the purposes of subsection 360-40(1) ITAA 1997 , 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 3 income years will include the years ending 30 June 20XX, 20YY and 20ZZ, and the income year before the current year will be the year ending 30 June 20WW (the 20WW income year). | Detailed Reasoning - Incorporation or Registration – paragraph 360-40(1)(a) ITAA 1997: 40. The Company was incorporated on XX XX 20XX, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) are satisfied. | Detailed Reasoning - Total expenses – paragraph 360-40(1)(b) ITAA 1997: 41. In applying the requirements of paragraph 360-40(1)(b), the Company and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20WW income year, being the income year before the current year. 42. The consolidated 20WW income tax return indicates that the Company and its Subsidiary had total expenses of $XX.XX in the 20WW financial year. Consequently, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income – paragraph 360-40(1)(c) ITAA 1997: 43. In applying the requirements of paragraph 360-40(1)(c), the Company and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the income year before the current year. 44. The consolidated 20WW income tax return indicates that the Company and its Subsidiary had total income of $XX.XX in the 20WW financial year. Consequently, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No Stock Exchange listing – paragraph 360-40(1)(d) ITAA 1997: 45. As the Company 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 FOR EARLY STAGE TEST: 46. The Company satisfies the early stage test for the 20XX 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. The Company has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20XX. For the Company to be a qualifying ESIC, it will need to satisfy the principles-based test. | Detailed Reasoning - Developing new or significantly improved innovations – subparagraph 360-40(1)(e)(i) ITAA 1997: 48. In applying the requirements of subparagraph 360-40(1)(e)(i), the Company must be developing an innovation which is either new or significantly improved for an applicable addressable market. 49. The Company is currently developing the first commercially available product in the addressable market, known as the Product. 50. The Product will incorporate a number of significant technology advances. 51. It is anticipated that the Product will be the first in a family of products to be developed by the Company. 52. It is clear that the Product will be a new and innovative product compared to other available products in the addressable market. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997 53. In applying the requirements of subparagraph 360-40(1)(e)(i), the Company must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company. 54. The R&D phase for the Product commenced in XX 20XX, and it is anticipated to run for 24 months. 55. It is anticipated that the pre-production phase will commence in January 20XX. 56. It is anticipated that the commercial phase will also commence in January 20XX. 57. The Company expects the launch Product to be fully developed by the end of the 20XX calendar year. 58. A sales program for the products has already commenced, and deposits have been received for eight (8) Products to date. 59. It is clear that the Company is genuinely focussed on developing the innovation for commercialisation. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 60. In applying the requirements of subparagraph 360-40(1)(e)(ii), the Company must be able to demonstrate that it has the potential for high growth within a broad addressable market. 61. The Company estimates that the addressable market is in excess of X,XXX units per annum. 62. The Company is in the process of developing a comprehensive ‘go to market’ strategy in conjunction with third-party agencies. It is expected that this strategy will be completed by the end of Q3 20XX. 63. The Company has demonstrated a high growth potential, so subparagraph 360-40(1)(e)(ii) is satisfied. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 64. In applying the requirements of subparagraph 360-40(1)(e)(iii), the Company must be able to demonstrate that it has the potential to successfully scale up the business. 65. As the Company increases its sales, it will be able to generate increased revenue with only a minimal increase in its operating costs. 66. This operating leverage ensures that the Company has the potential to successfully scale up the business. 67. Total revenue is projected to increase exponentially, increasing from a projected $X,XXX in the 20XX financial year, to $XX,XXX,XXX in the 20XX financial year. 68. Given the above, subparagraph 360-40(1)(e)(iii) will be satisfied. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 69. In applying the requirements of subparagraph 360-40(1)(e)(iv), the Company must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets. 70. The Company has a very simple portable, and adaptable business model. The Company will design, assemble, and distribute the products, however, the manufacture of components will be outsourced. 71. The Company’s target market in the first instance is a foreign country, however, the Company has the potential to rapidly expand its customer base internationally. 72. The Company’s business model will be applied to the global market with very little or no localisation or customisation required. 73. The Company has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: 74. In applying the requirements of subparagraph 360-40(1)(e)(v), the Company must demonstrate that it has potential to be able to have competitive advantage for that business. 75. The Company has no direct competitors in the current market, giving the Company first mover advantage. 76. The Company has identified a number of differentiating features of its products. 77. Intellectual property underpinning the innovation has been obtained by the Subsidiary, and these rights have been assigned to the Company. 78. The Company has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied. | Detailed Reasoning - CONCLUSION FOR PRINCIPLES BASED TEST: The Company 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 20XX until 30 June 20YY. | Detailed Reasoning - CONCLUSION: The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until 30 June 20YY.