Private ruling: Early stage innovation company (ESIC)
Date of advice: 10 July 2018
Published: September 2018
Ruling period: Income year ended 30 June 20xx
Date scheme commenced: May 20xx

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

Relevant facts and circumstances: A Pty Ltd was incorporated in May 20xx. A Pty Ltd and its wholly owned subsidiary started trading in April 20xx. A Pty Ltd owns 100% of the shares in B Pty Ltd and, through this association, A controls and owns the results of the innovation, which has been developed for use in Australia and New Zealand. Under the general principles of agency, A Pty Ltd has engaged B Pty Ltd to undertake the research and development activities to develop the innovation, for the sole benefit of the ultimate owner of the innovation, being A Pty Ltd. A Pty Ltd is developing an innovation which will be unique within a particular industry, offering a process that has not previously been available. Additional investment has been sought in order to complete this development and commercialisation of the innovation. A Pty Ltd and B Pty Ltd together derived assessable income of less than $200,000 in the 20xx financial year. A Pty Ltd and B Pty Ltd together incurred expenditure of less than $1m in the 20xx financial year. The industry is Australia wide but also has a large global presence. The innovation has been operating in one state of Australia since April 2017, and has achieved a number of users in the industry. Plans are to expand across Australia, New Zealand, and globally. A Pty Ltd has provided the reasons that it considers it to be highly innovative. Patent protection over the data generated by the innovation has been applied for. A Pty Ltd is not listed on any stock exchange of any country. A Pty Ltd is seeking eligibility to quality as an Early Stage Innovation Company (ESIC) under the principles-based innovation test.

Relevant legislative provisions: Section 360-40 of the Income Tax Assessment Act 1997

Reasons for decision: Summary: A Pty Ltd meets the requirements to become an Early Stage Innovation Company (ESIC) under section 360-40 of the Income Tax Assessment Act 1997 (ITAA 1997). | Detailed Reasoning - Detailed reasoning: Subsection 360-40(1) of the ITAA 1997 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. The early stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d) of the ITAA 1997. | Detailed Reasoning - Incorporation or Registration: To meet the requirement in paragraph 360-40(1)(a) of the ITAA 1997, at a particular time (the test time) in an income year (the current year) the company must have been either: ● incorporated in Australia within the last three income years (the latest being the current year); or ● 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 ● registered in the Australian Business Register (ABR) within the last three income years (the latest being the current year). A Pty Ltd was incorporated in May 20xx and thus meets the first requirement above. | Detailed Reasoning - Total expenses: To meet the requirement in paragraph 360-40(1)(b) of the ITAA 1997, the company and its 100% subsidiaries must have incurred total expenses of $1 million or less in the income year before the current year. A Pty Ltd meets this requirement as it and its wholly owned subsidiary incurred expenditure in the 20xx income year of less than $1 million. | Detailed Reasoning - Assessable income: To meet the requirement in paragraph 360-40(1)(c) of the ITAA 1997, 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. This requirement is satisfied as A Pty Ltd and its wholly owned subsidiary derived assessable income of less than $200,000 in the 20xx income year. | Detailed Reasoning - No stock exchange listing: To meet the requirement in paragraph 360-40(1)(d) of the ITAA 1997, the company must not be listed on any stock exchange in Australia or a foreign country. This requirement is satisfied as A Pty Ltd is not listed on any stock exchange in any country. | Detailed Reasoning - Innovation tests: In accordance with paragraph 360-140(1)(e), 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’: The applicant has advised that A Pty Ltd is not seeking eligibility under this test to quality as an ESIC. | Detailed Reasoning - ‘Principles-based test’: To satisfy the principles-based test, a company must meet five requirements in paragraph 360-40(1)(e) of the ITAA 1997. This is tested at a time immediately after the relevant new shares are issued to the investor. A company can demonstrate that it meets each requirement through existing documentation such as a business plan, commercialisation strategy, competition analysis or other company documents. A company must be able to show that tangible steps have been or will be taken in relation to each of the requirements. The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) of the ITAA 1997 are: ● the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation ● the business relating to that innovation must have a high growth potential ● the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation ● 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 ● 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: For the purposes of Subdivision 360-A of the ITAA 1997, 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… 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. 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. 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. In discussing services innovation activity, paragraph 111 of the OECD Oslo Manual states: Innovation activity in services also tends to be a continuous process, consisting of a series of incremental changes in products and processes. This may occasionally complicate the identification of innovations in services in terms of single events, i.e. as the implementation of a significant change in products, processes or other methods. 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. 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. ‘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: 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: 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: 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: 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 - The company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation: Based on the facts provided, A Pty Ltd and its subsidiary are genuinely focused on developing the innovation commercialisation. This product is an improved innovation over products already available in the market. | Detailed Reasoning - The business relating to that innovation must have a high growth potential: A Pty Ltd can demonstrate that the business relating to the innovation has a high growth potential. | Detailed Reasoning - The company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation: A Pty ltd can demonstrate that it has the potential to be able to successfully scale up the business. 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 A Pty Ltd can demonstrate that it has the potential to be able to address broader and global markets. | Detailed Reasoning - The company must demonstrate that it has the potential to be able to have competitive advantages for that business: A Pty Ltd can demonstrate it has the potential to be able to have competitive advantages for that business. | Detailed Reasoning - Conclusion on the principles-based test: A Pty Ltd satisfies the principles-based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) of the ITAA 1997 for the period commencing 1 July 20xx until 30 June 20xx. | Detailed Reasoning - Overall conclusion: A Pty Ltd meets the eligibility criteria of an ESIC under section 360-40 of the ITAA 1997 for the period commencing 1 July 20xx until 30 June 20xx.