Private ruling: Early stage innovation company
Date of advice: 9 June 2017
Published: October 2017
Ruling period: Year ending 30 June 2017
Date scheme commenced: 1 July 2016

Ruling: Q1: Does Company A qualify as 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: Company B 1. In 2015, Company B was incorporated. Company A currently holds 100% of the shares in Company B. a. Company B is the operating company for the group. b. To date the company has not generated any assessable income. Company A 2. Company A is a private company incorporated in Australia in 2016. None of its equity interests are listed on any stock exchange. The director and secretary of the company is Taxpayer A and the shareholding is spread across 20 shareholders. 3. Shares in Company A were issued to members of the public in December 2016. You state that five or six of your current shareholders are sophisticated investors. 4. The company was founded by Taxpayer A and Taxpayer B, in response to challenges they faced in their workplace as part of their training. Specifically, they identified that each workplace had different processes, policies and procedures that needed to be followed, and the information required was not readily available. 5. Company A aims to generate efficiencies for the workplace by providing employees with the tools to do their jobs more efficiently. To achieve these objectives, Company A is developing cloud based workplace management systems for employees. a. One of the founders, Taxpayer A, who is also a software engineer with a business background, has suspended his employment to work full-time on Company A on both the software engineering and business development sides of the business. b. All five staff members working for Company A are employed by Company B. 6. Company A has developed two mobile applications (apps). Company A owns the intellectual property associated with the two products and generates revenue by annually licensing the app to workplaces. It is in the process of registering its trademark and has applied for the trademarks to be registered globally. 7. Company A was assigned intellectual property by Taxpayer A via an Intellectual asset assignment deed in 2017. 8. Company A was assigned intellectual property by Company C via an Intellectual asset assignment deed in 2017. 9. You explain that Company A has not registered any patents for its products as a result of difficulties in enforcing patents for software. a. You decided that it was not a good investment for Company A to patent its applications due to your cost benefit analysis, together with the fact that there was a risk that the patent may not be enforceable in practice. b. b. Furthermore, as Company A commenced developing its intellectual property more than 12 months ago, there is now a 'prior art’ in the intellectual property and, as such, it can no longer be patented. c. Should the company develop intellectual property in the future that is capable of being patented, it will consider whether to register a patent at that point in time. 10. Company A is seeking to raise capital to further develop and sell products in the specific markets in Australia. You state that the company is not required to make a disclosure under section 708 of the Corporations Act 2001 in relation to any share offerings as the 'small scale offerings’ exemption applies to you. App 1 11. Company A’s current key focus is app 1 which is aimed to assist various employees in the workplace. It is an on boarding platform that centralises policies and procedures so that it is easily accessible to staff that regularly move between workplaces to operate efficiently. 12. The app 1 creates efficiency for workforce management by providing important workplace information, up-to-date rosters and provides a phone directory of the relevant contacts within the workplace. 13. The app 1 is intended to have 'value add’ features to be developed which will include managing compliance, shift swapping, training, education and other interactions between workplace management and their staff. 14. You state that the development and testing for app 1’s initial iteration has been completed and the first license was granted to a workplace in 2015. However the app was specific to that workplace and was not applicable to other workplaces without further developments. 15. Company A sees the development of app 1 as occurring in three tranches, being the initial prototype, more advanced app, and the final development. 16. It is currently generating revenue with licencing to various workplaces, with more workplaces expected before the end of 2017. 17. Although currently being on the market, Company A intends to continue further developing and testing the app 1 by adding more features. 18. You state that the key differentiators between the app 1 and other similar applications on the market are ● inefficiencies and costs of workplaces are addressed; ● provides crucial information when staff need it, and ensures currency of information across all staff; ● site-specific policies, procedures, phone directory and pager numbers, timetabling, education, shift management are centralised; ● up to five times efficiency gains on administrative tasks, as confirmed with a similar app used in the United Kingdom. App 2 19. App 2 is a workflow management tool, which assists workplaces to manage busy workflow. The app facilitates the distribution of task between staff on call to best manage time and achieve customer outcome. 20. It also assists with employee handover processes, allowing an audit trail for customer tasks, enabling complete transparency by workplaces. 21. App 2 is in the first phase of development. Company A’s intention is to have it completed around July 2017 with implementation and trials to occur over the rest of 2017. 22. Company A expect to undertake multiple phases of development and aim to commercialise the app 2 in 2018. 23. You state that due to the fact that the app 2 is the company’s key focus, Company A considers the app 2 as a secondary priority. You explain that as a result of the success of the app 1, Company A does not have the capacity to focus on two products at once. When the planned developments of the app 1 are completed, you state that Company A will then focus on the app 2. 24. Company A has been shortlisted for a third party program – designed to take the tech business idea and develop it into a profitable company as fast as possible. 25. Company A has identified its addressable market as various workplaces in an Australian state, with expansion to other Australian states and overseas markets. It intends to expand the market beyond Australia to comparable overseas workplace systems. 26. In the long term, Company A envisage an expansion into industries that are compliance driven and have casual labour markets like construction and mining. Information provided 27. You have provided information in a number of documents and phone conversations in relation to your private ruling application, including: a. Your private ruling application encompassing: ● Briefing documents for investors; ● Strategic plan for 2014/16; ● Pitch deck; ● Details of the app 1; ● Financial projections; and ● Handwritten plans. b. Response to our request for information c. Copy of trademark registration d. Copy of third party program We have referred to the relevant information within these documents and conversations in applying the relevant tests to your circumstances. Assumption(s) N/A

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 Further issues for you to consider | N/A

Reasons for decision: Summary: All legislative references are to the ITAA 1997 unless otherwise indicated. | Detailed Reasoning - Question 1:: Does Company A qualify as an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997)? | Summary: Company A meets the eligibility requirements of an ESIC under subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 28. 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 '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’: 29. 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): 30. 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). 31. 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. 32. 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 of shares; or ● one of the two income years prior to that year 33. 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): 34. 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): 35. 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): 36. 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: 37. 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: 38. 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 2017. 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 (iv): 39. 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. 40. 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. 41. 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: 42. 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. 43. 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. 44. 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. 45. 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. 46. '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: 47. 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: 48. 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: 49. 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: 50. 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: 51. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date on or after 1 July 2016, but before 30 June 2017. Shares in Company A were issued to members of the public in December 2016. 52. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2017 (the 2017 income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years includes the years ending 30 June 2015 to 30 June 2017.The income year before the current year is the year ending 30 June 2016 (the 2016 income year). | Detailed Reasoning - 'The early stage test’: 53. Company A was incorporated after 1 July 2016, which is within the current income year and satisfies subparagraph 360-40(1)(a). 54. The year before the current year is the year ended 30 June 2016. As Company A was incorporated in the year ended 30 June 2017, it could not have incurred any expenses in the year ended 30 June 2016. 55. Company A holds 100% of shares in company B, which is therefore a 100% subsidiary of Company A. Company B did not incur any expenses during the income year ending 30 June 2016. Consequently, paragraph 360-40(1)(b) is satisfied. 56. Company A and Company B had nil assessable income for the year ended 30 June 2016, thereby satisfying paragraph 360-40(1)(c). 57. As Company A is a private company that has not been listed for quotation on any foreign or domestic stock exchange that company satisfies paragraph 360-40(1)(d). | Detailed Reasoning - Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i): 58. 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’. 59. Company A states that its main focus is on the app 1. Development for app 1 is ongoing with modifications to adapt the app to make it site-specific for each workplace. The app 1 is currently generating revenue with licencing to various workplaces, with more workplaces to come on board. 60. Company A states that due to the success of the first iteration of app 1, they do not have capacity to focus on both apps at once. App 2 is of second priority and will be of focus after further development of the app 1. 61. App 2 is undergoing testing and Company A intends to complete the initial phase by July 2017. App 2 is expected to undertake multiple phases of development with an aim for commercialisation in 2018. 62. Company A has identified inefficiencies in work practices in relation to junior employees needing to deal with contrasting policies and procedures, and communication between different workplaces. The app 1 was trialled in two workplaces in 2015, followed by four workplaces in 2016, and is now in 14 workplaces across Australia, with further intended expansion overseas. It is accepted that Company A is genuinely focussed on developing the app 1. 63. This conclusion is confirmed by example 1.6 in the Explanatory Memorandum for Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 JS & RD Co is a small start-up company in the pharmaceutical industry seeking funding to develop a new process to manufacture a known pain medication. If the company can successfully scale up its process, the new process promises to be more efficient and more environmentally friendly than the conventional manufacturing process used by incumbents. Even though JS & RD Co does not intend to licence the innovation to another company, the innovation has the potential to provide the company with a direct competitive advantage over its rivals and generate significant economic value. As a result, JS & RD Co has developed the innovation for a commercial purpose. 64. With regards to the development of a new or significantly improved innovation for commercialisation, Company A was founded by two employees in response to challenges they faced during their employment training, Company A is developing cloud based workplace management systems for professionals. 65. Company A aims to generate efficiencies for workplaces by providing the tools for staff to do their job more efficiently. They identified that this would enable a higher level of support to be delivered to customers resulting in better customer outcomes. 66. The app 1 is an on boarding platform that centralises policies and procedures so that it is easily accessible to staff that regularly move between different workplaces. 67. The app 1 creates efficiencies for workforce management by centralising important up to date information, including policies, procedures, rosters and shift management. It also has a phone directory to store relevant workplace contacts. Company A claims that app 1 can increase up to five times efficiency on administrative tasks. 68. App 1 has 'value added’ features to enhance the capability of the app. These features include managing compliance shift swapping, training, education and other interactions between workplace management and staff. | Detailed Reasoning - Genuinely focussed on developing for commercialisation: 69. Company A intends to continue further developing and testing the app 1 by adding several features. 70. The app 1 is currently operational in several workplaces and it is intended that it’s use will expand to other Australian and overseas workplaces. It is forecast that Company A will be profitable in 2018. 71. The app 1 has been modified according to feedback received, and site-specific requirements. Users were asked to rate the app 1 in terms of how much time it had saved them. Over 90% of respondents felt it either saved them time a 'few times a week’ or 'significantly saved time every day’. 72. The app 1 has been produced to address identified inefficiencies in the workplace. An increasing number of workplaces have accepted that the app 1 is an improvement on current systems and have licensed the app. The users of the app have overwhelming agreed that the app saves them time. The significantly improved innovations of the app 1 have led to an increasing demand, confirming that the app has been used for commercialisation. | Detailed Reasoning - Conclusion on subparagraph 360-40(1)(e)(i): 73. Company A is genuinely focussed on developing the app 1 with its significantly improved innovations for commercialisation. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied. | Detailed Reasoning - High growth potential: 74. The app 1 currently has more demand than can currently be supplied, meaning there is growth potential to meet the demand. 75. Positive feedback from current users of the app 1 indicates that the app is meeting the needs of customers, and Company A states that it is five times more efficient compared to current manual systems. 76. Company A has identified several workplaces in an Australian state as its main market, with expansion expected in other Australian states. Further expansion is envisaged in other sectors, and into overseas countries with similar workplaces. 77. Company A has a high growth potential in the workplace. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. | Detailed Reasoning - Scalability: 78. Company A intends to expand its business from an Australian state to other states of Australia, and overseas. 79. Being shortlisted for a program shows that a third party considers Company A has potential to grow. The program is intended to help develop Company A’s ideas into a profitable company. 80. Financial projections show an expected increase in profits over the next three years. Operating revenue is likely to increase faster than operating expenses due to minimal alterations each time that the apps are sold to a new workplace. 81. Company A has the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. | Detailed Reasoning - Broader than local market: 82. Company A has identified its addressable market as several workplaces in an Australian state, with expansion to other Australian states and overseas markets. It intends to expand the market beyond Australia to comparable overseas workplaces. 83. In the long term, Company A envisage an expansion into industries that are compliance driven and have casual labour markets. 84. Company A has demonstrated that its technology has the potential to address a broader market than just the Australian market, including global markets. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied. | Detailed Reasoning - Competitive advantages: 85. Company A own the rights to the intellectual property underpinning its two mobile applications through licensing the apps to workplaces. It is in the process of registering its trademark and has applied for the trademarks to be registered globally. 86. One of Company A co-founders, who is also a software engineer with a background in business, has suspended his training to work full-time on Company A on both the software engineering and business development sides of the business. 87. The app 1 provides advantages for workplaces and staff that move between sites and creates efficiencies for workforce management. 88. Company A has demonstrated the potential for its technology to have competitive advantages within the industry, satisfying subparagraph 360-40(1)(e)(v). | Detailed Reasoning - Conclusion on principles-based test: 89. Company A satisfies the principles-based test as it satisfies all of the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period ending 30 June 2017. | Detailed Reasoning - Conclusion: 90. Company A meets the eligibility criteria of an ESIC under section 360-40 for the period ending 30 June 2017. In particular, Company A met the eligibility criteria at the 'test time’ immediately after the issue of shares to new investors in December 2016.