Private ruling: Early stage innovation company qualification
Date of advice: 3 October 2019
Published: November 2019
Ruling period: Year ending 30 June 20XX
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: 1. The Company was incorporated in Australia in the 20XX income year. Its equity interests are not listed for quotation in the official list of any stock exchange. 2. The Company has no subsidiaries and has expenses of less than $1 million in the previous income year, i.e. the year ended 30 June 20XX. The Company has assessable income of less than $200,000. 3. The Company's goal is to provide IT software. 4. Market position, the Company states that there are no direct competitors to the platform currently in the market. 5. Expertise of Founders and any Intellectual Property rights (i.e. ownership or licence): a. The Company has founders who are directors of the company. b. The Company has an experienced team. c. The Company owns the Intellectual Property rights. 6. The company believes it has the following differentiating features which may give it a competitive advantage: a. Access is optional to the marketplace; the company can anonymise the data and return value on each sale. b. The data is encrypted. c. The client's ability to share information instantly. This is one of the key barriers to efficiency in this industry currently. d. They are a group of professionals with over 20 years' experience working in this industry. 7. Being the first of such an innovation, the Company has the first mover advantage. 8. The Company has demonstrated the potential for the application to have competitive advantages within the professional business community. 9. The Company has identified its addressable market as industries in Australia. Commercialisation strategy 10. The Company has developed a business plan. 11. The Company's commercialisation strategy starts from the development stage. 12. The Company is initially targeting the Australian market. 13. Market segments have been identified as initial targets and the Company has identified specific potential customers. Information provided 14. You have provided information in a number of documents and phone conversations in relation to the innovation, including: a. your private ruling application. b. our phone conversations c. supplementary information. 15. We have referred to the relevant information within these documents and conversations in applying the relevant tests to your circumstances. 16. You propose to issue new shares in The Company to various investors to assist in funding the continued development and commercialisation of IT software.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-40

Reasons for decision: Summary: All legislative references are to the ITAA 1997 unless otherwise indicated. | Summary: The Company does meet the eligibility requirements of an ESIC under subsection 360-40(1). | Detailed Reasoning - Qualifying Early Stage Innovation Company: 17. 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': 18. 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): 19. 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). 20. 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. 21. 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): 22. 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): 23. 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): 24. 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: 25. 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 - 'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (v): 26. 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. 27. 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. 28. 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: 29. 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..." [1] 30. 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. 31. 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. 32. 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. [2] 33. 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." 34. 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." 35. 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. 36. '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: 37. 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: 38. 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: 39. 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: 40. 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 - Application to your circumstances: Test time 41. 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. Current year 42. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX (the 20XX income year). | Detailed Reasoning - Early stage test: Incorporation or Registration - paragraph 360-40(1)(a) 43. As The Company was incorporated in the 20XX income year, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. Total expenses - paragraph 360-40(1)(b) 44. As The Company had expenses of less than $1 million in the prior income year (the 20XX income year) paragraph 360-40(1)(b) is satisfied. Assessable income - paragraph 360-40(1)(c) 45. As The Company's assessable income in the prior income year (the 20XX income year) is $200,000 or less paragraph 360-40(1)(c) is satisfied. No stock exchange listing - paragraph 360-40(1)(d) 46. As The Company is privately owned and is not listed on any stock exchange in Australia or a foreign country paragraph 360-40(1)(d) is satisfied. Conclusion on early stage test 47. The Company will satisfy the early stage test for the entire 20XX income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | Detailed Reasoning - Principles based test: Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) 48. According to the Company, it is developing a unique system using innovate technology for use in this industry. The Company's mission is to use the power of this technology to digitalise processes, with the overall aim to increase agility and at the same time maintain a high level of security. This system will safely and securely place the power back into the hands of the client. They will be in total control of their information, allowing them to use and share their information as necessary, and enable others to coordinate and collaborate in ways that have never been possible until now. 49. The Company will be the first to offer such a product. 50. The Company states that there are no direct competitors to it offering an all-in-one solution. Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) 51. Since incorporating the Company has undertaken significant background research and literature studies to understand the existing state of the art, the opportunities which are available and potential global competitor offerings. 52. The Company has also undertaken preliminary planning to develop the concept design of the technology, formulate and test the relevant hypotheses and evaluate the different market opportunities for the new technology. During this process, the Company has evaluated the market need for a system which would revolutionise how we interact and value data, and the potential cost and benefits of developing the new technology. 53. The Company has taken the following steps in developing the innovation: a. Marketing plan b. Sales plan c. Operational plan d. Milestones and metrics 54. The Company expects that in the second half of 2019, they will have commercialised their MVP and they will ready to roll out our in a regional centre of Australia. 55. By making the innovation free the Company believes it will get strong uptake. The Company will develop contracts / potential customers to increase direct sales. Conclusion on subparagraph 360-40(1)(e)(i) 56. The Company is genuinely focussed on developing the innovation for a commercial purpose. The innovation will be a significantly improved product compared to existing products. 57. Therefore subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XX until 30 June 20XX or the date when the innovation has been fully developed, whichever occurs earliest. Once the innovation has been fully developed, The Company will no longer be 'developing' the product for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied. High growth potential - subparagraph 360-40(1)(e)(ii) 58. The Company expects the innovation to appeal to a wide range of people and businesses.. 59. The Company has provided the Growth Opportunities, the Target Market Groups, Revenue Groups and Timeline for Growth 60. Through its commercialisation strategy, The Company hopes to foster widespread use of its product. 61. Therefore subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability - subparagraph 360-40(1)(e)(iii) 62. The Company's projections and business model provided illustrates the increase in projected sales. 63. Given that the innovation will be available domestically and internationally, it is expected that the Company has the potential to successfully scale up its business. 64. The Company's strategy for the use of the innovation will be able to generate increased revenue. This operating leverage affords The Company the potential to successfully scale up its business. Therefore subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) 65. The Company's innovation will initially be targeted at the Australian market but is intended for worldwide use. It will be released globally once it gains traction in the initial targeted markets. 66. The innovation can be used internationally. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region. 67. The Company has stated that their innovation will roll out in three distinct phases. Firstly, in Q1 2019 they will launch the platform in the regional centre Australia. Their innovation will then scale rapidly and be deployed throughout another State in Q2 2019, before proceeding to rollout nationally in Q4. 68. Currently there are three stages of development mapped out, which include origin and build, integrate and expand. In the Company's third stage of development (i.e. expand), senior management will significantly shift their focus on growing its presence and adoption of its revolutionised innovation on a global scale. The Company aims to conduct an international roll out in 2022. 69. In order to successfully implement the above, the Company will look for opportunities to collaborate with key international non-government organisations. 70. The Company has demonstrated the innovation has the potential to address a broader market than just the local market, including international markets. Therefore subparagraph 360-40(1)(e)(iv) will be satisfied. Competitive advantages - subparagraph 360-40(1)(e)(v) 71. The Company has stated that they are the first group of professionals to build an innovation that restores integrity into how we interact and value data. They state that there are several unique properties that they deploy. Their innovation uses strong security and privacy controls offered by decentralised databases. The auditability of the data is paramount and being able to prove the providence of the data is crucial to capturing its true value. 72. The Company believes it has the following differentiating features which may give it a competitive advantage: a. Access is optional to the marketplace; the Company can anonymise the data and return value. b. The innovation is encrypted. c. The client's ability to share information instantly. This is one of the key barriers to efficiency in this industry currently. d. They are a group of professionals with over 20 years' experience working in this industry. 73. Being the first of such an innovation, the Company has the first mover advantage. The Company has demonstrated the potential for the innovation to have competitive advantages within the its market, satisfying subparagraph 360-40(1)(e)(v). Conclusion on principles test 74. The Company satisfies the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i)to (v) for the period commencing 1 July 20XX until 30 June 20XX or the date when the innovation has been fully developed and is ready for sale, whichever occurs earlier. Conclusion 75. The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until the earlier of 30 June 20XX or the date when the innovation has been fully developed and is ready for sale, whichever occurs earlier. [1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76. [2] OECD Oslo Manual, paragraph 124 and paragraph 151.