Private ruling: Early Stage Innovation Company
Date of advice: 18 September 2017
Published: January 2018
Ruling period: 1 July 2016 to 30 June 2017
Date scheme commenced: 1 July 2016

Ruling: Q1: Does the Company meet the criteria of an ESIC under subsection 360-40(1) of the Income Tax Assessment Act 1997 ? | A1: Yes | Q2: Will the Company continue to be an ESIC in relation to share issues during the period up to and including 30 June 2017? | A2: Yes

Relevant facts and circumstances: ● The Company was incorporated in Australia. Its equity interests are not listed for quotation in the official list of any stock exchange. ● 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 2016. The Company has not generated assessable income. ● The Company is developing innovative product for which it has two patents pending. ● The Company’s product is considered to be new globally in a market that is driven by high demand for cutting-edge innovation and rapidly expanding to be worth in excess of $XXX billion by the year 20XX. ● The Company will offer the product to customers across the general public as well as XY ● Having developed the basic framework for the development of the product, The Company is now seeking to raise capital through a series of investment help to capitalise on commercial interest. ● The Company was eligible to claim the Research & Development (“R&D”) Tax Incentive for the year ended 30 June 2016.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 360-A; and | Income Tax Assessment Act 1997 Section 360-40.

Reasons for decision: Detailed Reasoning - Qualifying early stage innovation company: 1. 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. ‘ The early stage test’ 2. 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): 3. 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). 4. 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. 5. 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): 6. 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): 7. 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): 8. 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: 9. 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 - 10. ‘Principles-based test’ – paragraph 360-40(1)(e): 11. 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. 12. 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. 13. 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: 14. 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…” 15. 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. 16. 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. 17. 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. 18. 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.” 19. 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.” 20. 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. 21. ‘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: 22. 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: 23. 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: 24. 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: 25. 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 26. 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 2017. Current year 27. 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 will include the years ending 30 June 2017, 2016 and 2015, and the income year before the current year will be the year ending 30 June 2016 (the 2016 income year). | Detailed Reasoning - Early stage test: Incorporation or Registration – paragraph 360-40(1)(a) 28. As the Company was incorporated within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. Total expenses – paragraph 360-40(1)(b) 29. As the Company had expenses less than $1 million in the prior income year, paragraph 360-40(1)(b) is satisfied. Assessable income – paragraph 360-40(1)(c) 30. As the Company’s assessable income for the prior income year is less than $200,000 paragraph 360-40(1)(c) is satisfied. No stock exchange listing – paragraph 360-40(1)(d) 31. 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 32. The Company will satisfy the early stage test for the whole of 2017 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) 33. The Company is an early mover in the development of new and innovative products. The products will introduce a new set of unique features and deliver new user experience. 34. Through the development of the products, the Company has generated a significant amount of knowledge and has a number of patents pending. Genuinely focussed on developing for commercialisation – subparagraph 360-40(1)(e)(i) 35. To date, significant amount of testing has been undertaken to determine whether the integration of the prototype would result in commercially viable 36. The Company is commencing the next stage to continue developing a product prototype which will take place over the next twelve months and will lead to the development of relevant Product. 37. The Company is now seeking to raise capital through a series of investment help to capitalise on commercial interest. 38. The Company is leveraging its relationship with some of major companies in the market space through its highly experienced management team. 39. In early 2017, the Company entered into an arrangement with another company that offers strategic and creative development to businesses that are in star-up phase. The Company seeks to leverage the partnership with this company to gain access to the global market for the product. Conclusion on subparagraph 360-40(1)(e)(i) 40. The Company has demonstrated that it is genuinely focussed on developing new and innovative products for a commercial purpose. The products will be significantly improved products compared to those currently available in the market. 41. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 2016 until 30 June 2017. High growth potential – subparagraph 360-40(1)(e)(ii) 42. The Company’s objective is to offer proprietary products to its customers. Based on its research and working knowledge of the industry, the Company believes that it can achieve the require market share of the customer base over the next 5 years. 43. Based on a 5% share of the market the Company estimate its market share value per annum to be around $XX million. 44. Based on the analysis of the target market and the commercialisation strategy, the Company is confident it has developed a product with high growth potential. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied. Scalability – subparagraph 360-40(1)(e)(iii) 45. The Company is working on building key partnerships with major commercial brand owners to enter the early stage market and scale substantially. The Company business model is to provide products that are designed to capture operating leverages. 46. The costs of developing the products can be leveraged against the operating costs. These operating costs are generally low (and in some cases fixed). This means that as more customers are using the products, the cost per customer decreases. 47. This provides the Company with an operating leverage that gives it the potential to successfully scale up its business. 48. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied. Broader than local market- subparagraph 360-40(1)(e)(iv) 49. There are limited impediments that would impact the ability for the Company to market and supply the product globally. The nature of the products being developed also means that the business has the potential to address a global market at inception. 50. The Company has demonstrated the ability to address a broader than local market through its strategic business relationships and product offerings, thereby satisfying the requirement outlined in subparagraph 360-40(1)(e)(iv). Competitive advantages – subparagraph 360-40(1)(e)(v) 51. The Company is an early mover in the development of new and innovative products. The products will introduce a new set of unique features and deliver new user experience in ways that had never been attempted. 52. There are several similar products in existence to date in the market. However, they are predominantly focused on delivering a different customer experience to the product that The Company is offering. 53. The Company derives its competitive advantage through the incorporation of a host of new features that will ultimately provide a much better user experience than major competitors. The Company has researched the existing offerings on the market and prepared an analysis to determine the players in each key market. The Company’s offering is the only one of its kind in its market space. 54. Based on the analysis above, the Company can demonstrate the potential to have a competitive advantage, thereby satisfying the requirement outlined in subparagraph 360-40(1)(e)(v). Conclusion on principles test 55. 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 2016 until 30 June 2017. Conclusion 56. The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 2016 until the earlier of 30 June 2017. | Detailed Reasoning - Detailed reasoning: 57. As outlined in the reasoning for question 1 above, a company qualifies as an ESIC if it satisfies the criteria set out in subsection 360-40(1) at a particular time in the current year, i.e. the ‘test time’. 58. The test time for ESIC eligibility is the point in time immediately after the new equity interests (shares) are issued by the early stage company. 59. There is also a requirement that the early stage company must still be developing the innovation for commercialisation. The Company will not satisfy this requirement once it is considered that the innovation is fully developed and available for sale. 60. Therefore, the Company will continue to be an ESIC in relation to shares that are issued during the period from 1 July 2016 to 30 June 2017 provided the Company continues to satisfy the eligibility criteria under subsection 360-40(1) and the Company is still developing the innovation for commercialisation.