Private ruling: Early stage innovation company eligibility
Date of advice: 28 October 2020
Published: December 2020
Ruling period: 1 July 20ZZ to 30 June 20YY
Date scheme commenced: 1 July 20ZZ

Ruling: Q1: Does Company A Pty Ltd satisfy the criteria as an Early Stage Innovation Company ('ESIC') pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 (Cth) for year ended 30 June 20YY? | A1: Yes

Relevant facts and circumstances: 1. Company A Pty Ltd ('Company A') is a proprietary company incorporated in Australia. 2. Company A's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country. 3. Company A is not part of a consolidated group. It does not have a parent company or any subsidiaries. 4. For the financial year ending 30 June 20YY, Company A has incurred and earned the following: · Total expenses of $XX · Total income of $XX 5. For the financial year ending 30 June 20ZZ, Company A has incurred and earned the following: · Total expenses of $XX · Total income of $XX 6. Company A is developing a unique automated, autonomous artificial intelligence (AI) engine based on rapid response technology for an addressable market (Product). 7. Company A software solution is at the forefront of the technology in this area. It is different from anything else currently offered in the market because of the AI powered engines capability to carry out automated and instantaneous tasks. 8. Company A provided a summary of the steps they have taken to develop their Product for commercialisation. The Product will be developed through several versions, each version building on the previous version to deliver a commercially viable product. Information provided 9. You have provided a number of documents containing detailed information in relation to Company As' Product, including: a) Private Binding Ruling ('PBR') Application 10. 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: Company As meets the eligibility requirements of an ESIC pursuant to subsection 360-40(1). | 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. | Detailed Reasoning - '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 before the current year it and its * 100% subsidiaries (if any) 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 - '100 POINT TEST' - PARAGRAPH 360-40(1)(E) AND SECTION 360-45: 10. 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 (V): 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 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: 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. 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. 17. 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." 18. 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. 19. 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: 20. 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: 21. 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: 22. 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: 23. 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: 24. For the purposes of this ruling, the 'test time' for determining if Company A is a qualifying ESIC in the year ended 30 June 20YY, will be upon the issue of qualifying shares on a particular date or dates on or after 1 July 20ZZ, and on or before 30 June 20YY. | Detailed Reasoning - Current year: 25. Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending 30 June 20YY (the 20YY income year). For clarity, in relation to requirements within subsection 360-40(1): · The last 3 income years will include the years ending 30 June 20YY, 20ZZ and 20ZY. · The income year before the current year will be the year ending 30 June 20ZZ (the 20ZZ income year). | Detailed Reasoning - Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997: 26. Company A was incorporated on XX December 20ZY, which is within the 3 income years as outlined above. 27. Therefore, the requirements of subparagraph 360-40(1)(a)(i) are satisfied. | Detailed Reasoning - Total expenses - paragraph 360-40(1)(b) ITAA 1997: 28. In applying the requirements of paragraph 360-40(1)(b), Company A and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20ZZ income year, being the income year before the current year. 29. Company A is not part of a consolidated group. It does not have a parent company or any subsidiaries. 30. Company A incurred $XX in expenses in the 20ZZ income year. Consequently, paragraph 360-40(1)(b) is satisfied. | Detailed Reasoning - Assessable income - paragraph 360-40(1)(c) ITAA 1997: 31. In applying the requirements of paragraph 360-40(1)(c), Company A and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20ZZ income year, being the income year before the current year. 32. Company A derived total assemble income of $XX in the 20ZZ income year. Consequently, paragraph 360-40(1)(c) is satisfied. | Detailed Reasoning - No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997: 33. In applying the requirements of paragraph 360-40(1)(d), Company A must not be listed on any Stock Exchange in Australia or a foreign country at the test time. 34. Company A is not listed on any Stock Exchange in Australia or a foreign country at the test time, so paragraph 360-40(1)(d) is satisfied. | Detailed Reasoning - CONCLUSION FOR EARLY STAGE TEST: 35. Company A satisfies the early stage test for the 20YY 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: 36. Company A are electing to seek eligibility by satisfying the Principles based Innovation test under section 360-40(1)(e)(i)-(v), in order to be issued with a Private Binding Ruling. | Detailed Reasoning - Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i) ITAA 1997: 37. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be developing an innovation which is either new or significantly improved for an applicable addressable market. 38. Company A is developing an automated, autonomous artificial intelligence (AI) engine based on rapid response technology for an addressable market. Company A's objective involves the development and testing of an AI rapid response engine. 39. Based on research across relevant industries on a national and global level, Company A found no evidence on pre-existing knowledge of a sophisticated, AI powered engine, capable of automated and instantaneous servicing of the market. 40. Company A is genuinely focussed on developing their Product, a unique AI rapid response engine for an applicable addressable market, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 20ZZ to 30 June 20YY. | Detailed Reasoning - Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997: 41. In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company. 42. Company A provided a summary of the steps they have taken to develop their Product for commercialisation. The Product will be developed through several versions, each version building on the previous version to deliver a commercially viable product. 43. Company A is genuinely focussed on developing their Product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 20ZZ to 30 June 20YY. | Detailed Reasoning - High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997: 44. In applying the requirements of subparagraph 360-40(1)(e)(ii), Company A must be able to demonstrate that it has the potential for high growth within a broad addressable market. 45. The company believes that the AI rapid response engine they are developing has the potential to acquire a significant percentage share of this market due to the time efficiency it can achieve and the significant cost reduction it can deliver. 46. Company A has demonstrated a high growth potential for their Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period 1 July 20ZZ to 30 June 20YY. | Detailed Reasoning - Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997: 47. In applying the requirements of subparagraph 360-40(1)(e)(iii), Company A must be able to demonstrate that it has the potential to successfully scale up the business. 48. As a technology driven platform powered by AI and automation, Company A can scale more quickly than traditional businesses with a minimal increase in operating costs. 49. The innately scalable nature of software with a minimal increase in operating costs and Company As predicted revenue growth displays that Company As has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period 1 July 20ZZ to 30 June 20YY. | Detailed Reasoning - Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997: 50. In applying the requirements of subparagraph 360-40(1)(e)(iv), Company A must be able to demonstrate that it has the potential to be able to address a broader than local market. 51. Company A is focusing on expansion into the $XX Australian addressable market which is currently being met by traditional service providers. 52. While Company A is currently focused on the Australian market, it has been built to be deployed and scaled overseas with multi-lingual and currency functions currently being developed. 53. Company A has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied for the period 1 July 20ZZ to 30 June 20YY. | Detailed Reasoning - Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997: 54. In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must demonstrate that it has potential to be able to have competitive advantage for that business over its competitors. 55. Company A's AI and platform is proprietary and constantly improving and evolving. Several years of research and development, incorporating practical experience and client feedback, provides significant barriers to potential competitors. 56. Company A has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period 1 July 20ZZ to 30 June 20YY. | Detailed Reasoning - CONCLUSION FOR PRINCIPLES BASED TEST: 57. Company A satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the periods 1 July 20ZZ to 30 June 20YY. | Detailed Reasoning - CONCLUSION: 58. Company A meets the eligibility criteria of an ESIC under section 360-40 for the periods 1 July 20ZZ to 30 June 20YY.