Private ruling: Early stage innovation company qualification
Date of advice: 9 October 2020
Published: November 2020

Ruling: Question 1 | Does the Rulee meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ended 30 June 20XX? | Answer | Yes. | Question 2 | Does the Rulee meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the ITAA 1997 for the year ended 30 June 20XX? | Answer | No, as their assessable income for the year ended 30 June 20XX exceeded the $200,000 limit set down paragraph 360-40(1)(c). | This ruling applies for the following periods: | Year ending 30 June 20XX | Year ending 30 June 20XX | The scheme commences on: | XX Month 20XX | Relevant facts and circumstances | 1. The Rulee was incorporated in Australia on XX Month 20XX. Its equity interests are not listed for quotation in the official list of any stock exchange nor does it intend to before 30 June 20XX. All shareholders are Australian residents. | 2. The Rulee has a subsidiary that it acquired on XX Month 20XX for $XXX,000. | 3. The Rulee and its subsidiary had expenses of less than $1 million in the years ended 30 June 20XX and 30 June 20XX. For the year ended 30 June 20XX, the subsidiary's profit and loss statement lists total income of less than $200,000. For the year ended 30 June 20XX, the subsidiary's profit and loss statement lists total income of more than $200,000. | 4. The Rulee's goal is to provide a search platform that meets the specific needs of the target industry and the needs of the customers that access services within the industry. | 5. Documents in respect of the innovation being developed by the Rulee were provided and the relevant information within these documents were used in applying the relevant tests to the platform being developed. | Relevant legislative provisions | Income Tax Assessment Act 1997 Subdivision 360-A | Income Tax Assessment Act 1997 section 360-40 | Reasons for decision | All legislative references are to the ITAA 1997 unless otherwise indicated. | Question 1: | Summary | The Rulee meets the eligibility requirements of an ESIC under subsection 360-40(1) for the year ended 30 June 20XX. | The Rulee does not meet the eligibility requirements of an ESIC under subsection 360-40(1) for the year ended 30 June 20XX. This is because the subsidiary's assessable income for the year ended 30 June 20XX is greater than the $200,000 limit set down in paragraph 360-40(1)(c). | Detailed reasoning | Qualifying Early Stage Innovation Company | 25. 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' | 26. The early stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d). | Incorporation or Registration - paragraph 360-40(1)(a) | 27. 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 6 income years (the latest being the current year), and across the last 3 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). | 28. 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. | 29. A company that does not meet any of these conditions will not qualify as an ESIC. | Total expenses - paragraph 360-40(1)(b) | 30. 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. | Assessable income - paragraph 360-40(1)(c) | 31. 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. | No stock exchange listing - paragraph 360-40(1)(d) | 32. 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. | Innovation tests | 33. 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. | 'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (iv) | 34. 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. | 35. 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. | 36. 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. | Developing new or significantly improved innovations for commercialisation | 37. 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] | 38. 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. | 39. 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. | 40. 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] | 41. 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." | 42. 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." | 43. 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. | 44. '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. | High growth potential | 45. 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. | Scalability | 46. The company must be able to demonstrate that it has the potential to successfully scale up the business. The company must have operating leverage, whereas 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. | Broader than local market | 47. 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. | Competitive advantages | 48. 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. | Foreign Company test - paragraph 360-40(1)(f) | 49. At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001. | 50. The dictionary in section 9 of the Corporations Act 2001 defines a foreign company to mean: | (a) a body corporate that is incorporated in an external Territory, or outside Australia and the external Territories, and is not: | (i) a corporation sole; or | (ii) an exempt public authority; or | (b) an unincorporated body that: | (i) is formed in an external Territory or outside Australia and the external Territories; and | (ii) under the law of its place of formation, may sue or be sued, or may hold property in the name of its secretary or of an officer of the body duly appointed for that purpose; and | (iii) does not have its head office or principal place of business in Australia. | Application to your circumstances | Test time | 51. For the purposes of this ruling, the test time for determining if the Rulee is a qualifying ESIC will be a particular date during the income years ending 30 June 20XX and 30 June 20XX. | Current year | 52. For the purposes of subsection 360-40(1), the current year will be either the year ending 30 June 20XX (the 20XX income year) or the year ending 30 June 20XX (the 20XX income year). | Early stage test | Incorporation or Registration - paragraph 360-40(1)(a) | 53. In respect of the 20XX income year, as the Rulee was incorporated on XX Month 20XX, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. | 54. In respect of the 20XX income year, as the Rulee was incorporated on XX Month 20XX, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied. | Total expenses - paragraph 360-40(1)(b) | 55. In respect of the 20XX income year, as the Rulee and the subsidiary had expenses of $1 million or less in the prior income years (the 20XX income year) paragraph 360-40(1)(b) is satisfied. | 56. In respect of the 20XX income year, as the Rulee and the subsidiary had expenses of $1 million or less in the prior income years (the 20XX income year) paragraph 360-40(1)(b) is satisfied. | Assessable income - paragraph 360-40(1)(c) | 57. In respect of the 20XX income year, as the Rulee and the subsidiary's assessable income in the prior income year (the 20XX income year) is $200,000 or less paragraph 360-40(1)(c) is satisfied. | 58. In respect of the 20XX income year, as the subsidiary's total income in the prior income year is more than $200,000, paragraph 360-40(1)(c) is not satisfied. | No stock exchange listing - paragraph 360-40(1)(d) | 59. As the Rulee 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 | 60. The Rulee will satisfy the early stage test for the 20XX year as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied. | 61. The Rulee will not satisfy the early stage test for the 20XX year as all the requirements within paragraphs 360-40(1)(a) to (d) have not been satisfied. In this instance the $200,000 assessable income limit set down in paragraph 360-40(1)(c) is exceeded. | 100 point test | 62. The Rulee has not provided any evidence of satisfying the 100 point test under section 360-45 for the years ending 30 June 20XX or 20XX. For the Rulee to be a qualifying ESIC it will need to satisfy the principles-based test. | Principles based test | Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i) | 63. According to the Rulee, the Innovation is a unique product Although it will initially be targeted at the Australian market, the Innovation has been identified as having a wider international addressable market. | 64. Information provided by the Rulee demonstrated that the Innovation will be the first offer of such a product. | Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) | 65. The Rulee provided a development timeline that lists activities that have already been completed and those that are still in progress in respect of developing their platform. | 66. That timeline and other information provided by the Rulee demonstrated that they are genuinely focused on developing the product which includes their innovation within their target market. | Conclusion on subparagraph 360-40(1)(e)(i) | 67. The Rulee is genuinely focussed on developing the Innovation for a commercial purpose. The Innovation will be a significantly improved product compared to existing products and a first mover in its field. | 68. 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 Rulee 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) | 69. The Rulee expects the platform to appeal to its addressable market and through its commercialisation and marketing strategy, the Rulee hopes to foster widespread use of its product by reputation and social media exposure. | 70. The Rulee is developing the Innovation themselves. It will make its revenue through subscriptions to its product. | 71. Information provided by the Rulee, including their financial projections, demonstrated the potential for high growth. | 72. Therefore subparagraph 360-40(1)(e)(ii) will be satisfied. | Scalability - subparagraph 360-40(1)(e)(iii) | 73. The Rulee's business model provided illustrates the increase in projected sales. | 74. Other information provided by the Rulee demonstrated that it should be able to generate increased revenue without increasing its operating costs affording it 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) | 75. The Rulee'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 market. | 76. The Innovation can be used worldwide by participants in the industry. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region. | 77. The Rulee 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) | 78. The information provided by the Rulee lists several differentiating features to be included in their platform which may give it a competitive advantage in the industry it is being specifically designed for use in. | 79. Being the first platform to implement the features the Rulee has the first mover advantage. The Rulee has demonstrated the potential for the Innovation to have competitive advantages within its chosen market satisfying subparagraph 360-40(1)(e)(v). | Conclusion on principles test | 80. The Rulee 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. | Foreign Company Test | 59. As the Rulee was incorporated in Australia it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied. | Conclusion | 61. The Rulee meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until 30 June 20XX. | 62. The Rulee does not meet the eligibility criteria of an ESIC for the year ended 30 June 20XX as it does not satisfy the early stage limb of the test.