Edited version of your written advice

Authorisation Number: 1051206896087

Date of advice: 24 March 2017

Ruling

Subject: Early Stage Innovation Company eligibility

Question 1

Does Company A meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

This ruling applies for the following period:

1 January 20YY to 30 June 20YY

The scheme commences on:

1 January 20YY

Relevant facts and circumstances

1. Company A was incorporated in Australia in the 20YY income year. Its equity interests are not listed for quotation in the official list of any stock exchange.

2. Company A was not in existence and as such did not incur any expenses or derive any assessable income during the income year ending 30 June 20XX. Company A has no subsidiaries.

3. Another entity has been developing an educational program (the Program) and its associated intellectual property (IP) underpinning the Program, which includes the documents and associated processes. Company A is in the process of acquiring the Program and all associated IP through a formal transfer of IP agreement.

4. Company A will continue to develop the Program and will operate the Program. The initial addressable market is to provide services to specific entrepreneurs in Australia. However, Company A's model will be capable of servicing a wider pool of clients than Australian entrepreneurs, including global consumers, as well as deriving some of its revenue streams from selling equity.

5. The Program is operated primarily to facilitate the partnership of Company A with a diversified global network of entrepreneurs. The partnerships will enable Company A to provide a number of services and ultimately derive fee income and revenue.

6. Investment proceeds will form part of the ordinary income of Company A and will fund the expansion of Company A.

7. The founders of Company A have considerable experience in their field.

Company A service model

8. Company A will complete the development of the Program that has a unique and proprietary curriculum encapsulating the know-how and expertise of the team.

9. In addition to the Program, Company A proposes to take its services offerings a step further under its new model by:

● overall tailoring its support services specifically to an industry;

● generate a synergistic “network effect” that underpins some of the most innovative new business models on the market place;

● applying the network effect as a core component of its business model;

● having control and flexibility to evolve the way services and support are provided; and

● utilising its global network to proactively pursue opportunities.

10. Company A provided details of steps/events towards development of the proposed model that have taken place to date and are planned for the future.

11. Company A believe they will be a viable commercial business once the prototype service offering (the Program) is fully developed. This is estimated to take three years, after which time Company A will be in a more mature phase of continual improvement.

12. Company A is developing the Program itself and will ultimately own the Program and its related intellectual property. The venture has thus far been funded, or services provided, by members of the Company A team.

13. Company A has identified a number of features that it considers make it unique and differentiate it from other entities in the industry.

Commercialisation strategy

14. Company A expects to earn revenue from multiple sources, including but not limited to:

● service fees;

● performance fees;

● management fees; and

● new revenue streams are expected over the coming years as Company A evolves the way that support/services are provided.

15. The key next step for Company A is to raise capital to build out the team and processes, and to continue to develop their Program through experimentation and incremental improvement.

16. Company A will offer shares to investors to raise funds to continue to build the Program, and provide the services necessary to be able to commercialise both Company A's services and the ventures that will undertake the Program.

Information provided

17. These facts are based on the comments made and information provided by you.

18. You have provided information in a number of documents and phone conversations in relation to the Program and services offered by Company A.

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

All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise indicated.

Question 1:

Detailed reasoning

Qualifying Early Stage Innovation Company

19. 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'

20. 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)

21. 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).

22. 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.

23. A company that does not meet any of these conditions will not qualify as an ESIC.

Total expenses - paragraph 360-40(1)(b)

24. 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)

25. 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)

26. 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

27. 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.

'100 point test' - paragraph 360-40(1)(e) and section 360-45

28. 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.

'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (iv)

29. 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.

30. 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.

31. 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 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.

Developing new or significantly improved innovations for commercialisation

32. 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…”

33. 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.

34. 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.

35. The OECD Oslo Manual defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. An innovation can also consist of a series of smaller incremental changes that together constitute a significant change.

36. 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.”

37. 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.”

38. 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.

39. The EM does not define the meaning of the term 'genuinely focussed' within the context of subparagraph 360-40(1)(e)(i). Genuine is defined in the online Macquarie Dictionary as “Being truly such; real; authentic.” Focus is defined as “ a central point, as of attraction, attention, or activity. … to concentrate; to focus one's attention.” In essence, the phrase “genuinely focussed” is looking to what the company is truly concentrating and focussing their attention on or, put another way, what is the real central point of the company's activities.

40. 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.

41. 'Commercialisation' is discussed further at paragraph 1.81 in the EM which states “Commercialisation encompasses a spectrum of activities including those leading to the sale of new or significantly improved product, process or service as well as activities involving the implementation of a new, or significantly improved, process or method, where the process or method directly leads to the generation of economic value for the company.”

High growth potential

42. 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.

Scalability

43. 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.

Broader than local market

44. 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

45. 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.

Application to your circumstances

Test time

46. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date between 1 January 20YY and 30 June 20YY.

Current year

47. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the income year before the current year will be the year ending 30 June 20XX (the 20XX income year).

Early stage test

48. Company A was incorporated within the current income year. Company A was not in existence and as such did not incur any expenses or derive any assessable income during the income year ending 30 June 20XX. Company A is privately owned and its equity interests are not listed for quotation in the official list of any stock exchange.

49. Company A will satisfy 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.

100 point test

50. Company A has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20YY. For Company A 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)

51. Company A are providing an integrated service model consisting of the Program and associated service offerings. Company A provided further detail on the components of the service model.

52. The current and future activities of Company A, as described in the facts, include ongoing activities to implement the Company A service offering and to generate economic value to Company A. Consistent with the guidance in paragraph 1.81 of the EM, these activities constitute commercialisation activities.

New or significantly improved

53. In order for Company A to satisfy the principles based test, specifically subparagraph 360-40(1)(e)(i), the service model being developed must be a new or significantly improved service.

New service

54. While Company A is the only entity offering the Program solely to an industry, other Programs within Australia are available to industry participants. The Program being offered by Company A is not a new Program.

55. Consequentially, Company A's integrated service is not a new service in the Australian market. There are other entities already providing a similar integrated service and aspects of Company A's service will not be new. The question remains as to whether Company A's service will be significantly improved.

Significantly improved service

56. The first round of the Program run by another entity has been completed and was considered by the team to be a work in progress. Following the first round, the team have been working on developing the service model. The improvements to the Program, including expanded curriculum and Program activities and services, will be implemented in delivering the second round of the Program. You state the Program will be 'significantly enhanced on the first round of the Program' and will 'include an expanded curriculum and set of Program activities and services'. Additionally, Company A has commenced a new program, an education program designed to be the most advanced education program for entrepreneurs available in Australia.

57. It is noted that an innovation can consist of a series of incremental changes that together constitute a significant change. However, the Commissioner considers Company A's ongoing activities relating to the enhancement and development of the Program will not result in a significant change to Company A's integrated service. Refinements to an aspect of the service, such as the curriculum, may lead to a more efficient and mature Program, but it is not apparent a significant improvement will result in the overall service being offered by Company A.

58. You consider Company A are currently at phase 1 of the service offering and through ongoing development the service will be built up over time to become a viable service. While the ongoing nature of service improvements can complicate the identification of an innovation activity in services, Company A's current activities do not satisfy the significantly improved requirement.

59. The OECD Oslo manual at paragraph 161 provides some examples of product innovations in services that include significant improvements. In considering these non-exhaustive examples, we provide the following comments in relation to your circumstances:

i. There is no evidence that Company A's ongoing refinement of the Program will lead to a significant improvement in how Company A's overall service will be provided. We accept the ongoing activities may result in enhancements to the curriculum within the Program but do not consider this will satisfy the significant improvement threshold for Company A's overall service as required.

ii. As Company A will not be providing new functions or characteristics to the existing service, and Company A are not introducing entirely new services to entrepreneurs, the significant improvement threshold will not be satisfied.

60. You state the Program is the 'first and only dedicated Program in Australia' for the industry and 'comprises a unique and proprietary accelerator curriculum…'. The ability to target a specific market, along with the unique features of the Program will provide Company A with a competitive advantage over entities offering similar services. However, a competitive advantage does not equate to Company A developing a significantly improved service.

Genuinely focussed on developing

61. Even if it was accepted that the Company A service is new or significantly improved, Company A must still demonstrate they are genuinely focussed on developing the service for commercialisation. Essentially, the central activities of Company A must be truly concentrated on developing their service for a commercial purpose. To determine Company A's genuine focus in the context of subparagraph 360-40(1)(e)(i), the activities of Company A are considered to determine what the central point of Company A's activities and attention are focussed on.

62. While it is accepted the service offering will be continually built on and matured over time, the Commissioner considers the primary activity of Company A is related to conducting the Program and providing services, rather than developing the Program and related service. Consequently, Company A are not genuinely focussed on developing their service, as the primary focus of Company A's activities is related to delivering their service.

Distinguishing features

63. You state the innovative model being developed by Company A has a number of features which make it unique and differentiate it from other entities. One of these features is that Company A will be a company vehicle rather than a different entity. This feature is perhaps unique in relation to the model Company A are implementing. However, the legislation requires Company A to be developing a significantly improved service. In your circumstances it does not follow that a different entity leads to the determination that Company A's service model is significantly improved.

64. Some of the other differentiating features put forward by Company A include deriving multiple revenue streams, being an integrated company and generating a 'network effect'. These features may provide competitive advantages to the success of Company A's investments, but do not lead to the conclusion that Company A's service model will be significantly improved in comparison to similar services offered to entrepreneurs within Australia.

Organisational method

65. Your private ruling application also submits that the innovation being developed could be a new or significantly improved organisational method.

66. An organisational method innovation would involve significant changes in organisational methods relating to Company A's business practices, workplace organisation or external relations. It is not apparent that Company A are implementing significant changes in relation to their own business, workplace organisation or external relations.

67. We note Company A are seeking to be a unique vehicle providing a service. While this may be a unique model and provide opportunities for new investors in Company A, it is not a new or significantly improved organisational change in relation to Company A's external business relations. In conclusion, Company A are not developing a new or significantly improved organisational method for the purposes of subparagraph 360-40(1)(e)(i).

Conclusion on subparagraph 360-40(1)(e)(i)

68. It is accepted that Company A will undertake continual refinements to enhance the effectiveness of the curriculum within the Program. However, the Commissioner does not consider these activities will lead to a significant improvement in Company A's integrated service model. Additionally, the Commissioner does not consider Company A is genuinely focussed on developing their service, but rather is genuinely focussed on providing services to entrepreneurs.

69. Based upon the facts, and in comparison to current services available to the market in Australia, the Company A service will not be a new or significantly improved service. Therefore, subparagraph 360-40(1)(e)(i) will not be satisfied.

High growth potential - subparagraph 360-40(1)(e)(ii)

70. Company A has demonstrated the business relating to their service offering has a high growth potential within a broad addressable market, therefore subparagraph 360-40(1)(e)(ii) will be satisfied.

Scalability - subparagraph 360-40(1)(e)(iii)

71. As Company A expands and increases its services, there is a potential for existing revenues to be multiplied with a minimal increase in operating costs. Therefore, Company A has the potential to increase revenue and scale its business, satisfying the scalability requirement in subparagraph 360-40(10(e)(iii).

Broader than local market- subparagraph 360-40(1)(e)(iv)

72. The addressable market for Company A's service model is on a global scale and is not confined to a local city, area or region. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

Competitive advantages - subparagraph 360-40(1)(e)(v)

73. Company A has demonstrated the potential for the service to have competitive advantages in the Australian market, satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

74. Company A does not satisfy the principles based test as it will not satisfied the requirement within subparagraph 360-40(1)(e)(i) for the period commencing 1 January 20YY until 30 June 20YY.

Conclusion

75. Company A does not meets the eligibility criteria of an ESIC under subsection 360-40(1) for the period commencing 1 January 20YY until 30 June 20YY.

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