Edited version of private advice

Authorisation Number: 1051662765043

Date of advice: 3 August 2020

Ruling

Subject: Early stage innovation company

Question

Does Entity 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

Yes.

This ruling applies for the following period:

Year ending 30 June 20XX.

The scheme commences on:

1 July 20XX.

Relevant facts and circumstances

Entity A is an Australian unlisted, privately owned company which was incorporated in Australia and registered in the Australian Business Register on xx/xx/20XX.

Entity A does not own any subsidiaries.

Entity A is not listed for quotation in the official list of any stock exchange in Australia or a foreign country.

Entity A is a technology start-up company currently in the early stages of product and technology development.

Entity A currently has XXX ordinary shares on issue. Entity A will be raising additional capital to assist in funding the continued development and rapid commercialisation of your product.

Entity A derived assessable income of $XX and incurred total expenses of $XXX during the year ended 30 June 20XX.

Entity A was founded to develop and take to market product P.

Entity A is currently undertaking research, development and commercialisation activities.

Entity A intends to apply for intellectual property rights, including a trademark for the logo and patents in relation to the methods and technologies underpinning product P.

Entity A provided a detailed commercialisation strategy for product P.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 subsection 360-40(1)

Income Tax Assessment Act 1997 paragraph 360-40(1)(a)

Income Tax Assessment Act 1997 paragraph 360-40(1)(b)

Income Tax Assessment Act 1997 paragraph 360-40(1)(c)

Income Tax Assessment Act 1997 paragraph 360-40(1)(d)

Income Tax Assessment Act 1997 paragraph 360-40(1)(e)

Income Tax Assessment Act 1997 subparagraphs 360-40(1)(e)(i) to (iv)

Income Tax Assessment Act 1997 section 360-45

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise indicated.

Question 1 summary:

Entity A meets the eligibility requirements of, an ESIC under, subsection 360-40(1).

Detailed reasoning

Qualifying Early Stage Innovation Company

Subsection 360-40(1) outlines the criteria required for a company to qualify as an 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 whether it is developing new or significantly improved innovations to generate an economic return.

A company qualifies as an ESIC if it satisfies the early stage test and one of two 'innovation' tests which are the 100-point innovation test or the principles-based innovation test.

'The early stage test'

The early stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d) and (f) and are outlined below

Incorporation or Registration - paragraph 360-40(1)(a)

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).

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.

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

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

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)

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)

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.

Not a foreign company - paragraph 360-40(1)(f)

To meet the requirement in paragraph 360-40(1)(f) the company, at the test time, must not be a foreign company within the meaning of the Corporations Act 2001.

Innovation tests

If you satisfy the early stage test, you must also satisfy one of two innovation tests: the objective (100 point) test or the principles-based test. You have only provided evidence in respect of the principles-based test. Therefore, the 100-point test will not be addressed in this ruling.

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

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.

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.

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.

The five requirements in paragraph 360-40(1)(e) are explored in more detail below.

Developing new or significantly improved innovations for commercialisation

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...'

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 identified by making a realistic and objective assessment of the company's intended market for its innovation. It includes identification of the immediately accessible market to which the innovation will initially be introduced, or a new market which may be created by the innovation. Factors in identifying the addressable market may include the location of the company's potential customers, the type of industry to be served and the geographical area it will serve. The addressable market must be objective and realistic.

A 'new' innovation means novel or introduced to the addressable market for the first time. It must be compared to the products, services, processes or methods that may or may not exist in the intended market for the innovation.

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.

The OECD Oslo Manual (paragraphs 124 and 151) 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.

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."

The company must be genuinely focussed on developing the 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. This requirement draws the distinction between simply having an idea and commercialising an idea.

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 "3. A central point, as of attraction, attention, or activity...8. 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. That is, the central activities of the company must be truly concentrated on developing their innovation for a commercial purpose. Developing an innovation for commercialisation in relation to a range of activities such as proof of concept activities, market research, prototyping, pilots and user testing, and other activities to prepare for the launch of the new innovation.

High growth potential

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

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

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

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

For the purposes of this ruling, the test time for determining if Entity A is a qualifying ESIC will be a particular date during the 20XX income year.

Current year

For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX (the 20XX 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 20XX, 20XX and 20XX, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year).

Early stage test

Incorporation or Registration - paragraph 360-40(1)(a)

Entity A was incorporated and registered on 1 September 20XX, which is within the last 3 income years. Subparagraph 360-40(1)(a)(iii) is satisfied.

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

As Entity A it 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)

Entity A's assessable income for the prior income year is also less than $200,000. Paragraph 360-40(1)(c) is therefore satisfied.

No stock exchange listing - paragraph 360-40(1)(d)

Entity A is not listed on any stock exchange in Australia or a foreign country. Subparagraph 360-40(1)(d) is satisfied.

Not a foreign company - paragraph 360-40(1)(f)

Entity A is not considered a foreign company within the meaning of the Corporations Act 2001. Subparagraph 360-40(1)(f) is satisfied.

Conclusion on early stage test

Entity A 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) and (f) have been satisfied.

100-point test

Entity A has not provided evidence of satisfying the 100-point test under section 360-45 for the year ending 30 June 20XX. For Entity A to be a qualifying ESIC it therefore needs to satisfy the principles-based test.

Principles-based test

Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i)

Entity A is developing product P which aims to reduce costs by automating steps in developing software. Entity A provided a comprehensive competitor analysis comparing product P to similar solutions that are currently available on the market. The comparison highlights several key advantages that product P provides that the competitors' products currently do not provide. In developing product P, Entity A has sought through its experimentation, knowledge that is new and improved compared with the existing offering in industry.

Entity A has provided its Commercialisation strategy for product P, which included a commercialisation timeline which outlines detailed steps towards commercialisation, including planning, design, preparation and development of infrastructure and technology used in developing product P.

Based on the information provided, it is considered that Entity A has demonstrated that it is genuinely focussed on developing for commercialisation a new, or significantly improved product. Therefore, subparagraph 360-40(1)(e)(i) is satisfied.

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

Entity A has provided competitor analysis for competitors in the industry chosen from the following industry analyst reports. Product P is designed to address huge gaps in the market as it meets a global demand for this type of product. Entity A provided five-year revenue estimations, profit and loss projections, and cash flow projection forecasts. Entity A has designed a product with distinct advantages compared to its counterparts.

It is considered that product P has a high growth potential and subparagraph 360-40(1)(e)(ii) is satisfied.

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

Product P is a technology product which is designed to scale while reducing the associated cost per user. The more users, the cheaper the per user costs becomes. By choosing to deliver product P on selected public cloud providers, the underlying infrastructure supporting product P is designed to scale at rapid pace.

Entity A is developing product P initially for Australia, but it is suitable for other similar target markets around the world. As a technology product, once product P is fully developed, you will be able to market your product internationally with relatively small costs as well. Entity A designed

Product P to support characters and languages other than English. This would allow the business to scale into non-English speaking countries and regions at the appropriate time.

It is considered that Entity A has established that it has the potential to successfully scale up its business and that subparagraph 360-40(1)(e)(iii) is satisfied.

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

Product P aims to be online, highly scalable and require minimal additional developmental and customer servicing costs to enter global markets. Being a wholly online, cloud-based software business, product P is unconstrained by the traditional barriers to growth and therefore has the capability to enter overseas markets at low to no additional costs.

Entity A's market will not be confined to Australia and it intends to market the Technology globally.

It is considered that Entity A has demonstrated that the Technology has the potential to address a broader market than just the local market, including international markets. Therefore subparagraph 360-40(1)(e)(iv) is satisfied.

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

The configuration of product P will be exclusively unique to you and this will provide you with a distinct competitive advantage. Entity A's founders have extensive experience working with businesses in the Information Technology sector. Entity A provided a comprehensive comparison guide with competitors' products in the IT sector. The guide sets out several needs that product P is designed to meet that competitors' products currently do not address.

It is considered that subparagraph 360-40(1)(e)(v) is satisfied.

Conclusion on principles-based test

Entity A satisfies the principles-based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v).

Conclusion

Entity A meets the eligibility criteria of an ESIC under section 360-40.

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