Edited version of private advice

Authorisation Number: 1051734389759

Date of advice: 11 August 2020

Ruling

Subject: Early stage innovation company eligibility

Question

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?

Answer

Yes

Question

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 20XX?

Answer

Yes

This ruling applies for the following periods:

1 July 20ZZ to 30 June 20YY

1 July 20YY to 30 June 201X

The scheme commences on:

1 July 201Z

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 is testing the AI engines ability to successfully source, verify and deliver tasks, which conventionally requires multiple human equivalent roles, and outperform the current best performing practices.

8.      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.

9.      Current solutions offered by competitors only use simple algorithmic methods, no existing services can achieve instantaneous success rates close to Company A's hypothesised outcome.

10.   The current process for businesses to complete this task takes typically XX days. Company A is aiming to complete this task with a maximum timeframe of XX hours with only X hour of physical labour input required.

11.   Company A is developing their AI engine to address a discrete market and is continuing to develop their Product.

12.   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 has been undertaken.

13.   The addressable market in Australia is $XX which is currently being met by traditional service providers. Company A believes that the AI rapid response engine they are developing has the potential to acquire a significant percentage share of the market due to the time efficiency it can achieve and the significant cost reduction it can deliver.

14.   Company A has signed several service agreements with large scale organisations.

15.   Company A does not intend to licence the innovation to another company.

16.   For the year ending 30 June 20YX, Company A has achieved XX% revenue growth when compared to 20ZZ and is forecasting revenue growth of $XX in financial year ended 30 June 20XY.

17.  Company A has been identified as having an international addressable market. The Product has been built to be deployed and scaled overseas with multi-lingual and currency functions currently being developed.

18.   The International market is being met by a range of traditional service providers. Al rapid response engine has the potential to expand into the international market due to the time efficiency and significant cost reduction it can deliver. An expansion overseas is planned for X to Y years time.

19.   There have been three versions of the Product developed to date and in between each development phase continuous testing and client feedback has taken place. This testing and feedback has fed into ongoing research, development and improvements to subsequent product development rounds.

20.   Company A has undertaken the following steps to develop their Product for commercialisation:

·         The Version 1 platform was the minimum viable product to take to market for early stage client testing and feedback.

·         Version 2 was a rebuild of Version 1 and built in several new features incorporating both client and broader user testing. Some other key improvements were made.

·         Version 3 was a ground up rebuild in a more scalable computer coding language. During the Version 3 development round a large focus was placed on artificial intelligence and machine learning and automating workflows. As part of this process Company A implemented several third-party integrations.

Information provided

21.  You have provided a number of documents containing detailed information in relation to Company As' Product, including:

a)    Private Binding Ruling ('PBR') Application

b)    Response to further questions provided

22.  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

Qualifying Early Stage Innovation Company

23.   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'

24.   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)

25.   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).

26.   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.

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

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

28.   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)

29.   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)

30.   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

31.   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

32.   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)

33.   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.

34.   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.

35.   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.

Developing new or significantly improved innovations for commercialisation

36.   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..."

37.   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.

38.   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.

39.   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."

40.   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.

41.   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.

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

'THE EARLY STAGE TEST'

Application for the year 1 July 20ZZ to 30 June 20YY

TEST TIME

46.   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.

Current year

47.   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 20WW.

·         The income year before the current year will be the year ending 30 June 20ZZ (the 20ZZ income year).

THE 'EARLY STAGE TEST' - PARAGRAPHS 360-40(1)(A) - (D) ITAA 1997

Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997

48.   Company A was incorporated on XX XX 20ZY, which is within the 3 income years as outlined above.

49.   Therefore, the requirements of subparagraph 360-40(1)(a)(i) are satisfied.

Total expenses - paragraph 360-40(1)(b) ITAA 1997

50.   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 20YY income year, being the income year before the current year.

51.   Company A is not part of a consolidated group. It does not have a parent company or any subsidiaries.

52.   Company A incurred $XX in expenses in the 20ZZ income year. Consequently, paragraph 360-40(1)(b) is satisfied.

Assessable income - paragraph 360-40(1)(c) ITAA 1997

53.   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 20YY income year, being the income year before the current year.

54.   Company A derived total assemble income of $XX in the 20YY income year. Consequently, paragraph 360-40(1)(c) is satisfied.

No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997

55.   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.

56.   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.

CONCLUSION FOR EARLY STAGE TEST

57.   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.

Application for the year 1 July 20YY to 30 June 20XX

TEST TIME

58.   For the purposes of this ruling, the 'test time' for determining if Company A is a qualifying ESIC in the year ended 30 June 20XX, will be upon the issue of qualifying shares on a particular date or dates on or after 1 July 20YY, and on or before 30 June 20XX.

Current year

59.   Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending 30 June 20XX (the 20XX income year). For clarity, in relation to the requirements within subsection 360-40(1):

·         the last 6 income years will include the years ending 30 June 20XX, 20YY, 20ZZ, 20WW, 20ZY and 20WY.

·         The income year before the current year will be the year ending 30 June 20YY (the 20YY income year).

·         the last 3 income years before the current year will include the years ending 30 June 20YY, 20ZZ and 20WW.

Total expenses

60.   Company A is not part of a consolidated group. It does not have a parent company or any subsidiaries.

61.   Across the last 3 of income years before the current year Company A incurred the following total expenses:

·         Total expenses for the year ending 30 June 20YY: $XX

·         Total expenses for the year ending 30 June 20ZZ: $XX

·         Total expenses for the year ending 30 June 20WW: $XX

THE 'EARLY STAGE TEST' - PARAGRAPHS 360-40(1)(A) - (D) ITAA 1997

Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997

62.   Company A was incorporated on XX XX 20ZY, which is within the 6 income years as outlined above.

63.   Across the last 3 of income years before the current year Company A has incurred total expenses of $1 million or less, as outlined above.

64.   Therefore, the requirements of subparagraph 360-40(1)(a)(ii) are satisfied.

Total expenses - paragraph 360-40(1)(b) ITAA 1997

65.   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 20YY income year, being the income year before the current year.

66.   Company A incurred $XX in expenses in the 20YY income year. Consequently, paragraph 360-40(1)(b) is satisfied.

Assessable income - paragraph 360-40(1)(c) ITAA 1997

67.   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 20YY income year, being the income year before the current year.

68.   Company A derived total assemble income of $XX in the 20YY income year. Consequently, paragraph 360-40(1)(c) is satisfied.

No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997

69.   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.

70.   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.

CONCLUSION FOR EARLY STAGE TEST

71.   Company A satisfies the early stage test for the 20XX income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

THE '100 POINT TEST' - PARAGRAPH 360-40(1)(E) AND SECTION 360-45

72.   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.

Application for the income years 1 July 20ZZ to 30 June 20YY and 1 July 20YY to 30 June 20XX

THE 'PRINCIPLES-BASED TEST' - PARAGRAPH 360-40(1)(E) ITAA 1997

Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i) ITAA 1997

73.   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.

74.   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.

75.   The current process for businesses to obtain complete this specific scope of work takes typically XX days. Company A is aiming to deliver an outcome with a maximum timeframe of XX hours with only X hour of physical labour input required.

76.   Through an automated AI engine, the marketplace will be able to manage workflows and make relevant process decisions. Overall technical success is achieved if Company A's developed AI engine can successfully source, verify and deliver tasks, which conventionally requires multiple human equivalent roles, and outperform the best performing current practices.

77.   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.

78.   Competitors currently use simple algorithmic keyword matching techniques; no existing services can achieve instantaneous success rates close to Company A's hypothesised outcome.

79.   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 periods 1 July 20ZZ to 30 June 20YY and 1 July 20YY to 30 June 20XX.

Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997

80.   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.

81.   Company A provided a summary of the steps they have taken to develop their Product for commercialisation. There have been three versions of the Product developed to date and in between each development phase continuous testing and client feedback has taken place. This testing and feedback has fed into ongoing research, development and improvements to subsequent product development rounds.

82.   Company A has undertaken the following steps to develop their Product for commercialisation:

·         The Version 1 platform was the minimum viable product to take to market for early stage client testing and feedback.

·         Version 2 was a rebuild of Version 1 and built in several new features incorporating both client and broader user testing. Some other key improvements were made.

·         Version 3 was a ground up rebuild in a more scalable computer coding language. During the Version 3 development round a large focus was placed on artificial intelligence and machine learning and automating workflows. As part of this process Company A implemented several third-party integrations.

83.  Company A does not intend to licence the innovation to another company, the innovation has the potential to provide the company with a direct competitive advantage over existing competitors and generate significant economic value.

84.  Company A is genuinely focussed on developing their Product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the periods 1 July 20ZZ to 30 June 20YY and 1 July 20YY to 30 June 20XX.

High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997

85.  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.

86.  The current process for businesses to complete this specific scope of work takes typically XX days from introduction to onboarding. Company A is aiming to deliver outcomes with a maximum timeframe of XX hours with only X hour of physical labour input required.

87.  Competitors currently use simple algorithmic keyword matching techniques, no existing services can achieve instantaneous success rates close to Company A's hypothesised outcome.

88.  The addressable market in Australia is $XX which is currently being met by traditional service providers.

89.  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.

90.  Company A has demonstrated a high growth potential for their Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the periods 1 July 20ZZ to 30 June 20YY and 1 July 20YY to 30 June 20XX.

Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997

91.  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.

92.  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.

93.  For the year ending 30 June 20YX, Company A has achieved XX% revenue growth when compared to 20XX. Company A is forecasting revenue growth of $XX in financial year ended 30 June 20XY.

94.  Company A have reportedly signed several service agreements with large scale organisations which supports to their forecasted revenue growth.

95.  The innately scalable nature of software with a minimal increase in operating costs and Company As proven revenue growth and 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 periods 1 July 20ZZ to 30 June 20YY and 1 July 20YY to 30 June 20XX.

Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997

96.  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.

97.  Company A is focusing on expansion into the $XX Australian addressable market which is currently being met by traditional service providers.

98.  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.

99.  Similarly, to Australia, the International market is being met by a range of traditional service providers. Company A believes that the AI rapid response engine they are developing has the potential to expand significantly into this international market due to the time efficiency it can achieve and the significant cost reduction it can deliver.

100.    Company As experience and predicted success in Australia will provide the platform to launch an international expansion. This expansion is mapped to take place in 2 to 3 years' time.

101.    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 periods 1 July 20ZZ to 30 June 20YY and 1 July 20YY to 30 June 20XX.

Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997

102.    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.

103.    Company As direct competitors are traditional companies who currently use simple algorithmic keyword matching techniques to service customers. The current process for businesses to complete this specific scope of work takes typically XX. Company A is aiming to deliver an outcome with a maximum timeframe of XX hours with only X hour of physical labour input required.

104.    The software solution developed makes use of artificial intelligence ('AI'). As crucial AI software has only been developed recently, the Company A software solution for are at the forefront of this technology.

105.    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.

106.    Company A have reportedly signed several service agreements with large scale organisations which provides a further barrier to competing products.

107.    Company A has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the periods 1 July 20ZZ to 30 June 20YY and 1 July 20YY to 30 June 20XX.

CONCLUSION FOR PRINCIPLES BASED TEST

108.    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 and 1 July 20YY to 30 June 20XX.

CONCLUSION

109.    Company A meets the eligibility criteria of an ESIC under section 360-40 for the periods 1 July 20ZZ to 30 June 20YY and 1 July 20YY to 30 June 20XX.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).