Edited version of private advice

Authorisation Number: 1051835531182

Date of advice: 5 May 2021

Ruling

Subject: Early stage innovation company

Question:

Does Company A satisfy the criteria of an Early Stage Innovation Company (ESIC) pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 ('ITAA 1997') for the period x XX 20XX to y YY 20YY?

Answer:

Yes

This ruling applies for the following periods

x XX 20XX to y YY 20YY

The Scheme commences on

x XX 20XX

RELEVANT FACTS AND CIRCUMSTANCES

Company A is an Australian proprietary company incorporated in State X on x XX 20ZZ.

Company A was registered in the Australian Business Register and issued an ABN on x XX 20YY. Company A's ABN is xyz xyz xyz.

The trading name of Company A is XYZ.

Company A's director is Taxpayer A.

Company A is not part of a consolidated group and is not planning to join a tax consolidated group.

For the financial year ending x XX 20XX, Company A has incurred and earned the following:

•           Total expenses of $xxx

•           Total income of $yyy

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.

Company A is not a foreign company pursuant to the Corporations Act 2001 (Cth).

Company A is developing an online platform that is focused on a particular experience for the consumer ('the Product'). This platform will utilise contemporary market leading technology to deliver a user experience unique to its customers.

This platform will encompass online sales, education and a communications platform, plus other innovative vertically integrated elements, to be commercialised as XYZ.

Company A is developing and commercialising the intellectual property ('IP') owned by Taxpayer A to develop a significant, world-leading innovation in sales and marketing. The IP, which is exclusively licensed to Company A, provides the genesis of a system being developed to offer a unique user experience.

The innovation is a world-first process that will utilise the platform developed by Company A to promote sales suggestions to individuals, based on information provided by individual users and matched with XYZ's IP. The platform will use artificial intelligence to enable users to interrogate the IP and to provide feedback to the suggestions provided.

Company A's concept is being thoroughly scoped, key personnel at Board and Operations level have been engaged, and the company is completing capital raising. Capital is required to provide seed funding to enable payment from the commencement of trading for key personnel, stock and marketing resources.

Company A is developing their online platform to address a number of discrete markets and is continuing to develop their Product.

Company A's Product has been identified as having an international addressable market.

Information provided

You have provided a number of documents containing detailed information in relation to Company A's Product, including:

•           Private Binding Ruling ('PBR') Application, dated y YY 20YY

•           Response to further questions provided on x XX 20XX

We have referred to the relevant information within these documents in applying the relevant tests to your circumstances.

You propose to issue new shares in Company A to various investors to assist in funding the continued development and commercialisation of the 'Product'.

Assumption(s)

Not applicable.

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

Further issues for you to consider

Not applicable.

REASONS FOR DECISION

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

QUESTION:

SUMMARY

Company A meets the eligibility requirements of an ESIC pursuant to 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 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'

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)

To meet the requirement in paragraph 360-40(1)(a), at a particular time (the test time) in an income year (the current year) the company must have been either:

           i.          incorporated in Australia within the last three income years (the latest being the current year); or

          ii.          incorporated in Australia within the last six income years (the latest being the current year), and across the last three of those income years before the current year, 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.

INNOVATION TESTS

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

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 (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 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 - subparagraph 360-40(1)(e)(i) ITAA 1997

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.[1] 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.

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.

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 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.

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 - subparagraph 360-40(1)(e)(ii) ITAA 1997

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

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, 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.

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

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

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)

At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001 (Cth).

The dictionary in section 9 of the Corporations Act 2001 (Cth) 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

For the purposes of this ruling, the 'test time' for determining if Company A is a qualifying ESIC, will be upon the issue of qualifying shares on a particular date or dates on or after x XX 20XX, and on or before y YY 20YY.

Current year

Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending y YY 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending y YY 20YY, 20XX and 20ZZ, and the income year before the current year will be the year ending x XX 20XX (the 20XX income year).

THE 'EARLY STAGE TEST' - PARAGRAPHS 360-40(1)(a) - (d) ITAA 1997

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

Company A was registered in the Australian Business Register and issued an ABN on x XX 20YY, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(iii) are satisfied.

Total expenses - paragraph 360-40(1)(b) ITAA1997

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 20XX income year, being the income year before the current year.

Company A did not incur any expenses in the 20XX income year. Consequently, paragraph 360-40(1)(b) is satisfied.

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

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 20XX income year, being the income year before the current year.

Company A did not earn any assessable income in the 20XX income year. Consequently, paragraph 360-40(1)(c) is satisfied.

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

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.

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

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.

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

Company A has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending y YY 20YY. Company A is electing to seek eligibility by satisfying the Principles Based Innovation test under section 360-40(1)(e)(i)-(v), and to be issued with a Private Binding Ruling.

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

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.

Company A is developing an online platform (the 'Product'), via a software system that can uniquely sell products to every individual user or customer of the site.

The innovation being developed is a world-first process that will utilise the platform to output unique recommendations to individuals, based on information provided by individual users and matched with XYZ's IP which is exclusively licensed to Company A.

XYZ's system enables each product to be classified according to designated variables. The nature of this IP is highly confidential and highly valuable. It forms the basis of the unique engine being developed for Company A's platform.

These tables are being refined by XYZ, who is working with software engineers to ensure the effectiveness of the build and the ability of the system to be fine-tuned once it has been constructed.

XYZ is working with Company A's chosen Artificial Intelligence ('AI') provider to develop a means by which AI can be deployed to enhance the system's ability to generate additional information by which it can better achieve its objective of providing the best possible experience to each individual user.

Company A aims to deliver a new and innovative platform for commercialisation to drive the generation of income in a number of phases:

•           Phase 1 - World-leading model. This phase will adopt advanced technology and AI to develop an app that meets the requirements of each unique customer

•           Phase 2 - Personalised model. This phase will develop a Virtual Assistant ('VA'), which is a text-based system of direct engagement with VA with Machine Learning ('ML') capability to analyse customer purchases

•           Phase 3- Voice recognition model. This phase will integrate voice recognition capability, allowing a user to ask XYZ a question, and the system would then be able to respond with a live answer from XYZ.

Company A is developing their online platform to address a discrete market and is continuing to develop their Product through to mid-20YY.

Company A is genuinely focussed on developing their Product, an online platform with other elements, for an applicable addressable market, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 20YY.

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

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.

Company A is currently developing their Product for commercialisation by a process that involves:

•           Development of core functionality

•           Scoping of platform

•           Scoping of User Interface

•           Integration of platform with content-driven social media channels

•           Development of business structure, ie. key executive, contract and non-contract personnel

•           Capital raise

•           Build of platform

•           Test of functionality

•           Launch of Product

There are a number of steps which are required to be completed into the future, before the Product is considered to be fully developed for commercialisation. It is anticipated that the Product will be fully developed by the time of its estimated launch by mid-20YY. The current and future focus of the company is the capital raise, which will enable the build process to commence in YY 20YY.

It is Company A's intention that they will continue to reinvest into the future refinement and development of its innovation, especially to maintain a distance between its capabilities and those of its competitors in the recommendation space.

Company A anticipate that the current programme of development will be completed towards the end of the 20YY financial year.

Company A is genuinely focussed on developing their Product, an online platform, for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 20YY, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier. Once the Product has been fully developed, Company A 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) ITAA 1997

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.

Company A anticipates it will achieve strong growth in XXX before potentially moving into the ZZZ region. Company A has completed sales projections which are anticipated to convert to a strong revenue position from Year X onwards. These forecasts are based on significant but achievable growth when compared to comparable online businesses.

Competitive online businesses in XXX are achieving online sales between xyz and zyx at similar price points to those targeted for XYZ.

Comparable corporate businesses without the synergies of this concept are achieving sales of $xyz per annum.

Company A has a high growth potential as their Product is intended to be easily scalable to a global audience.

Company A has demonstrated a high growth potential for their Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period x XX 20XX to y YY 20YY.

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

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.

Company A has the potential to successfully scale up their business by driving a growth strategy as follows:

•           Develop an online presence in the XXX market

•           Amplify the online brand and identification of the platform with physical stores in international capital cities

•           Expand online and offline components of the business into selected markets

While Company A is building its brand and reputation, it will invest heavily in marketing and personnel to ensure the achievement of at least these targets:

•           Online sales will be driven by the platform's extensive promotion, unique IT and user engagement emphasis

•           Offshore community sales will be driven by XYZ's connectivity with this group, the IT build, the ongoing promotional program

After Year X, Company A will be able to take advantage of the strength of its branding, the level of its recognition, a reduced proportion of operating costs and economies of scale to deliver a higher percentage of net profit relative to turnover.

This leverage ensures that Company A has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period x XX 20XX to y YY 20YY.

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

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, including global markets.

The initial objective for Company A is a national online market and corporate sales market that will each be amplified by the development of associated offline stores.

By the time that Australians are again able to engage more closely with overseas countries, Company A will be in a strong position to expand into selected international markets for the following reasons:

•           From the outset, Company A and its brand will be very heavily promoted via social media outlets such as Facebook, Instagram and LinkedIn, creating a strong awareness amongst individuals in a range of markets

•           Company A will have, from the outset of trading, created an online platform on social media and promoted itself significantly, via the local language, on those social platforms

Company A has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied for the period x XX 20XX to y YY 20YY.

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

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.

Company A will commence trading with a range of unique advantages over its competitors.

In addition to offering each customer the ability to have a unique relationship with XYZ via the IT platform, it provides a wide range of other unique benefits to the customer, which as a differential advantage, significantly position Company A apart from its competitors.

A summary of Company A's key competitor advantages is:

•           Technical / User Experience

o    The first online sales platform with a true focus on the customer experience

o    A uniquely informative, authoritative and content-rich online environment that equips users with knowledge

o    The unique opportunity for consumers to have a direct relationship with XYZ as their personal coach

•           Branding, marketing and quality control

o    The unique strength of the XYZ brand in the XXX market and across ZZZ

o    Regular online events - corporate and private

o    Regular coverage and appearances by XYZ in traditional media supported by a program of targeted media activity, particularly via radio, magazines and newspapers

Company A is aware that its competitors will attempt to compete with its innovation, and because of such will continue to reinvest in its core functionality to maintain a strong and obvious distance in the market between its Product and that of its competitors.

Company A has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period x XX 20XX to y YY 20YY.

CONCLUSION FOR PRINCIPLES BASED TEST

Company A satisfies the Principles Based Innovation Test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period x XX 20XX to y YY 20YY, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier.

Foreign Company Test - subparagraph 360-40(1)(f) ITAA 1997

As Company A was incorporated in Australia, it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied.

CONCLUSION

Company A meets the eligibility criteria of an ESIC under section 360-40 for the period x XX 20XX to y YY 20YY, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier.

ATO view documents

Not applicable

Other references (non ATO view)

Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016

Other relevant comments

Not applicable

Key words

Early Stage Innovation Company

Tax incentives for Early Stage Investors

Early Stage Test

Principles Based Innovation Test

[1] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.79.

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