Edited version of private advice

Authorisation Number: 1052019965663

Date of advice: 11 August 2022

Ruling

Subject: Early stage innovation company

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

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XA

Relevant facts and circumstances

1.    Company A was incorporated in Australia in the last year. Its equity interests are not listed for quotation the official list on any stock exchange.

2.    Company A has no subsidiaries

3.    Company A has expenses totalling less than $1M for the 20XA year and will have less than $1M for the 20XX year.

4.    Company A was co-founded by two individuals. It is focused on filling the gap in the Australian and global market by developing a digital platform. The product is expected to be first to market.

5.    From the Investors Memorandum (IM) of Company A, Company A is allocating X% of its funds to Development and X% to infrastructure. With revenue forecast to rise from $XXX,000 in the first 12 months after going to market to $X.XM by year 3.

6.    As Company A is an online platform, it has the potential to connect with the global market, which is seen in the IM.

7.    Company A will be submitting a claim for the Research and Development Tax Incentive offset for the year ended 30 June 20XX.

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 paragraphs 360-40(1)(a) to (d)

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

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

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

Income Tax Assessment Act 1997 section 360-45

Reasons for decision

Question 1:

Summary

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

Detailed reasoning

Qualifying Early Stage Innovation Company

1.     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 it is developing new or significantly improved innovations to generate an economic return.

'The early stage test'

2.     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)

3.     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).

4.     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.

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

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

6.     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)

7.     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)

8.     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

9.     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

10.  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)

11.  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.

12.  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.

13.  The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are:

              i.                the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation;

             ii.                the business relating to that innovation must have a high growth potential;

           iii.                the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation;

           iv.                the company must demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business; and

            v.                the company must demonstrate that it has the potential to be able to have competitive advantages for that business.

Developing new or significantly improved innovations for commercialisation

14.  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 the revenue opportunity or market demand arising from the innovation or the related business. The addressable market must be objective and realistic.

15.  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.

16.  The OECD Oslo Manual defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. However, it is important to recognise that an innovation can also consist of a series of smaller incremental changes that together constitute a significant change.

17.  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.

18.  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."

19.  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.

20.  '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

21.  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

22.  The company must be able to demonstrate that it has the potential to successfully scale up the business. 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 per unit.

Broader than local market

23.  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

24.  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.

Competitive advantages

25.  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)

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

27.  The dictionary in section 9 of the Corporations Act 2001 defines a foreign company to mean:

(a) a body corporate that is incorporated in an external Territory, or outside Australia and the external Territories, and is not:

(i)            a corporation sole; or

(ii)           an exempt public authority; or

(b) an unincorporated body that:

(i)            is formed in an external Territory or outside Australia and the external Territories; and

(ii)           under the law of its place of formation, may sue or be sued, or may hold property in the name of its secretary or of an officer of the body duly appointed for that purpose; and

(iii)         does not have its head office or principal place of business in Australia.

Application to your circumstances

Test time

28.  Company A issued shares to investors on during 20XX. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be the time immediately after the company issued these shares.

Current year

29.  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 20XA, 20XB and 20XC, and the income year before the current year will be the year ending 30 June 20XA (the 20XA income year).

Early stage test

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

30.  As Company A was incorporated during 20XA, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied.

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

31.  As Company A 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)

32.  As Company A has not generated any assessable income for the prior income year paragraph 360-40(1)(c) is satisfied.

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

33.  As Company A is privately owned and is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(d) is satisfied.

Conclusion on early stage test

34.  Company 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) have been satisfied.

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

35.  Company A has not applied under this test and provided no information in respect of its requirements.

Principles based test

Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i)

36.  We need to test whether there is a process being developed including third party interaction and automation that will be demonstratively new or significantly better than the industry leader's equivalent process when shares were issued during the 2022 income year.

37.  It I considered that Company A is genuinely focussed on developing this new or improved innovation for a commercial purpose. The innovation will be a significantly improved product compared to existing products.

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

38.  Company A has provided the following timeline of actions completed over that time:

•                     Identified opportunity (together with another party) in XXXX 20XB and engaged solution architect for design;

•                     After another party elected to not proceed, you identified another lead architect to help develop and commercialise the product ourselves;

•                     Pilot development started in XXXX 20XA. Founders contributed $XXX,000 to fund initial development;

•                     Pilot solution employed at Company B in XXXX 20XA;

•                     Engaged lawyer to draft equity agreements for key staff;

•                     Initial 'family and friends' round of funding in XXXX 20XA raised $XXX,000;

•                     Development team interviewed and engaged XXXX 20XX;

•                     Promotional video advertising Company B pilot success developed in conjunction with partner firm, released XXXX 20XX;

•                     Created first promotional video and released it in XXXX 20XX; and

•                     First client launch on production platform in XXXX 20XX.

39.  The timeline provides that Company A has launched its production platform in XXXX 20XX which is in the 20XZ financial year.

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

40.  Company A is genuinely focussed on developing the platform for a commercial purpose. Its platform will be a significantly improved product compared to existing products.

41.  Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XA until 30 June 20XB

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

42.  Company A expects to appeal to a wide range of retail businesses and consumers. This aids decision making and is particularly useful when assessing product or service viability in particular markets.

43.  Company A has acted on significant research showing trends in engagement of customers across all channels. Utilising this research, Company A, together with the extensive retail experience of its founders and their network of contacts, will have the ability to utilise this high growth potential.

44.  Company A's sales forecasts in its IM predicts sales of $XXX,000 in year 1 to increase to $X.X million in year 3.

45.  If Company A's commercialisation strategy is successful, Company A will be able to increase sales through increased uptake (of retail market in Australia and New Zealand) and then penetration in other overseas markets.

46.  Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied.

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

47.  Company A's projections provided in the IM and business plan illustrate the increase in projected sales. Their pilot retailer has shown a monthly increase in $XXX,000 and in directly attributed sales and over XX,000 interactions per month.

48.  Given that Company A will eventually be available globally, it is expected that Company A has the potential to successfully scale up its business.

49.  Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied.

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

50.  Company A will initially be targeting the Australian and New Zealand retail market (but is intended for worldwide use and will be released globally once it gains traction in the initial targeted markets).

51.  Company A's platform can be used worldwide. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region. Company A has illustrated the size of the potential world-wide market within its IM.

52.  Company A has demonstrated it has the potential to address a broader market than just the local market, including international markets. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

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

53.  Company A has provided a table which outlines the points of difference between Company A's product and those currently available.

54.  Being the first to offer its product to the market Company A has the first mover advantage. Company A has demonstrated the potential to have competitive advantages within its retail community, satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

55.  Company A satisfies the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20XA until 30 June 20XX.

Foreign Company Test

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

Conclusion

57.  Company A meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XA until 30 June 20XX.

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