Edited version of private advice

Authorisation Number: 1052115708764

Date of advice: 22 May 2023

Ruling

Subject: ESIC eligibility

Question 1

Does Company A satisfy the criteria of the principles-based innovation test pursuant to paragraph 360-40(1)(e) of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ended 30 June ZZZZ?

Answer

Yes.

Question 2

Does Company A satisfy the criteria of the foreign company test pursuant to paragraph 360-40(1)(f) of the Income Tax Assessment Act 1997 (ITAA 1997) for the period year ending 30 June ZZZZ?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June ZZZZ

The scheme commenced on:

DD/MM/ZZZZ

Relevant facts and circumstances

Background facts

1.      Company A ('the Company') is an Australian public company which was incorporated in Australia and registered on the Australian Business Register on DD/MM/ZZZZ. Its equity interests are not listed for quotation in the official list of any stock exchange in Australia or overseas.

2.      During the YYYY income year, Company A did not hold an ownership interest in any entity and did not incur any expenses or derive any assessable income.

3.      During the ZZZZ income year, Company A acquired 100% of the shareholding in Company B and Company C. Company B has a wholly owned subsidiary (Company D) that operates a business overseas.

4.      Sometime after the share acquisition of Company B and Company C in the year ending 30 June ZZZZ, Company A issued new shares to new investors.

5.      Company A is the group head of a tax consolidated group.

6.      Company A's board of directors is comprised of multiple individuals.

7.      A services agreement has been drawn up between Company A and its wholly owned subsidiary company, Company B, under which Company B as a service provider will develop the Company's innovation ('the Product'). Under the agreement all existing and future intellectual property rights in the inventions and specified deliverables in relation to the development of the Product will be the sole and exclusive property of Company A.

8.      A previous Private ruling confirms that Company A meets the early stage test under subsections 360-40(1)(a) to (d) of the ITAA 1997 for the year ending 30 June ZZZZ.

Development of new or significantly improved innovations

9.      Company A (through the engagement, under a binding agreement, of the services of its wholly owned subsidiary Company B), is in the process of developing a platform ('the Product' or 'the Platform') to transform the future of a business process at scale, by changing the way in which small and medium sized (SME) business owners engage service providers for their financial back office needs.

10.   The Platform will cater to the changing needs of SME business owners and service providers and help them to form relationships in a digital world.

Genuinely focussed on developing innovations for commercialisation

11. Company A's commercialisation strategy is to contract business owners to the Platform via a subscription-based model.

12. The company has devised a business plan for the next three (and future) years which summaries the timeline of the milestones it intends to achieve to bring the Platform to its intended addressable markets.

High growth potential

13. The target markets for the Platform are growing SMEs seeking to streamline their financial back-office operations in specific identified industries.

14. Company A intends for the Platform to fill an identified growing trends gap in the market.

15. The growth potential of the Platform is driven by demand in the Australian market by SME business owners. Company A estimate that there are a substantial number of businesses within the Australian market that can easily be served by the Platform.

16. Company A believe that the growth potential of the Platform is supported by the fact that there is a large untapped supply of self-employed professionals in Australia looking for work in the gig economy, who would benefit from contracting with the Company to utilise the Platform to source additional work.

Scalability

17. Company A believes that it can reach a critical mass by achieving subscription of a small percentage of the potential SME clients in Australia. The Company believes that reaching critical mass in Australia before scaling overseas into larger, less regulated markets presents significant opportunity.

18. Company A believe that the Platform will achieve economies of scale as the business scales up.

Broader than local market

19. Company A are initially targeting the Australian market, and if success is achieved in the Australian market the Company intends to expand to overseas markets.

20. Company A believe that as the platform services a global industry, mainly dominated by sole practitioners, and the Platform streamlines a global standard, that the Platform offers a global opportunity to significantly improve back-office functions at scale.

Competitive advantages

21. Company A believe that the Platform will provide a number of significant competitive advantages over sole practitioners (who are likely to run outdated and inefficient processes), as well as other global services available in the market.

22. The Platform will be human capital light with a service expansion strategy, and a differentiated target market and expert marketplace strategy, which sets it apart from existing services on the global stage.

23. Company A believe that the Platform will fill a gap in a market that lacks a sophisticated scale brand associated with the services.

Information provided

24. You have provided information in a number of documents in relation to Company A's product.

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

Assumption

The services agreement document (as provided to the ATO), between Company A and Company B has been executed.

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.

SUMMARY

Company A satisfies the criteria of the early stage test pursuant to paragraph 360-40(1)(a) to (d) of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ended 30 June ZZZZ.

Company A satisfies the criteria of the principles-based innovation test pursuant to paragraph 360-40(1)(e) of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ended 30 June ZZZZ.

Company A satisfies the criteria of the foreign company test pursuant to paragraph 360-40(1)(f) of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ending 30 June ZZZZ.

Company A meets the criteria of an ESIC under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ended to 30 June ZZZZ.

DETAILED REASONING

Qualifying Early Stage Innovation Company

1.     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.

'EARLY STAGE TEST'

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

'INNOVATION TESTS'

3.     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

4.     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)

5.     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.

6.     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.

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

8.     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..."[1]

9.     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.

10.  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.

11.      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.[2]

12.      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."

13.      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."

14.  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.

15.  '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

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

17.  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 - subparagraph 360-40(1)(e)(iv) ITAA 1997han local market

18.  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

19.  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)

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

21.  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

22.  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 DD/MM/ZZZZ, and on or before 30 June ZZZZ.

Current year

23.  For the purposes of subsection 360-40(1), the current year will be the year ending 30 June ZZZZ (the ZZZZ 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 WWWW, XXXX and YYYY, and the income year before the current year will be the year ending 30 June YYYY (the YYYY income year).

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

24.  Private ruling Authorisation number 1051052019700508 confirms that Company A meets the early stage test under subsections 360-40(1)(a) to (d) of the ITAA 1997 for the year ended 30 June ZZZZ.

CONCLUSION FOR 'EARLY STAGE TEST'

25.  Company A meets the early stage test for the year ended 30 June ZZZZ, as each of the requirements under paragraphs 360-40(1)(a) to (d) of the ITAA 1997 have been satisfied

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

26.  Company A has not provided evidence of having satisfied the 100-point test under section 360-45 for the year ending 30 June ZZZZ. Company A is 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.

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

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

27.  In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be developing an innovation which either new or significantly improved for an applicable addressable market.

28.  Company A (through the engagement, under a binding agreement, of the services of its wholly owned subsidiary Company B), is in the process of developing a proprietary platform ('the Product' or 'the Platform') to transform the future of a business process at scale, by changing the way in which small and medium sized (SME) business owners engage service providers for their financial back-office needs.

29.  The Platform will cater to the changing needs of SME business owners and service providers and help them to form relationships in a digital world.

30.  Company A has provided details substantiating that it is developing a product that is either new or significantly improved for an applicable addressable market.

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

31.  In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be genuinely focussed on developing an innovation for commercial purpose in order to generate economic value and revenue for the company.

32.  Company A's commercialisation strategy is to contract business owners to the Platform via a subscription-based model.

33.  The company has devised a business plan for the next three (and future) years which summaries the timeline of the milestones it intends to achieve to bring the Platform to its intended addressable markets.

34.  Company A has provided details substantiating that that it is genuinely focussed on developing its innovation for commercial purpose in order to generate economic value and revenue for the company.

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

35.  Company A is genuinely focussed on developing their product for commercialisation. The product will be a significantly improved product compared to existing products in their addressable market.

36.  Therefore, subparagraph 360-40(1)(e)(i) is satisfied for the period DD/MM/ZZZZ to 30 June ZZZZ. 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)

37.  In applying the requirements of subparagraph 360-40(1)(e)(ii), Company A must be able to demonstrate that it has high potential growth within a broad addressable market.

38.  Company A has provided details substantiating that it meets this requirement.

39.  Therefore, subsection 360-40(1)(e)(ii) is satisfied.

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

40.  In applying the requirements of subparagraph 360-40(1)(e)(iii), Company A must be able to demonstrate that it has the potential to scale up the business.

41.  Company A has provided details substantiating that it meets this requirement.

42.  Therefore, subsection 360-40(1)(e)(iii) is satisfied.

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

43.  In applying the requirements of subparagraph 360-40(1)(e)(iv), Company A must be able to demonstrate that it has the potential to address a broader than local market, including global markets.

44.  Company A has provided details substantiating that it meets this requirement.

45.  Therefore, subsection 360-40(1)(e)(iv) is satisfied.

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

46.  In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must be able to demonstrate that it has the potential to be able to have competitive advantages for that business

47.  Company A has provided details substantiating that it meets this requirement.

48.  Therefore, subsection 360-40(1)(e)(v) is satisfied.

Conclusion on principles-based test

49.  Company A satisfies the principles-based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the ZZZZ income year.

'FOREIGN COMPANT TEST' - subparagraph 360-40(1)(f) ITAA 1997

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

CONCLUSION

51.  Company A meets the eligibility criteria of an ESIC under section 360-40 of the ITAA 1997 for the ZZZZ income year.

[1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76.

[2] OECD Oslo Manual, paragraph 124 and paragraph 151.

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