Edited version of private advice

Authorisation Number: 1052234065819

Date of advice: 22 March 2024

Ruling

Subject: Early stage innovation company eligibility

Question:

Does Company X meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 ('ITAA 1997') for the period from a test time occurring after the company incorporated on DD MM YYYY to DD MM YYYY?

Answer:

Yes.

This ruling applies for the following periods:

DD MM YYYY to DD MM YYYY

The Scheme commences on:

DD MM YYYY

RELEVANT FACTS AND CIRCUMSTANCES

Background information

Company X is an Australian proprietary company incorporated in XYZ on DD MM YYYY.

Company X's directors are AAA and BBB.

Company X's registered office is situated at XYZ

Company X's principal place of business is situated at ZYX.

Company X has no wholly or partly owned subsidiaries. Company X is not part of an income tax consolidated group.

For the financial year ending DD MM YYYY, Company X incurred and earned the following:

•         Total expenses of $xxx

•         Total income of $yyy

Company X's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.

Product Development

Company X is developing an app ('the Product') which uses a unique algorithm which is a world first particular technology that will provide a comprehensive solution so that users can easily connect with other users, fostering an active atmosphere that pushes their limits and facilitates growth, while prioritising safety, trust and the joy of engaging in experiences. The algorithm gets smarter the more the app users are active on the app.

The app will allow users to freely communicate with each other and upload content.

Existing platforms and resources often fail to cater specifically to the needs of particular enthusiasts, leaving them without a dedicated space to connect. Inefficient networking channels and limited opportunities make it arduous to find suitable partners, particularly in less populated areas.

Safety and trust become paramount concerns when engaging in activities with unfamiliar people. The absence of reliable verification methods leaves players uncertain about the quality of their experiences. Additionally, busy schedules and conflicting time availability make it challenging to align with other similar users.

Communication and coordination issues further hinder the process of connecting with unknown people. This app will enable the people to meet while eliminating numerous challenges.

Company X's app Version 1 features to match potential users most accurately.

Company X will offer the first broad use booking and payment system for multiple venues. This service will be via a business subscription and access via an online portal. Company X will facilitate the booking, receipt the funds, deduct a booking fee and send the funds to the participating business.

Product Development Stages

Company X is currently developing their Product as follows:

•         Market Research: Company X has conducted a review of current solutions in the market and determined there is not a satisfactory solution to this problem.

•         Product Development: Based on market research and refined to ensure it meets the needs and expectations of the target market.

•         Branding and Positioning: Company X have developed a strong brand ID that will convert across multi country demographics, both culturally and from a social acceptance perspective.

•         Distribution Channels: Version 1 has business heads of agreements for use which features over xxx customers in Australia and one of the businesses has over x million members overseas.

•         Marketing and Promotion: Version 1 will be marketed through the initial businesses that continue to sign up pre and during development.

•         Launch Marketing Strategy to be completed - MM YYYY

•         Continue seeking businesses to participate in the first release (MM YYYY)

•         Develop and test application (MM YYYY)

•         Release to businesses under HOA - MM YYYY

•         General Release - MM YYYY

•         Potential promotion - MM YYYY

Company X outlined future steps which still need to be completed.

Commercialisation Strategy

Company X provided details of commercialisation strategies it has employed for the Product:

High Growth Potential

Company X has signed up businesses with over xx customers under an EOI. This states that if the technology was available today, they would implement it in their business to better enhance their customer experience.

They have xx EOIs committed with only x businesses, they have not yet promoted the product as they are still in confidential stages. The market estimated around the world in terms of users is xx million.

Company X is using strategies to generate high growth.

Scale up the Business

Company X will start by signing on various organisations. The ongoing revenue projections in year x and y is circa $xx million and $xx million respectively with a base operating cost of xx%.

The app will scale up during each version release. Version 1 will feature the minimum feature requirements to accurately match a team between users.

A strong marketing campaign will commence shortly after the second raise with a heavy emphasis on user acquisition.

Broader than Local Market

Company X aims to thrive in the global market as the larger the populous, the better the results. The marketing program incorporates overseas based initiatives which are earmarked for approach.

The app will have great appeal for traveling as users can update their location with ease and start meeting up with users in different locations.

The transition between countries/markets will be with ease, each country release will be culturally and lingually appropriate.

The global market size of the industry is forecast to grow at an annual rate of over xx percent in the coming years.

It has been demonstrated by companies in similar fields that these apps have the potential to go global. The plan is to start with a local market and then go global as the app has the ability to expand and use different geographic locations.

Competitive Advantages

The app's technology is a world first, the algorithm scraps the internet to build a profile for the user and combined with other attributes of the user, it will recommend users connect.

Furthermore, it encompasses geo location/user's availability and frequency.

The level of detail required, and the unique algorithm will be far superior to any competitors in the market.

Key competitive advantages of Company X's app were provided.

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

Company X'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 X's Product, including:

•         Private Binding Ruling ('PBR') Application, dated DD MM YYYY

•         Response to further questions provided

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

Company X proposes to issue new shares prior to DD MM YYYY.

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

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

SUMMARY

Company X meets the eligibility requirements of an ESIC under subsection 360-40(1) for the period froma test time occurring after the company incorporated on DD MM YYYY to DD MM YYYY.

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 any 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 any 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 any 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 Innovation 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 X is a qualifying ESIC, will be upon the issue of qualifying shares on a particular date or dates after DD MM YYYY, and on or before DD MM YYYY. Company X proposes to issue new shares before DD MM YYYY.

Current year

Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending DD MM YYYY (the YYYY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending DD MM YYYY, YYYY and YYYY, and the income year before the current year will be the year ending DD MM YYYY (the YYYY 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 X was incorporated in in XXX on DD MM YYYY, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) are satisfied.

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

In applying the requirements of paragraph 360-40(1)(b), Company X and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the YYYY income year, being the income year before the current year.

Company X incurred expenses of $xx in the YYYY 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 X and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the YYYY income year, being the income year before the current year.

Company X earned assessable income of $xx in the YYYY 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 X must not be listed on any Stock Exchange in Australia or a foreign country at the test time.

Company X 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 X satisfies the early stage test for the period froma test time occurring after the company incorporated on DD MM YYYY to DD MM YYYY, 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 X has not provided sufficient evidence of satisfying the 100-point test under section 360-45 for the year ending DD MM YYYY. Company X 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.

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 X must be developing an innovation which is either new or significantly improved for an applicable addressable market.

Company X is developing an app ('the Product') which uses a unique algorithm which is a world first particular technology that will provide a comprehensive solution so that users can easily connect with other users, fostering an active atmosphere that pushes their limits and facilitates growth, while prioritising safety, trust and the joy of engaging in experiences. The algorithm gets smarter the more the app users are active on the app.

The app will allow users to freely communicate with each other and upload content.

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

Company X is genuinely focussed on developing their Product for an applicable addressable market.

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 X must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company.

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.

Company X anticipate that the current programme of development will be completed in the YYYY financial year.

Company X is genuinely focussed on developing their Product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period froma test time occurring after the company incorporated on DD MM YYYY to DD MM YYYY, 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 X will no longer be 'developing' the product for commercialisation.

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

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

Company X has high growth potential as their Product is easily and infinitely scalable to a global audience.

Company X has provided details to satisfy this requirement.

Company X has demonstrated a high growth potential for their Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period froma test time occurring after the company incorporated on DD MM YYYY to DD MM YYYY.

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

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

Company X has provided details to satisfy this requirement.

This leverage ensures that Company X has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period froma test time occurring after the company incorporated on DD MM YYYY to DD MM YYYY.

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

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

Company X has provided details to satisfy this requirement.

Company X 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 froma test time occurring after the company incorporated on DD MM YYYY to DD MM YYYY.

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

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

Company X has provided details to satisfy this requirement.

Company X has demonstrated that it has competitive advantages for its business, so subparagraph 360-40(1)(e)(v) is satisfied for the period froma test time occurring after the company incorporated on DD MM YYYY to DD MM YYYY.

CONCLUSION FOR PRINCIPLES BASED TEST

Company X satisfies the Principles-based Innovation test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period froma test time occurring after the company incorporated on DD MM YYYY to DD MM YYYY, 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 X was incorporated in Australia, it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied.

CONCLUSION

Company X meets the eligibility criteria of an ESIC under section 360-40 for the period froma test time occurring after the company incorporated on DD MM YYYY to DD MM YYYY, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier.

Other references (non ATO view)

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

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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