Edited version of your written advice

Authorisation Number: 1013101503609

Date of advice: 30 September 2016

Ruling

Subject: Income Tax: Tax Incentive for Early Stage Investors

Question 1

Does Company A meet the criteria of an Early Stage Innovation Company under section 360-40 of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following periods:

1 July 20YY to 30 June 20ZZ

The scheme commences on:

1 July 20YY

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Background facts

1. Company A is an Australian resident company incorporated in 20XX and started trading in 20XX.

2. Company A is not listed for quotation in the official list of any stock exchange in Australia or a foreign country.

3. Company A is in the business of software development.

4. Company A owns all of the intellectual property and related assets of the Business.

5. Company A is seeking investment to continue to develop a mobile application that will provide a service to its users.

Information provided

6. You have provided us with the following:

● A draft Private Ruling application.

● A copy of Company A's 20YY Business Plan.

● Responses to our queries.

● Detailed Profit and Loss (with notes) for the year ended 30 June 20YY.

● Detailed Balance Sheet for the year ended 30 June 20YY.

● Income Tax Return (with supporting schedules and work papers) for the year ended 30 June 20YY.

7. We have referred to the relevant information within these documents in applying the principles based test to your circumstances.

8. You propose to issue shares in Company A to various investors to assist in funding the continued development and commercialisation of the mobile application.

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

Reasons for decisions

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

Detailed reasoning

Qualifying early stage innovation company (ESIC)

9. Subdivision 360-A sets out the main requirements for being eligible for either the early stage investor tax offset or the modified capital gains tax (CGT) treatment on eligible equity interests.

10. Subsection 360-15(1) outlines the requirements for an investor to assess entitlement to the tax offset. The relevant point in time is when the newly issued shares are issued. It is also immediately after that time the company would need to meet the requirements of being an ESIC.

11. Section 360-40 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

12. The early stage test determines if the company is at an early stage in its development. In short, the company must satisfy the following requirements at a particular time in an income year:

● Recent incorporation or registration in the Australian Business Register

● Total expenses of $1 million or less

● Assessable income of $200,000 or less, and

● Not listed on a stock exchange.

13. These requirements are outlined in detail within paragraphs 360-40(1)(a) to (d).

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

14. 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).

15. 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.

16. It is considered that a company will satisfy the incorporation test in subparagraph 360-40(1)(a)(i) where, immediately after the issue of shares to the investor, the company had been incorporated in either:

● that part of the current year which precedes the issue of shares; or

● one of the two income years prior to that year.

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

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

18. 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)

19. 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.

20. In determining the company's assessable income, any amount of Accelerating Commercialisation Grant that the company received in that year can be disregarded.

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

21. 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

22. 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. These tests determine whether the company is developing new or significantly improved innovations to generate an economic return.

23. For the purposes of Division 360, an innovation is considered to be a development of a new or significantly improved product, process, service, marketing or organisational method.

Principles- based test - paragraph 360-40(1)(e)

24. 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.

25. 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.

26. 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)

The addressable market

27. The term "addressable market" is not used in the ITAA 1997 but is mentioned in paragraph 1.79 of the Explanatory Memorandum to the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016.

28. The company must be able to demonstrate that the company is developing a new or significantly improved innovation that is a product, process, service, marketing method or organisational method.

29. Depending on what type of innovation the company is developing, whether the innovation is new or significantly improved is measured against either:

● the products and services that are available in the company's addressable market, or

● the processes and methods that are in use in the company's addressable market.

30. The addressable market is commonly referred to as the total addressable market (TAM) or total available market. It means the total available revenue opportunity or market demand for the innovation that the company is developing, or the business relating to its innovation. A company should be realistic and objective when identifying the company's addressable market.

31. Considering the size of the company's addressable market helps to prioritize business opportunities by serving as a quick metric of the underlying potential of a given opportunity.

32. Considerable support for defining the term "addressable market" can be drawn from how the term "market" is defined in competition law (former trade practices). Under competition law (Competition and Consumer Act 2010), a market can be defined in various ways which are:

(a) product market (i.e. the nature and characteristics of the goods or services)

(b) geographic market (e.g. local, state, national or international)

(c) functional market (e.g. wholesale or retail), and

(d) temporal market.

33. This competition law term can be used to help define the term "addressable market". In determining the addressable market, a company should consider the location of its potential customers and the geographical area that it will serve. For example, if the company is seeking to serve customers in Australia, then its addressable market will be the Australian market.

New or significantly improved in the addressable market

34. Once the company has identified its addressable market, it should consider whether the company is developing a product, service, process, marketing method or organisational method that is new or significantly improved for that market.

35. The innovation being developed by the company must either be new or significantly improved for an applicable addressable market.

36. 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.

37. The Oslo Manual published by the OECD (Oslo Manual) uses three concepts to measure the novelty of an innovation, which consider whether an innovation is new to the firm, new to the market, or new to the world. As the principles-based innovation test asks whether an innovation is new or significantly improved in relation to the company's addressable market, it is most closely aligned to the 'new to market' concept of innovation.

38. The Oslo Manual describes four different types of innovation; one of them is Product or service innovations (paragraph 156 to 162 and 540 to 542 of the Oslo Manual).

39. A product or service innovation involves a significant change in the capabilities of goods or services. Paragraph 156 of the Oslo Manual states that this can involve either:

● the introduction of new products or services, or

● a significant improvement in the functional characteristics or intended uses of an existing product or service.

40. A product or service is new if it differs significantly in its characteristics or intended uses from existing products or services that are available in the addressable market.

41. Significant improvements of existing products can occur through changes in technical specifications, materials, components, incorporated software, user friendliness or other functional characteristics that enhance performance.

42. Product innovations exclude the following (para 541 of the Oslo Manual):

● Minor changes or improvements

● Routine upgrades, and

● Design changes that do not alter the function, intended use or technical characteristics of a good or service.

Developing an innovation for commercialisation

43. 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.

44. '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.

45. It is not sufficient for the company to have an innovative idea - instead it must be taking or planning to take tangible steps to develop an innovation to the point where it will generate revenue for the company.

46. The company needs to consider whether it is genuinely focussed on developing an innovation that will lead towards either:

● the sale of the new or significantly improved product, process or service, or

● the implementation of a new or significantly improved process or method, which will be used by the company in a way that directly leads to the generation of revenue.

47. The pre-commercialisation stage may involve a range of activities such as market research, developing a proof of concept, prototyping, user testing, setting up manufacturing and marketing processes, and other business development activities to prepare for the launch of a product or service.

48. To be developing an innovation for commercialisation, the company must `be at a stage before the innovation has been successfully commercialised. If the company has achieved a number of commercial sales or it is otherwise generating significant revenue from the business relating to the innovation, it is likely that the innovation is no longer being developed for commercialisation.

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

49. 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.

50. The company should be able to demonstrate the factors that have the potential to drive high growth, such as the company's ability to enter into new markets or the strength of the appeal of its products or services to customers across a broad area.

51. The company should have a strategy that sets out the tangible steps that will be taken, or have been taken, to capitalise on these growth opportunities. Evidence that the company is experiencing early traction, for example by developing key relationships with customers or suppliers, could be used to support its high growth potential.

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

52. 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)

53. 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)

54. 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.

55. The company can analyse what competitors in the market offer, and consider whether the company has a differentiating advantage that would allow it to outperform these competitors.

Application to your circumstances

Test time

56. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date on or after 1 July 20YY, but before 30 June 20ZZ.

57. Therefore, for the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20ZZ (the 20ZZ income year).

58. For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending 30 June 20ZZ, 20YY and 20XX.

The early stage test

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

59. Company A was incorporated in 20XX, which is within the last 3 income years, therefore subparagraph 360-40(1)(a)(i) is satisfied.

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

60. To meet the requirement in paragraph 360-40(1)(b), Company A must have incurred total expenses of $1 million or less in the 20YY income year, being the income year before the current year.

61. Company A recorded $X of expenses at item six as part of their total profit or loss calculation in their company income tax return for the year ended 30 June 20YY. The same amount is included in financial statements for the year ended 30 June 20YY.

62. As the incurred total expenses for Company A during the 20YY financial year is less than $1 million, paragraph 360-40(1)(b) is satisfied.

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

63. Company A recorded $X of assessable income in their company income tax return for the year ended 30 June 20YY. The same amount is included in financial statements for the year ended 30 June 20YY.

64. As Company A did not receive any other income during the 20YY financial year, the total assessable income derived by Company A in the 20YY financial year is less than $200,000. Therefore, paragraph 360-40(1)(c) is satisfied.

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

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

Conclusion on early stage test

66. Company A will satisfy the early stage test for the entire 20ZZ income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

Principles based test

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

The addressable market

67. Based on the details you provided we are of the view the addressable market is the Australian market.

New or significantly improved in the addressable market

68. Company A is developing a software system. The system provides a service and is particularly suited for a variety of customers.

69. The information you provided outlines in detail the design of the system.

70. There are only a few companies in the Australian market that currently offer solutions similar to your system. You have provided extensive details comparing features and outlining why your system will be a unique system compared to other available systems.

71. You state there is no other competitor in the Australian market which offers a system comparable to your system.

Developing an innovation for commercialisation

72. You do not expect the system to be fully developed before 30 June 20ZZ. You have provided us with a list of additional steps required to completely commercialise the service, achieve product-market fit and achieve its growth and traction targets.

73. The above facts demonstrate that Company A has taken tangible steps to lead to the sale of its products, which demonstrate a genuine focus on developing the app system for commercial sale.

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

74. Company A is genuinely focussed on developing the mobile application in the Australian market for a commercial purpose. The fact that the service is currently available does not automatically mean that it has been commercialised.

75. The Company A's mobile application will be a significantly improved product compared to the mobile applications currently available in the Australian market.

76. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied, for the time period from 1 July 20YY until 30 June 20ZZ or the date when the app has been fully developed, whichever occurs earliest. The Commissioner considers that once the app has been fully developed, Company A will no longer be 'developing' the app and subparagraph 360-40(1)(e)(i) will no longer be satisfied.

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

77. Company A has a strategy that sets out the tangible steps that will be taken, or have been taken, to capitalise on the growth opportunities in the Australian market.

78. The information you provided outline factors which indicate that Company A has high growth potential.

79. Company A's month on month growth demonstrated ability to scale quickly and ensure supply is keeping pace or outpacing demand along the way.

80. Conversion rates from social media advertising and retention rates from customers after having their first experience have been very high.

81. The business relating to the mobile application has the potential to rapidly expand its customer base across the Australian market. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied.

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

82. The unit economics of Company A business model have been provided to us.

83. With gross margin being maintained at x%, Company A can take advantage of economies of scale as volume increases for relatively stable operating costs. This operating leverage means that existing revenues can be multiplied while incurring a reduced, or minimal, increase in operating costs.

84. You state that as Company A expands its sales, it will be able to generate increased revenue with only a minimal increase in its operating costs, due to the app already being completed.

85. This operating leverage ensures Company A has the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied.

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

86. Company A has a very simple, portable, and adaptable business model. The information you provided outline in detail the business model.

87. Company A's business model can easily be replicated in other markets both inside Australia and overseas with very little localisation or customisation required.

88. The business relating to the app has the potential to rapidly expand its customer base across the Australian market and internationally. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

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

89. Company A currently has no direct competitors in the current market and, therefore, has first mover advantage which is a considerable competitive advantage in the technology industry.

90. Company A is also currently recruiting personnel and forming business relationships which also provide a significant intangible asset to the company and make it very difficult for a follower to quickly and easily enter the market with the same scale.

91. While there are competitors in other states around Australia, Company A has competitive advantages that are demonstrably rare and difficult to copy that provide significant value for customers.

92. You state that while there are competitors in other states around Australia, Company A has competitive advantages that are demonstrably rare and difficult to copy that provides significant value for customers. These are based on intellectual property (i.e. integrated menus for food merchants, live GPS tracking, and a driver reputation system).

93. Company A intends to raise capital and undertake an extensive sales, marketing and PR campaign in order to consolidate its number 1 status in the Australian market and use this as a base from which to defend against any potential new entrants.

94. The company plans to sustain its competitive advantage continuing to be as efficient as possible and ensure it can compete on price, while also being nimble and agile and pivoting as product-market fit dictates as the industry matures and evolves.

119. Therefore, Company A has demonstrated the potential for the app to have competitive advantages for customers in Australia satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

120. Company A satisfies the principles based test as it meets the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20YY until 30 June 20ZZ or the date when the app has been fully developed, whichever occurs earlier.

Conclusion

121. Company A meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20YY until the earlier of 30 June 20ZZ or the date when the app has been fully developed, whichever occurs earlier.

ATO view documents

N/A

Other references (non ATO view)

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

Oslo Manual published by the OECD