Edited version of your written advice

Authorisation Number: 1013137045630

Date of advice: 7 December 2016

Ruling

Subject: Early Stage Innovation Company

Question:

Does the Company 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 period

1 July 201X to 30 June 201X

The scheme commences on

1 July 201X

Relevant facts and circumstances

The Company is an Australian resident company incorporated on DD MM YY.

The Company is not listed for quotation in the official list of any stock exchange in Australia or a foreign country and has no subsidiaries.

The Company is focused on developing a new proprietary technology product that will provide an easy interface for business to business interaction.

The intellectual property (IP) of the business is owned by the Company. There is a relevant application which restricts competitor duplication of the product and early competitor entry in the same market. The brand name has an Australian Trade Mark application number.

Information provided

You have provided us with the following:

● A Private Ruling application.

● A copy of the Company's Business Plan.

● Responses to our queries in emails dated mid 201X, mid 201X and mid-late 201X.

● Profit and Loss Statement for the year ended 30 June 201X.

● Balance Sheet for the year ended 30 June 201X showing expenses and income.

● Relevant market research Industry report

● Deed of Assignment between the Founder and the Company.

● Timetable for Delivery

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

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

Income Tax Assessment Act 1997 section 975-505

Income Tax Assessment Act 1997 section 975-150

Reasons for decision

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

Qualifying early stage innovation company (ESIC)

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.

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.

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

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.

These 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 the company and its 100% subsidiaries incurred total expenses of $1 million or less; or

iii. registered in the Australian Business Register (ABR) within the last three income years (the latest being the current year).

The term 'current year' is defined in subsection 360-40(1) with reference to the 'test time'; the 'current year' being the income year in which the company issues shares to the investor.

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.

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

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

To meet the requirement in paragraph 360-40(1)(b), the company and its 100% subsidiaries must have incurred total expenses of $1 million or less in the income year before the current year.

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

To meet the requirement in paragraph 360-40(1)(c), the company and its 100% subsidiaries must have derived total assessable income of $200,000 or less in the income year before the current year.

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)

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

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)

To satisfy the principles-based test, the company must meet five requirements in paragraph 360-40(1)(e). This is tested at a time immediately after the relevant new shares are issued to the investor.

The company can demonstrate that it meets each requirement through existing documentation such as a business plan, commercialisation strategy, competition analysis or other company documents. The company must be able to show that tangible steps have been or will be taken in relation to each of the requirements.

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

i. The company must be genuinely 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

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.

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.

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.

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.

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.

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.

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

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.

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

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.

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.

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).

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.

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.

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.

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

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.

'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.

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.

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.

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.

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)

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.

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.

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)

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)

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)

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.

Application to your circumstances

Test time

For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC will be a particular date on or after 1 July 201X, but before 30 June 201X.

Therefore, for the purposes of subsection 360-40(1), the current year will be the year ending 30 June 201X (the 201X income year).

For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending 30 June 201X, 201X and 201X.

The early stage test

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

The Company was incorporated in 201X, which is within the last 3 income years, therefore subparagraph 360-40(1)(a)(i) is satisfied.

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

To meet the requirement in paragraph 360-40(1)(b), the Company must have incurred total expenses of $1 million or less in the 201X income year, being the income year before the current year.

The Company has not lodged an income tax return for the year ended 30 June 201X. The Profit and Loss Statement shows expenses totalling less than $1 million.

As the incurred total expenses for the Company during the 201X financial year is less than $1 million, paragraph 360-40(1)(b) is satisfied.

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

To meet the requirement in paragraph 360-40(1)(c), the Company must have derived total assessable income of $200,000 or less in the 2016 income year.

The Company has not lodged an income tax return for the year ended 30 June 201X. The Profit and Loss Statement shows income less than $200,000.

As The Company did not receive any income during the 201X financial year, the total assessable income derived by The Company in the 201X financial year is less than $200,000. Therefore, paragraph 360 40(1)(c) is satisfied .

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

The Company 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

The Company will satisfy the early stage test for the entire 201X 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

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

New or significantly improved in the addressable market

The Company is developing a new technology product. The system provides a service and is particularly suited for a variety of customers wishing to link with other businesses.

The information provided outlines in detail the design of the new technology product.

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

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

Developing an innovation for commercialisation

You expect to launch the product to be launched before 30 June 201X. You have provided us with a list of additional steps required to completely commercialise the service.

The above facts demonstrate that the Company has taken tangible steps to lead to the sale of its product, which demonstrate a genuine focus on developing the new technology product system for commercial sale.

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

The Company is genuinely focussed on developing its product, being a new interface that matches businesses to businesses. Although this business model is not new per se, it is new to the industry in the Australian market, as stated in your ruling application.

The service is not currently available since it is still in the process of being developed for commercialisation.

Therefore, subparagraph 360-40(1)(e)(i) will be satisfied, for the time period from 1 July 201X until 30 June 201X or the date when the new technology product has been fully developed, whichever occurs earliest. The Commissioner considers that once the new technology product has been fully developed, the Company will no longer be 'developing' the new technology product and subparagraph 360-40(1)(e)(i) will no longer be satisfied.

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

The Company 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.

Marketing of will be in two steps.

The above factors indicate that The Company has the potential to rapidly expand its customer base across the Australian market. Therefore, subparagraph 360-40(1)(e)(ii) is satisfied.

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

The unit economics of the Company's business model have been provided to us.

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

The Company 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.

This operating leverage ensures the Company 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)

The Company has a very simple, portable, and adaptable business model. The core of the platform lies in the software that receives requests from the front-end user interface, being the new technology product, and then, using algorithms, assigns the most appropriate service to the customer.

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

The business relating to the new technology product 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)

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

The comparative analysis provided as part of the Private Ruling application, in conjunction with the analysis of competitors in the Business Plan, indicate that there are no direct competitors offering the same services as the Company.

The Company is also currently forming partnerships and these relationships 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.

The intellectual property (IP) of the business was transferred from the inventor to the Company. The IP includes a relevant application which restricts competitor duplication of the product and early competitor entry in the same market. The brand name has an Australian Trade Mark application number.

The Company's competitive advantages of being first to market will be maintained through a combination of its IP protection, trade secrets, exclusivity contracts with partners, as well as the opportunity afforded by being first to market of building and maintaining a large customer base.

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

Conclusion on principles test

The Company 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 201X until 30 June 201X or the date when the new technology product has been fully developed, whichever occurs earlier.

Conclusion

The Company meets the eligibility criteria of an early stage innovation company under section 360-40 for the period commencing 1 July 201X until the earlier of 30 June 201X or the date when the new technology product has been fully developed, whichever occurs earlier.