Edited version of your written advice

Authorisation Number: 1051348447366

Date of advice: 12 March 2018

Ruling

Subject: Early Stage Innovation Company qualification

Question

Does Company A meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes but only up to the date when it decided to discontinue the development of the innovation on Date X.

This ruling applies for the following period:

Year ended 30 June 2017

The scheme commences on:

1 July 2016

Relevant facts and circumstances

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

2. Company A has no subsidiaries and has expenses of $2X in the year ended 30 June 2016. It did not generate any assessable income in the year ended 30 June 2016.

3. Company A was developing an online customer service portal to support its product.

4. Company A’s goal was to allow customers to use their portal in their dealings with Company A rather than use human staff to provide their clients services.

5. Company A’s market is an Australian market.

6. The online service would have provided:

● Sales advice (personalised sales)

● Customer service (answering common questions about their product and resolving customer enquiries without human contact)

● Advice (providing advice about their products)

1. A list of key differentiators was provided:

Commercialisation strategy

2. The original development plan of was to design and build the technology behind the online service and have it available for use within 13 months.

3. The initial prototype was delivered on time and tested with customers.

4. The second stage was far more resource intensive than expected and this delayed its delivery.

5. Other issues arose and Company A’s board decided on Date X not to move forward with the service and resources were diverted to a more conventional web-based product which was ultimately delivered.

Information provided

6. You have provided information in a number of documents in relation to the online service, including:

a. your private ruling application dated 14 February 2018.

b. information provided with the application; and

c. supplementary information provided on 6 March 2018.

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

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-40

Reasons for decision

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

Summary

Company A met the eligibility requirements of, an ESIC under, subsection 360-40(1) but only up to the date the board decided to discontinue the development of the online service on Date X.

Detailed reasoning

Qualifying Early Stage Innovation Company

8. 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’

9. 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)

10. 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).

11. 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.

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

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

13. 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)

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

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

15. 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

16. 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.

‘Principles-based test’ – subparagraphs 360-40(1)(e)(i) to (iv)

17. 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.

18. 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.

19. 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

20. 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…”

21. 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.

22. 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.

23. 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.

24. 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.”

25. 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.”

26. 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.

27. ‘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

28. 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

29. 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

30. 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

31. 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

32. For the purposes of this ruling, the test time for determining if Company A is a qualifying ESIC will be a particular date during the income year ending 30 June 2017.

Current year

33. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2017 (the 2017 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 2017, 2016 and 2015, and the income year before the current year will be the year ending 30 June 2016 (the 2016 income year).

Early stage test

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

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

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

35. As Company A had expenses was $1 million or less in the prior income year paragraph 360-40(1)(b) is satisfied.

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

36. As Company A had no assessable income for the prior income year is paragraph 360-40(1)(c) is satisfied.

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

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

Conclusion on early stage test

38. Company A satisfies the early stage test for the entire 2017 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)

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

40. Company A was developing their own products for the Australian market and will be competing against other providers of similar products.

41. Looking at product there are a large number of competing products already in the market. As a result it is difficult to determine if this product is new or significantly improved in the sense required under the principles-based test because of the volume of competing products.

42. In this case it was easier to examine to the online service as a ‘process’ innovation.

43. In this case the online service would have interacted with their clients in a life-like manner. Once developed it would have removed the need to provide their services through human interaction greater reducing their customers services costs.

44. Therefore for the purposes of the principles-based test the innovation that would have been new or significantly improved the online service as we could not identify a competitor using an online service as sophisticated as the one Company A intended to develop.

45. Therefore the online service would have been a significantly improved process compared to existing ways in which competitors interact with their clients.

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

46. As explained in the commercialisation strategies in the facts of this ruling the original plan of was to commercialise within 13 months of commencing development.

47. However after testing initial porotypes issued were identified with the system that delayed development.

48. Company A’s board decided not to move forward with the development beyond 7 February 2017 and resources were diverted to developing a more conventional web-based product which is was ultimately delivered.

49. Once the board decided to cease developing the online service they were no longer focused on developing it for commercialisation.

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

50. Company A was genuinely focussed on developing their online service for a commercial purpose.

51. Once the level of complexity was determined a decision was made to switch the focus to more conventional web-based product they ceased developing it.

52. In looking at this subparagraph it is satisfied up to the point Company A’s board chose to discontinue development of Chat for commercialisation.

53. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 2016 until Date X when the board decided to suspend the development of the service.

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

54. Information provided outlines how Company A will earn its assessable income.

55. The financial projections show the predicted growth of Company A.

56. If the commercialisation strategy is successful, this may give Company A the ability to increase sales through the uptake of its product.

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

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

58. The financial projections illustrate the potential increase in projected sales.

59. The Online service would have removed then need to use human staff to provide a service. It is the human element of Company A’s industry that generally impacts negatively on whether a business can be scaled up.

60. The strategy for the use of inline service would have abled them to generate increased revenue without the need to employee more staff. This would have afforded Company A the potential to successfully scale up its business.

61. Setting aside the online service, the financial projections and ‘total costs’ projected costs have remained steady or have only small increases when compared with the increase in projected revenue.

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

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

63. Company A’s market is the Australian market and they intend to target customers all over Australia.

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

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

65. Company A provided the differentiating features of the online service that may have given them a competitive advantage.

66. Being the in their market to provider to use the type of service they intended to develop Company A had the potential for first mover advantage had it been implemented.

67. The fact that Company A’s board ceased development once the level of complexity was fully established does not mean that the potential was not there. As with all companies applying this principles-based test the potential may not be realised as the future events and development activities of their competition may mean that no competitive advantage is realised.

68. Although the potential competitive advantages were never realised the potential for a competitive advantage was there so subparagraph 360-40(1)(e)(v) was still satisfied.

Conclusion on principles test

69. Company A satisfied the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i)to (v) for the period commencing 1 July 2016 until the board decided to cease the development of the online service on Date X.

Conclusion

70. Company A met the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 2016 until the board decided to cease the development of the online service on Date X.