Edited version of your written advice

Authorisation Number: 1051456181971

Date of advice: 23 November 2018

Ruling

Subject: Early Stage Innovation Company

Question

Does the Company 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

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

1. The Company was incorporated in Australia within the last three income years. Its equity interests are not listed for quotation in the official list of any stock exchange.

2. The Company has no subsidiaries and has expenses of less than $1 million in the previous income year, i.e. the year ended 30 June 20XX. Its assessable income is less than $200,000 in the year ended 30 June 20XX.

3. The Company is developing a product, which aims to offer something beyond any other competing product on the world stage.

4. The Company has identified its ultimate market as being the global market, with its initial target being Australia.

5. The product was developed and funded by person A, who owned 100% of The Company.

6. Person A has transferred all the IP rights to the Company, which so far has been protected by confidentiality agreements via an Assignment Deed dated and executed on XX/mth/20XX.

7. The Company will formally register the IP as close to the public launch of the product as possible.

8. An application has been made to IP Australia to register the name as a Trademark to help protect the brand.

9. From research conducted by you, within Australia the market is still in its infancy.

10. You submitted that sales and resultant revenue from the product are currently riding the crest of a wave.

11. In addition to the above, you have highlighted that in respect of other competitors that No other product in the world provides a comprehensive package of useful features. There are many features designed by the Company and unique to the product.

12. Research predicts the market for the product to grow over the next eight years.

13. Predicted sales forecasts over the next five years shows that the Company aims to double sales each year increasing its Australian and European market share.

14. Total revenue from product sales is forecast to go up significantly between the years 20XX and 20XX.

15. It is forecast that production costs will reduce and profit margins will increase between 20XX and 20XX as the Company to turns to more automated methods with manufacturing processes completed offshore where labour costs are low.

16. Estimations suggest a 50% reduction in cost to produce the product once production reaches a certain level.

Commercialisation strategy

17. The Company has completed a number of market validation activities including:

a) Research

b) Seeking feedback

c) Surveys

d) Customer interviews

18. The Company’s product has deliberately been designed to meet both Australian and European standards.

19. The product will initially be sold in location A.

20. The business raised equity capital in March 20XX to further the design and engineering of the product, and 6 Beta versions will be completed in late 20XX for rigorous user testing. In addition, the company is investigating options for manufacturers for the production of the first commercial output of the product.

21. The Company will pursue product sales through:

a) An online sales system

b) A website

c) Social media

d) Brand Ambassadors

e) Engaging a market professional with experience in growing market share in the target areas.

22. The Company will first target places where there is an established market but high level of competition. The second focus will be on specific locations where the product has not taken off yet but have the right ingredients to be large markets.

Information provided

23. You have provided information in a number of documents and phone conversations in relation to ‘The Innovation’, including:

a) Your private ruling application.

b) Supplementary information provided.

24. We have referred to the relevant information in applying the relevant tests to your circumstances.

25. You propose to issue new shares in the Company to various investors to assist in funding the continued development and commercialisation of the product.

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 ITAA 1997 unless otherwise indicated.

Question 1:

Summary

The Company meets the eligibility requirements of, an ESIC under, subsection 360-40(1).

Detailed reasoning

Qualifying Early Stage Innovation Company

1. Subsection 360-40(1) outlines the criteria required for a company to qualify as an Early Stage Innovation Company (ESIC) at a particular time in an income year. This time is referred to as the test time. The criteria are based on a series of tests to identify if the company is at an early stage of its development and it is developing new or significantly improved innovations to generate an economic return.

‘The early stage test’

2. 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)

3. 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).

4. 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.

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

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

6. 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)

7. 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)

8. 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

9. 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)

10. 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.

11. 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.

12. 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

13. 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…”

14. 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.

15. 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.

16. 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.

17. 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.”

18. 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.”

19. 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.

20. ‘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

21. 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

22. 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

23. 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

24. 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

25. For the purposes of this ruling, the test time for determining if The Company is a qualifying ESIC will be a particular date during the income year ending 30 June 20XX.

Current year

26. For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX (the 20XX 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 20XX, 20XX and 20XX, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year).

Early stage test

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

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

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

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

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

29. As the Company’s assessable income for the prior income year was less than $200,000, paragraph 360-40(1)(c) is satisfied.

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

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

Conclusion on early stage test

31. The Company will satisfy the early stage test for the entire 2019 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)

32. According to the Company the product goes way beyond any other product on the world stage. Although it will initially be targeted at the Australian market, the product has been identified as having a wider International addressable market.

33. Once developed the product will have brought together features that will make the Company’s product unique in the market.

34. The Company will be the first to offer the product using their innovative frame design which allows for a suite of incorporated features.

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

35. The Company has taken the following steps in developing its product:

a) Research

b) Seeking feedback on design ideas

c) Surveys

d) Customer interviews

36. The Company expects to continue to refine the product with an official launch of the product and delivery of first edition in 20XX.

37. The Company will also pursue sales through the following:

a) An online sales system

b) A website

c) Social media

d) Brand Ambassadors

e) Engaging a market professional with experience in growing market share in the target areas.

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

38. The Company is genuinely focussed on developing the product for a commercial purpose. The product will be a significantly improved product compared to existing products.

39. Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XX until 30 June 20XX or the date when the product has been fully developed, whichever occurs earliest. Once the product has been fully developed, the Company will no longer be ‘developing’ the product for commercialisation and subparagraph 360-40(1)(e)(i) will no longer be satisfied.

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

40. From the information provided the Company has demonstrated that the market for the product has high growth potential. Therefore subparagraph 360-40(1)(e)(iii) has been satisfied.

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

41. From the information provided the Company has demonstrated that it 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)

42. From the information provided the Company has demonstrated that it has the potential to address a broader market than just the local market, including international markets. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

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

43. From the information provided the Company has demonstrated that it has demonstrated the product has the necessary competitive advantages and therefore subparagraph 360-40(1)(e)(v) will be satisfied.

Conclusion on principles test

44. The Company satisfies the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20XX until 30 June 20XX or the date when the product has been fully developed and is ready for sale, whichever occurs earlier.

Conclusion

45. The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until the earlier of 30 June 20XX or the date when the product has been fully developed and is ready for sale, whichever occurs earlier.