Edited version of private advice

Authorisation Number: 1051530098217

Date of advice: 13 June 2019

Ruling

Subject: Early Stage Innovation Company qualification

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 in the 20XX income year. Its equity interests are not listed for quotation in the official list of any stock exchange.

2.            The Company has subsidiaries and has expenses of less than $1 million in the previous income year, i.e. the year ended 30 June 20XX. The Group has assessable income of less than $200,000.

3.            The Company's goal is to provide IT software.

4.            Market position:

            a. The Company states that there are no direct competitors to the IT software currently in the market.

5.            Expertise of Founders and any Intellectual Property rights (i.e. ownership or licence):

             a. The Company has founders who are directors of the company.

             b. The Company has an experienced team.

             c. The Company owns the Intellectual Property rights.

6.            In addition to the above, you have highlighted the key differentiators as being:

            a. The IT software.

7.            The Company has identified its addressable market as industries in Australia.

Commercialisation strategy

8.            The Company has developed a business plan.

9.            The Company's commercialisation strategy starts from the development stage.

10.         The Company is initially targeting the Australian market. They will pursue product sales.

11.         Market segments have been identified as initial targets and the Company has identified specific potential customers.

Information provided

12.         You have provided information in a number of documents and phone conversations in relation to the IT software, including:

            a. your private ruling application.

            b. our phone conversations

            c. supplementary information.

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

14.         You propose to issue new shares in The Company to various investors to assist in funding the continued development and commercialisation of IT software.

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 does meet the eligibility requirements of an ESIC under subsection 360-40(1).

Detailed reasoning

Qualifying Early Stage Innovation Company

15.         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'

16.         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)

17.         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).

18.         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.

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

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

20.         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)

21.         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)

22.         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

23.         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)

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

27.         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..."

28.         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.

29.         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.

30.         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.

31.         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."

32.         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."

33.         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.

34.         '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

35.         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

36.         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

37.         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

38.         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

39.         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 2019.

Current year

40.         For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2019 (the 2019 income year).

Early stage test

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

41.         As The Company was incorporated in the 20XX income year, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied.

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

42.         As The Company had expenses of less than $1 million in the prior income year (the 20XX income year) paragraph 360-40(1)(b) is satisfied.

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

43.         As The Company's assessable income in the prior income year (the 20XX income year) is $200,000 or less paragraph 360-40(1)(c) is satisfied.

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

44.         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

45.         The Company will satisfy the early stage test for the entire 20XX 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)

46.         According to the Company, the IT software is the first holistic product. Although it will initially be targeted at the Australian market, the IT software has been identified as having a wider international addressable market.

47.         The IT software will be the first to offer such a product.

48.         The Company states that there are no direct competitors to the IT software currently in the market.

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

49.         The Company has taken the following steps in developing IT software.

a.            The Company has developed a business plan.

50.         The Company will develop contracts and potential customers to increase direct sales.

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

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

52.         Therefore subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 2018 until 30 June 2019 or the date when IT software has been fully developed, whichever occurs earliest. Once IT software 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)

53.         The Company expects the IT software to appeal to a wide range of businesses. This aids decision making and is particularly useful when assessing product or service viability in particular markets.

54.         Through its commercialisation strategy, The Company hopes to foster widespread use of its product.

55.         The Company is developing IT software.

56.         If the commercialisation strategy is successful, this may give The Company the ability to increase sales through referrals and online.

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

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

58.         The IT software's projections / business model provided illustrates the increase in projected sales.

59.         Given that IT software will be available domestically, it is expected that IT software has the potential to successfully scale up its business.

60.         The Company's strategy for the use of the IT software will be able to generate increased revenue. This operating leverage affords The Company 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)

61.         The Company's IT software will initially be targeted at the Australian market but is intended for worldwide use. It will be released globally once it gains traction in the initial targeted markets.

62.         The IT software can be used domestically by any user. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region.

63.         The Company has demonstrated the IT software 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)

64.         The IT software has differentiating features which may give it a competitive advantage.

65.         Being the first of such The Company's IT software has the first mover advantage. The Company has demonstrated the potential for the IT software to have competitive advantages within the 'addressable market' satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

66.         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 IT software has been fully developed and is ready for sale, whichever occurs earlier.

Conclusion

67.         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 IT software has been fully developed and is ready for sale, whichever occurs earlier.