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Edited version of private advice
Authorisation Number: 1051588464958
Date of advice: 3 October 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 periods:
Year ending 30 June 2020
The scheme commences on:
1 July 2019
Relevant facts and circumstances
The Company was incorporated in Australia within the last three years.
· The previous income year was the Company's first year of operation
· The Company's equity interests are not listed for quotation in the official list of any stock exchange
· The Company has no subsidiaries
· The Company has incurred expenses of less than $1 million in the previous income year
· The Company has generated less than $200,000 of assessable income in the previous income year.
The Company is developing a solution for management of visual data, and allows users to view and manipulate data in efficient and intuitive ways.
The Company has identified that their target market is expanding rapidly and disrupting traditional methods of managing visual data.
The Company's goal is to market their solution to customers, which will allow them to view and manipulate composite visual data. The Company has identified a market segment that their product will appeal to.
At this time the Company have a viable product offered to customers on a subscription basis. Customers load their data via the Company's online portal, and the data is converted by into a user friendly visual model.
The online portal includes several tools to assist with analysis of data.
· Ability to compare data over a timeline to track changes
· Ability to make annotations and notes
· Ability to share information and allocate tasks to allow for collaborative working methods.
The Company has two ongoing innovation projects that will work together in the future to improve the features of the online portal.
Project 1 - Continued program of work for the Company's online portal.
Although the online portal is a viable product the Company has an ongoing program of work. Many of these innovations are completely new to the marketplace.
Project 2 - Development of supporting software.
The Company is developing software to support data collection methods to assist with their process, and will allow collection of high quality data.
Commercialisation
The further development of the Company's online platform and supporting software will have immediate commercial applications.
The addressable market for the Company's online platform is estimated as in the billions.
The replacement of traditional working methods with updated data collection is expected to result in savings of up to 50% for customers. This makes this process a very attractive option for customers.
The Company has forecast that projected revenue in the current income year will exceed $X million based on subscriptions to the online portal, and this is expected to further increase in future years as further innovations are introduced to the online portal.
As the Company's product is intangible, the Company's activities are very scalable as once fixed costs are met further sales will generate revenue without substantial further costs.
As the Company's product is subscription based and accessed through an online portal its customer base could be located anywhere in the world. The Company's online portal and website is currently live, and the Company will commence a partner program to generate wholesale sales.
The Company has identified that there are no similar options to their online platform available at either the local, national, or global level.
The Company is the owner of the intellectual property associated with their online portal. The Company believes that the particular feature set they offer would be difficult to copy, and provides them with a competitive advantage.
Information provided
The Company have provided information in a number of documents and phone conversations in relation to their innovations, including:
· private ruling application
· supplementary information provided
· The Company's website.
We have referred to the relevant information within these documents in applying the relevant tests to your circumstances.
The Company has fielded interest from a number of interested sophisticated investors in purchasing issued shares. The Company proposes to issue new shares to various investors to assist in funding the continued development and commercialisation of the Company's online platform and software projects.
Assumption(s)
N/A
Relevant legislative provisions
Income Tax Assessment Act 1997 Subdivision 360-A
Income Tax Assessment Act 1997 section 360-40
Income Tax Assessment Act 1997 section 360-45
Further issues for you to consider
N/A
Reasons for decision
All legislative references are to the ITAA 1997 unless otherwise indicated.
Summary
The Company meets the eligibility requirements of an ESIC under subsection 360-40(1).
Detailed reasoning
Qualifying Early Stage Innovation Company
Subsection 360-40(1) outlines the criteria required for a company to qualify as 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 requirements are outlined in detail within paragraphs 360-40(1)(a) to (d).
Incorporation or Registration
To meet the requirement in paragraph 360-40(1)(a), at the test time in 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.
A company that does not meet any of these conditions will not qualify as an ESIC.
Total expenses
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
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
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.
Principles-based test
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 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:
- the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation
- the business relating to that innovation must have a high growth potential
- the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation
- 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
- 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
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...'[1]
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.
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 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.[2]
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.'
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'.
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.
High growth potential
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
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
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
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 during the specified income year.
Current year
For the purposes of subsection 360-40(1), the current year will be the specified income year. For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years will include the years three years prior to the specified income year.
Early stage test
Incorporation or Registration
As the Company was incorporated within the last three last three income years, subparagraph 360-40(1)(a)(i) is satisfied.
Total expenses
As the Company had expenses of less than $1 million in the prior income year, paragraph 360-40(1)(b) is satisfied.
Assessable income
As the Company's assessable income for the prior income year is less than $200,000 paragraph 360-40(1)(c) is satisfied.
No stock exchange listing
As the Company 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
The Company will satisfy the early stage test for the entire specified 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
It is considered that the Company's development of their two projects meet the definition of ongoing innovation as outlined in the OECD Oslo Manual. Their online platform will offer a feature set not currently available to the identified target market.
Genuinely focussed on developing for commercialisation
The Company have identified their addressable market. An independent assessment on the value of this addressable market is considered to be significant.
The innovations the Company will introduce will provide significant improvements on the traditional methods of data management, and add innovative features to the management of that data. Feedback has been received from potential customers in the offshore that the Company's online platform will offer desirable features and generate a customer base.
Conclusion on subparagraph 360-40(1)(e)(i)
The Company is genuinely focussed on developing its online platform managing data. The future developments will offer features and quality not currently available from other organisations. The developments are for a commercial purpose, and go beyond minor changes such as software updates.
Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for specified income year, or the date when the products become fully developed, whichever occurs earliest. Once the products have 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
The Company expects the online platform and data collection software to appeal to a wide range of businesses in their identified target market. The process will aid customers in their decision making and future planning.
As the Company's product will be available via an online platform its appeal and use is unrestricted by geography, and will be available to customers globally.
The appeal of the Company's online platform is expected to increase over time as subsequent data sets uploaded to the platform will provide further utility to customers.
Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied.
Scalability
The Company's business model is saleable as once their fixed costs are met, additional subscriptions will result in increasing profits as each sale will decrease the cost of goods sold per unit.
Given that the Company's online platform will be available both domestically and globally, it is expected that 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
The Company's online platform will be available to the Australian market, however it is expected that the bulk of customers will be located outside of Australia.
The Company's online platform can be used by any business in any location worldwide. The Company's addressable market is on a global scale and is not confined to a local city, area or region.
The Company have demonstrated that their online platform has the potential to address a broader market than just the local market, and includes international markets. Therefore subparagraph 360-40(1)(e)(iv) will be satisfied.
Competitive advantage
The Company will have a competitive advantage over competitors in the market place as their online portal will be targeted specifically at their target market and will offer a unique feature set, as well as the further support through the development of data collection software. The Company also own the intellectual property associated with their online platform and have stated that their feature set would be hard to duplicate.
The Company's subscription model and product feature set provide enhanced utility with repeated use. This will encourage customers to be less likely to change business to a competitor.
The Company's online portal will include differentiating features which will offer a competitive advantage.
The Company has demonstrated that their innovations will provide a competitive advantage. Therefore subparagraph 360-40(1)(e)(v) will be satisfied.
Conclusion on principles test
The Company satisfies the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the specified income year, or the date when the Company's online platform and data collection software has been fully developed and is ready for sale, whichever occurs earlier.
Conclusion
The Company meets the eligibility criteria of an ESIC under section 360-40 for the specified income year, or the date when their innovation projects have been fully developed and is available for use by customers, whichever occurs earlier.
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[1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76.
[2]OECD/Eurostat (2018), Oslo Manual 2018: Guidelines for Collecting, Reporting and Using Data on Innovation, 4th Edition, The Measurement of Scientific, Technological and Innovation Activities, OECD Publishing, Paris/Eurostat, Luxembourg, https://doi.org/10.1787/9789264304604-en, paragraph 124 and paragraph 151.