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Edited version of private advice
Authorisation Number: 1051592607356
Date of advice: 10 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) for the year ending 30 June 2020?
Answer
Yes
This ruling applies for the following period:
Year ending 30 June 2020
The scheme commences on:
1 July 2019
Relevant facts and circumstances
The Company was incorporated in Australia during the year ended 30 June 2019. Its equity interests are not listed for quotation in the official list of any stock exchange.
The Company has no subsidiaries and had expenses of less than $1 million in the income year ended 30 June 2019. It had income of less than $200,000 in that year.
The Company is developing an application (app).
The Company has identified its ultimate market as being a global one, with its initial target being Australia.
The founders have networks to industry and years of app design experience.
The Company has submitted applications for trademarks for the app in Australia and the overseas.
The Company has highlighted a number of key differentiators which have the potential to be competitive advantages.
The app has gone through the design and prototyping phase in the past year. Developers are currently building the server frameworks.
The app is scheduled to launch in 2020.
A management company has shown interest in utilising the app developed by the Company for its clients.
Relevant legislative provisions
Income Tax Assessment Act 1997, subsection 360-40(1)
Income Tax Assessment Act 1997, paragraph 360-40(1)(a)
Income Tax Assessment Act 1997, paragraph 360-40(1)(b)
Income Tax Assessment Act 1997, paragraph 360-40(1)(c)
Income Tax Assessment Act 1997, paragraph 360-40(1)(d)
Income Tax Assessment Act 1997, paragraph 360-40(1)(e)
Income Tax Assessment Act 1997, subparagraph 360-40(1)(e)(i)
Income Tax Assessment Act 1997, subparagraph 360-40(1)(e)(ii)
Income Tax Assessment Act 1997, subparagraph 360-40(1)(e)(iii)
Income Tax Assessment Act 1997, subparagraph 360-40(1)(e)(iv)
Income Tax Assessment Act 1997, subparagraph 360-40(1)(e)(v)
Income Tax Assessment Act 1997, section 360-45
Reasons for decision
All legislative references are to the ITAA 1997 unless otherwise indicated.
Summary
The Company meets the eligibility requirements of an Early Stage Innovation Company (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 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 if 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).
A company that does not meet any of these conditions will not qualify as an ESIC.
Incorporation or Registration
To meet the requirement in paragraph 360-40(1)(a), at the test time in an income year (the current year being the income year in which the company issues shares to the investor), 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 within the last three income years (the latest being the current year).
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.
'100 point test'
To satisfy the 100 point test the company must obtain at least 100 points by meeting the innovation criteria in the table within section 360-45. The criteria are tested at a time immediately after the relevant shares are issued. If a company satisfies this test it does not need to satisfy 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 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;
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
For the purposes of Subdivision 360-A, the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (the EM) states 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.
Paragraph 1.79 of the EM explains that the innovation being developed by the company must either be new or significantly improved for the 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.
Paragraph 1.80 of the EM clarifies that merely 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 improvements.
Paragraph 1.81 of the EM states that the company must be genuinely focused on developing the innovation for a commercial purpose; 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
Paragraph 1.82 of the EM explains that the company must be able to demonstrate that it has the potential for high growth within a broad addressable market. Companies that service a single local market are unlikely to demonstrate high growth potential.
Scalability
Paragraph 1.83 of the EM clarifies that the company must be able to demonstrate that it has the potential to successfully scale its business - the company must have operating leverage, where existing revenues can be multiplied through incurring a reduced or minimal increase in operating costs.
Broader than local market
Paragraph 1.84 of the EM explains that the company must be able to demonstrate potential to address a market that is beyond its immediate 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 can be adapted to a national, multinational or global scale in the future.
Competitive advantages
Paragraph 1.85 of the EM explains that 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. Competitive advantage can be evaluated through the measures of the level of value for customers, rarity, imitability and substitutability of the advantage.
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 during the income year ending 30 June 2020.
Current year
For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2020.
Early stage test
For the year ending 30 June 2020, the Company satisfies the requirements in paragraphs 360-40(1)(a) to (d) because:
- It was incorporated within the last 3 income years;
- It had expenses of less than $1 million in the prior income year;
- It's income for the prior income year was less than $200,000; and
- It is privately owned and is not listed on any stock exchange in Australia or a foreign country.
100 point test
For the year ending 30 June 2020, the Company has not provided any evidence to satisfy the 100 point test under paragraph 360-40(1)(e). Therefore, the Company will need to satisfy the principles-based test.
Principles-based test
Developing new or significantly improved innovations for commercialisation
According to the Company, the app will be an improved innovation in the market.
Although it will initially be targeted at the Australian market, the app has been identified as having a wider global addressable market.
Genuinely focussed on developing for commercialisation
The Company has taken the following steps in developing the app:
· Conducted market research and developing a project schedule.
· Incurred costs of designing and developing the app.
· Worked with management companies to ensure there are active users when the app launches.
The project schedule provides that the Company expects the app to launch in 2020.
The Company is genuinely focussed on developing the app for a commercial purpose. The app will be a new and significantly improved product compared to existing products.
Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 2019 until 30 June 2020 or the date when the app has been fully developed, whichever occurs earliest. Once the app 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
The Company is a first mover with the app they are developing.
The Company can address a global market given the app is an online platform.
Discussions with management companies are already underway to ensure there are active users at launch.
The management companies allow access to larger markets than Australia which demonstrates the Company's potential to significantly increase its economic value by broadening its customer base around the world.
Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied.
Scalability
The Company's financial projections illustrate the increase in projected revenue.
Given that the app should be available domestically and eventually globally, it is expected that the app has the potential to successfully scale up its business.
The app should be able to generate increased revenue once the initial costs to get the app up and running have been undertaken. As the app is online based, being available in multiple markets does not necessarily mean significant physical presences are required in those markets. As such its operating costs are not expected to increase significantly after the app has launched. This operating leverage affords the Company potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied.
Broader than local market
The app 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 market.
The Company has demonstrated the app 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
The app has a number of key differentiators which have the potential to be competitive advantages. Most significantly, the Company is a first mover with the app they are developing.
The Company has demonstrated the potential for the app to have competitive advantages, thereby satisfying subparagraph 360-40(1)(e)(v).
Conclusion on principles-based test
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 2019 until 30 June 2020, or the date when the app 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 period commencing 1 July 2019 until the earlier of 30 June 2020, or the date when the app has been fully developed and is ready for sale, whichever occurs first.