Edited version of private advice

Authorisation Number: 1051595053530

Date of advice: 17 October 2019

Ruling

Subject: Early stage innovation company eligibility

Question

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

Answer

Yes

This ruling applies for the following periods

1 July 20XX to 30 June 20YY

The Scheme commences on

1 July 20XX

Relevant Facts and Circumstances

Background

Company A (the "Company") is a proprietary company incorporated in Australia on XX/XX/20XX.

The Company director is Mr X.

The Company has no subsidiaries.

The Company has incurred less than $1 million in total expenses in the 20XX financial year.

The Company has less than $200,000 assessable income for the 20XX financial year.

The Company's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.

The Company issued shares to investors on 30 June 20YY.

Description of the Company's business premise

The Company is designing and developing a product (the "Product").

The Product has a number of competitive advantages over competitors due to its differentiating features.

There a number of steps which are required to be completed into the future before the Product is considered to be fully developed for commercialisation. The Company estimates that product features requiring further development and testing should be completed in 20ZZ.

Information provided

You have provided a number of documents containing detailed information in relation to the Company's Product, including:

a.      Private Binding Ruling Application (the "Application"), dated XX/XX/20XX.

b.      Response to further questions and further information provided.

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 360-15

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 section 360-45

Reasons for Decision

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

Summary

The Company meets the eligibility requirements of an ESIC pursuant to 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 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'

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)

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).

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 - paragraph 360-40(1)(b)

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)

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)

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' - Paragraph 360-40(1)(E) and section 360-45

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' - Subparagraphs 360-40(1)(e)(i) to (iv)

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 focussed on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods

          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

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..."

The innovation being developed by the company must either be new or significantly improved for an applicable addressable market.[1] 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. Significant is defined in the online Macquarie Dictionary as "important; of consequence." 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, 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 focussed 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.

For a company to qualify as an ESIC under the principles based test, the company must be "genuinely focussed on developing for commercialisation" their innovation. That is, the central activities of the company must be truly concentrated on developing their innovation for a commercial purpose. '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 the business relating to the innovation has a high growth potential 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 relating to the innovation. 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.

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 upon the issue of qualifying shares on a particular date or dates on or after 1 July 20XX, and on or before 30 June 20YY. In particular, the Company issued shares to investors on 30 June 20YY and this will be a test time for this ruling.

Current year

Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending 30 June 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending 30 June 20YY, 20XX and 20WW, and the income year before the current year will be the year ending 30 June 20XX (the 20XX income year).

The 'Early Stage Test' - Paragraphs 360-40(1)(a) - (d) ITAA 1997

Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997

The Company incorporated on XX/XX/20XX, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(iii) are satisfied.

Total expenses - paragraph 360-40(1)(b) ITAA 1997

In applying the requirements of paragraph 360-40(1)(b), the Company and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20XX income year, being the income year before the current year.

The Company has incurred total expenses of less than $1 million in the 20XX income year. Consequently, paragraph 360-40(1)(b) is satisfied.

Assessable income - paragraph 360-40(1)(c) ITAA 1997

In applying the requirements of paragraph 360-40(1)(c), the Company and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20XX income year, being the income year before the current year.

The Company has less than $200,000 assessable income in the 20XX income year. Consequently, paragraph 360-40(1)(c) is satisfied.

No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997

In applying the requirements of paragraph 360-40(1)(d), the Company must not be listed on any Stock Exchange in Australia or a foreign country at the test time.

The Company is not listed on any Stock Exchange in Australia or a foreign country at the test time, so paragraph 360-40(1)(d) is satisfied.

Conclusion For Early Stage Test

Reveel Media satisfies the early stage test for the 20YY income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

The '100 Point Test' - Paragraph 360-40(1)(e) and section 360-45

The Company has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20YY. The Company are electing to seek eligibility by satisfying the Principles based Innovation test under section 360-40(1)(e)(i)-(v), in order to be issued with a Private Binding Ruling.

THE 'Principles-Based Test' - Paragraph 360-40(1)(e) ITAA 1997

Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i) ITAA 1997

In applying the requirements of subparagraph 360-40(1)(e)(i), the Company must be developing an innovation which is either new or significantly improved for an applicable addressable market.

The Company is designing and developing the Product.

The Product will be significantly improved from other available products available on the market.

The Company is genuinely focussed on developing their Product for an applicable addressable market, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 20XX to 30 June 20YY.

Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997

In applying the requirements of subparagraph 360-40(1)(e)(i), the Company must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company.

The Company has already undertaken a number of steps to develop the Product.

The Company conducted a successful working trial in XX/ 20YY.

There are a number of steps which are required to be completed into the future, before the Product is considered to be fully developed for commercialisation. The Company estimate that product features requiring further development and testing should be completed in 20ZZ.

The Company has already secured a number of clients.

Additionally, the Company has commenced presentations to a number of potential clients.

The Company is genuinely focussed on developing their Product for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 20XX to 30 June 20YY.

High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997

In applying the requirements of subparagraph 360-40(1)(e)(ii), the Company must be able to demonstrate that it has the potential for high growth within a broad addressable market.

The Company has conducted research which shows the addressable market has total value of $8.7 billion.

The Company has extremely high growth potential.

The Company has demonstrated a high growth potential for their Product, therefore subparagraph 360-40(1)(e)(ii) is satisfied for the period 1 July 20XX to 30 June 20YY.

Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997

In applying the requirements of subparagraph 360-40(1)(e)(iii), the Company must be able to demonstrate that it has the potential to successfully scale up the business.

The Product is scalable without significant growth in costs.

This leverage ensures that the Company has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period 1 July 20XX to 30 June 20YY.

Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997

In applying the requirements of subparagraph 360-40(1)(e)(iv), the Company must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets.

The Company is developing its Product to be available in any market.

The Company has had early stage discussions with various brands with an Australian and New Zealand marketing budget.

Additionally, the Company is also in discussion with a potential international client based overseas.

Therefore, the Company has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied for the period 1 July 20XX to 30 June 20YY.

Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997

In applying the requirements of subparagraph 360-40(1)(e)(v), the Company must demonstrate that it has potential to be able to have competitive advantage for that business.

While there are numerous competitors in the digital marketing industry generally, the Company has identified a number of competitive advantages that the Product has over competitors due to its differentiating features.

In trials, the Company has achieved results that 10-15 times that of its competitors.

The Company has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period 1 July 20XX to 30 June 20YY.

Conclusion for Principles Based Test

The Company satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period 1 July 20XX to 30 June 20YY.

Conclusion

The Company meets the eligibility criteria of an ESIC under section 360-40 for the period 1 July 20XX to 30 June 20YY.

[1] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.79.